How Mutual Funds work – how MFs work?
All about mutual funds in India
Mutual Funds are popular investment instruments for indirect investment in different types of assets in India and offshore. This has empowered the investors by giving them the facility to invest in assets which were mainly used by rich. In Mutual Funds investors can professionally invest in different categories of assets like Fixed Income, Shares, Gold, Real Estate, etc.
Basic Concept of Mutual Fund Schemes
AMC – Asset management companies – are known as Mutual Fund companies which manage schemes. There are number of schemes managed by a single company, on the basis of investment objective and risk category; investors select their suitable scheme. Many investors come together to make a pool that is scheme or fund. Every scheme has a fund manager who is professionally qualified and experienced to invest and manage the amount of the particular scheme. Initially when AMC launches a new scheme through New Fund Offer – NFO it defines the objective of the scheme like – capital appreciation equity in long term from shares or bonds in India or abroad, at this time subscriptions are taken at Rs. 10 per unit and generally the minimum amount of subscription is Rs. 5000/- (Five thousand). So if you invest Rs. 5000 you get 500 units at the price of Rs. 10 known as NAV – Net Asset Value. This initial subscription is open for a specified period only. On the day of listing or opening for regular subscription at market NAV people can buy or sell units at current NAV depending on market valuation of assets in the scheme.
By investing into Mutual funds the investor gets units of the scheme and they can sell the units at current price – NAV. The value of investment can be calculated by multiplying the nav with number of units. If you have Rs. 10 in a unit this Rs. 10 is invested in shares or bonds of different companies, in this manner your money is not invested in single company. So you can take advantage of diversification in Mutual Funds with small amount.
NAV – Net Asset Value
NAV is calculated on daily basis from Monday to Friday, except holidays. It is calculated by dividing entire value of assets by the number of units subscribed in the scheme. Formulae for NAV
NAV = (Value of assets + Dividends + Amount Receivable by the scheme – Expenses – Dues)/ No. Of Units
Asset Management Companies update NAV by 8 pm on AMFi site from Monday to Friday.
MFs don’t give you guarantee of a single rupee on your investments, this is run on a mutual understanding or benefits. MF Schemes are managed by professional fund managers they invest funds of the scheme as per the objective and guidelines of the Fund house. They are better person to take decisions on your behalf in general. For this they charge you fund management Charges annually – adjusted in NAV on daily basis. This structure of no guarantee of returns or capital puts fund managers under pressure to perform so they can deliver better returns to their investors to remain in the business.
Regulations of Mutual Funds
Mutual Funds are regulated by Securities Exchange Board of India (SEBI). SEBI has issued the best practices so that the investor is not cheated. No one can take your investment from you by converting the units in his or her name.
All AMCs are member of Association of Mutual Funds in India (AMFI), AMFI issues guidelines for intermediaries and best practices from time to time for the interest of all the stake holders.
Risks in investment through Mutual Funds
Any investment has the risk of lower returns or capital loss, the investments are made for a few primary purpose
Liquidity is very high in Mutual Funds, you can get your money back in your account in 1 day from Bond Funds and 3 days from Equity Funds by selling the units of the scheme. So liquidity is very high and your money is safe under the scanner of SEBI. As far as Investment Risk is concerned it depends on asset type you have chosen for investment as underlying asset in your particular scheme. Like Equity – Shares, Bonds, Liquid Funds. Every asset class has different investment cycle and its own risks, all the asset class have investment risk, equity can be volatile which may increase your blood pressure level, in bonds there can be the risk of default and it can be volatile because of change in current interest rates in market, although equity is more volatile than the equity is. So to make optimum returns you should match your objectives with the right asset class and MF Scheme. Depending upon your investment horizon and goal you can choose the better scheme. Suggested time duration for schemes
|Fund Type||Holding Period|
|Liquid Funds||1 day to 90 days|
|Short Term (Bond) Funds||90 days to 1 year|
|Bond Funds||1 year and above|
|Monthly Income Plans||3 years and above|
|Balanced Funds||3 years and above (higher risk)|
|Equity Funds||5 years and above (High risk)|
Most of the time returns on mutual fund have been better, fund managers have given good returns to the investors. This is the primary reason for Mutual Funds became popular.
Market Risk of Mutual Funds
You must have heard or seen this before, what is market risk? This is the risk which can not be avoided if you are invested, there can be heavy pessimism in the market because of any political, economic crisis or news or wars, in this kind of situation your valuable assets may not be valued properly. This risk is difficult to diversify.
Types of Mutual Fund Schemes in India
Broadly there are two types of asset classes managed in the schemes, Bonds and Equity or Shares.
In these schemes the funds are invested in money market instruments only, these are very less volatile and these can be used for parking funds.
In these funds the money is invested in securities which will give fixed interest to the holder of the bonds. These are less volatile and depending on time horizon of investment from 1 day to 10 years, you can choose a scheme. There are different types of Bond Funds or Debt Funds
Monthly Income Plans – MIP (Hybrid – Debt oriented)
These funds are mix of Bond/Debt funds and Equity funds. In general they have debt and equity proportion of 70:30. These have taxation of debt funds, returns from these funds will attract taxation. These funds give you better returns than fixed deposits, but these have the exposure of equity which makes them volatile. People looking for regular income may consider these carefully.
Balanced Funds (Hybrid – Equity oriented)
Contrary to the name of “Balanced Funds” these are equity oriented hybrid funds with equity and debt in the ratio of 70:30, this make them more focused towards equity so these become more volatile and should be seen very very carefully as these are not actually balanced. Historically these were as volatile as equity funds.
Diversified Equity Funds
Assets of these funds are invested mainly in the shares of different companies, these are more volatile and investors with low level of risk tolerance should avoid these funds, although historically it has been seen that equity has outperformed all the other asset classes if held for longer time period. Moreover it diversifies risk by investing you money in diversified sectors and companies. These funds can further be divided into several categories of Equity Funds.
In Sector Funds the investment is done in one or some focused sectors or industry to take advantage of the growth of the particular sector. At the same time it attracts more risk related to the particular industry or sector, which can not be diversified as it is done in Diversified funds. Investment in these funds require more research and the investment horizon should be higher like 5 years or more.
ELSS – Equity Linked Savings Scheme – Tax Saving MF Schemes
Primarily these funds invest funds in diversified equity, these schemes have compulsory lock in period of 3 years, these are one of most efficient tax saving instruments in India.
Options of Mutual Fund Schemes
There are primarily two options in MF schemes Growth and Dividend. The people who want accumulation and want returns with the capital amount invested should opt for Growth option. If a person has invested for 5 years the investor will get the returns at the time of redemption by selling the units at nav on the day of redemption. Where as Dividend option gives you periodic returns when the scheme declares dividend, although the nav of the scheme falls by the dividend distributed, if nav of scheme is Rs. 15 and fund gives 10% dividend on face value of Rs. 10, the dividend is Rs. 1 on the date of dividend to be distributed the nav will fall to Rs. 14. In these options a kind of profit booking is there for the people who invest in equity funds. People who need periodic returns may choose dividend option with sub option of Dividend Payout.
Direct Vs. Regular Plan
SEBI has given a wonderful gift to investors by empowering investors who wish to invest directly with mutual fund companies without intermediary. Direct plans have approximately lower expense ratio of 1% yearly. Investment through intermediary goes in Regular Plan. If possible one should invest in Direct Plans with the help of skilled and efficient advisors.
Taxation of Mutual funds in India
Investments in Mutual Funds are subject to Capital Gains Tax. On the basis of tax treatment these can be divided into two sections Equity Taxation and Debt Taxation.
Taxation of Equity MFs
Depending upon the time horizon of investment there are two types of capital gains – Long Term and Short Term.
Long Term Capital Gains from Equity Mutual Funds
If the units are held for the period of more than a year the investment is considered as long Term and the gains are subject to Long Term Capital Gains. At present there is no tax on these gains.
Short Term Capital Gains from Equity Mutual Funds
If the units are sold before completion of 1 year, any gain from the investment is considered as short term and gains are taxed at flat 15% subject to other conditions of Income Tax
Taxation of Debt MFs
Like equity funds here also the taxation depends on the period of investment. If the units are sold before 3 years the gain is Short Term and beyond 3 years the gains are long term in nature.
Long Term Capital Gains from Debt Mutual Funds
At present the long term gains from debt funds are taxed @ 20% after indexation. For this calculation you are allowed to account for inflation by way of calculating Indexed Cost of Acquisition with Cost Inflation Index.
Short Term Capital Gains from Debt Mutual Funds
When units of Debt Funds are sold before 3 years the absolute returns or gains are considered as income and taxed according Income Tax Slab.
By now you have got fair idea of mutual funds. In general the investment trend is shifting from fixed deposits to variable returns, now more and more people are realizing the importance of mutual funds and its benefits.