What is Mutual Fund

Mutual Fund is a vehicle to pool money from investors for the purpose of investing in securities such as stocks, bonds, money market instruments, commodities and other assets in an attempt to produce capital gains and income for the fund's investors. Mutual Funds are operated by Professional fund managers, who manage the money for the benefit of their investors in return of a management fee. A Mutual Fund's portfolio is structured and maintained to match the investment objectives stated in its prospectus. Mutual Fund is a suitable investment option for the common man as it offers an opportunity to invest in a diversified, professionally managed basket of securities at a relatively low cost.

Benefits of investing in Mutual Funds

  • Professional management : Qualified professionals with the support of a research team that continuously analyses the performance and prospects of companies manage the money.
  • Diversification : Diversification lowers the risk of loss by spreading the money across various industries and geographic regions. It is a rare occasion when all stocks decline at the same time and in the same proportion.
  • More choice : Mutual Funds offer a variety of schemes that will suit the needs of an investor over a lifetime.
  • Affordability : Mutual Funds offer investors an affordable way to diversify their investment portfolios.
  • Tax benefits : Investments held by investors for a period of 12 months or more qualify for capital gains and will be taxed accordingly. These investments also get the benefit of indexation.
  • Liquidity : In open-end funds, one can redeem all or part of his investment any time he wishes and receives the current value of the shares. Funds are more liquid than most investments in shares, deposits and bonds. Moreover, the process is standardised, making it quick and efficient so that one can get his cash in hand as soon as possible.
  • Transparency : The performance of a Mutual Fund is reviewed by various publications and rating agencies, making it easy for investors to compare fund to another. A unit holder is provided with regular updates, for example daily NAVs, as well as information on the fund's holdings and the fund manager's strategy.
  • Regulations : All Mutual Funds are required to register with SEBI (Securities Exchange Board of India). They are obliged to follow strict regulations designed to protect investors. All operations are also regularly monitored by the SEBI.

Learn more about Mutual Funds

How does a Mutual Fund Work

Our Process

Different types of Mutual Fund

Equity schemes invest primarily in stocks. Depending on the scheme objective, investments could be in:

  • Growth stocks where earnings growth is expected to be attractive.
  • Momentum stocks that go up or down in line with market.
  • Value stocks where the fund manager is of the view that current valuations in the market do not reflect intrinsic value
  • Income stocks that earn high returns through dividends

The aim of Equity Funds is to provide capital appreciation over medium to long term.

Types of Equity Funds

  1. Large Cap Funds : Large cap funds invest a larger proportion of their corpus in companies with large market capitalization. They are safe, have predictable returns, easy to understand and less volatile to market swings compared to other diversified equity funds. These funds mirror the performance of the economy and are geared to handle market cycles better as they have the size and scale to weather the long down market cycle. However, when compared to mid and small cap stock, these investments lag in providing exceptional returns in a rising market situation.
  2. Large and Mid Cap Funds : These target large and mid-capitalization companies to invest their corpus. The ratio in which the investment is diversified becomes variable as investments made are unique for each fund. These funds are generally placed on a higher risk return trade off plane in comparison with a pure large cap fund, as its target market includes both large and mid-cap funds.
  3. Mid Cap and Small Cap Funds : These funds invest in a mix of midcap and small cap companies. The lack of any standardized definition or classification of small and medium sized company gives freedom to each Mutual Fund to draw their own definitions and classifications. The general thumb rule for small companies is to have a market capitalization of up to 500 crores. When market capitalization is over 500 crores but below 1000 crores, it is defined as a medium sized company. Due to their exposure in high beta stocks, they have a high risk return trade-off compared to a large cap fund. Investment in Mid-Cap Funds should have long term perspective.
  4. Multi Cap Funds : Portfolio of multi cap funds comprises large cap, mid cap and small cap stock. These diversified Mutual Funds are thus in a position to invest in all stocks across market capitalization. This makes multi cap funds less risky when compared with pure mid cap or small cap funds and therefore are looked upon with favour by investors who are not looking for very aggressive investment options.
  5. Sectorial Funds : As the name suggests sectorial funds invest in a specific sector or industry viz. energy or utilities. These funds are diverse and variable with respect to market capitalization, investment objectives (i.e growth and/ or income) and class of securities within any portfolio. These funds cannot be singularly categorized like a large or mid cap fund and are deemed considerably risky as their entire execution depends on the performance of the only sector in which they have been invested. Lack of diversity to fall back on makes this plan suitable for aggressive investors only.
  6. Thematic Funds : A thematic fund is one where the fund’s objective is to deliver optimal returns by investing in stocks which qualify to belong within the particular theme that is considered. For example, themes may range from Multi-Sector, International/ Multi Economy, Commodity, particular style of investing etc. Theme based funds are often mistaken to be sector funds. Yet unlike a sector fund, theme funds have a broader spectrum to operate in. Thematic funds are also dependent on the performance of a particular set of sectors all belonging to the same nature. Thus lacking the diversity and support of a broader market, they are volatile and prone to risk. This sort of investment is preferred by seasoned investors who are well aware of the market trends and are adept in making speculations.
  7. Index Funds : Index funds are designed to match the performance of a market index which it tracks (e.g. BSE, NSE). It is generally done by maintaining an investment portfolio that replicates the composition of the chosen index. Thus the stocks and their weightage in the portfolio would be same as that of the chosen market index. This replicating style of investment is called passive investing. Characteristics of an index Mutual Fund are broad market exposure, low operating expense and a low portfolio turnover. It would be erroneous to assume that the performance of index funds match the performance of the actual index. There may be two factors responsible for this. A) The management fees charged becomes a liability on the returns. B) Weightage given by the funds for particular securities may not be exact with the weightage of the securities in the actual index. The marginal difference that exists is termed as tracking error.
  8. Equity-linked savings scheme (ELSS) : ELSS is open-ended, diversified equity scheme. They offer tax benefits up to Rs.150000 under Section 80C of Income Tax Act 1961. There is 3 years lock-in period.

Risk of investing in Equity Mutual Funds

  1. Market Risk : At times the prices of all the securities in a particular market rise or fall due to broad outside influences affecting stock prices. This change in price is due to "market risk".
  2. Investment Risks : NAV of Sectorial schemes are linked to the equity performance of such companies and may be more volatile than a more diversified portfolio of equities.
  3. Liquidity Risk : Thinly traded securities carry the risk of not being easily saleable at or near their real values.
  4. Changes in the Government Policy : Policy changes, especially in regard to the tax benefits may impact the business prospects of the companies leading to an impact on the investments made by the fund.

Various options or plans in Mutual Funds

  • Growth Option : In this plan the investor realizes only the capital appreciation on the investment (by an increase in NAV).
  • Dividend Payout Option : In this plan dividends are paid-out to investors. However, the NAV of the scheme falls to the extent of dividend payout. This plan provides a regular income to the investor.
  • Dividend Re-investment Plan : In this plan dividends are declared but re-invested in the same scheme by purchasing additional units.

Different methods of investment in Mutual Funds

  • Lump sum Investment : In case of lump sum investing, the investor has money in hand which can be invested entirely at one go.
  • Systematic Investment Plan (SIP) : SIP is a disciplined way of investing where investors invest a fixed amount of money on regular intervals. The frequency of investment is usually weekly, monthly or quarterly. SIP provides an investor the benefits of Rupee Cost Averaging as he gets more units when the price is low and fewer units when the price is high. As a result, in the long run the average cost per unit is supposed to be lower. SIPs are the best form of controlled investment. They provide option to the investor to increase or decrease the invested amount or even to quit the plan as per their convenience. This is a common choice for retail investors who have a resource constraint to pursue active investment.
  • Systematic Transfer Plan (STP) : A systematic transfer plan is a disciplined way of shifting part of investors' current investments into other schemes, thus providing diversification. STP is one of the best risk mitigation strategies of the market. Systematic Transfer Plan is of two types:
    • Fixed STP : A fixed STP is where investors take out a fixed sum from one investment to another.
    • Capital appreciation STP : A capital appreciation STP is where investors take the profit part out of one investment and invest in the other.
  • Systematic Withdrawal Plan (SWP) : In a Systematic Withdrawal Plan (SWP) the investor has the freedom to withdraw money at predetermined intervals from his/ her existing Mutual Fund. The funds thus withdrawn may be opted for reinvestment in other funds, or may be used as per the investor’s convenience. Systematic withdrawal plans are used by investors to create a regular flow of income from their investments. SWP is available in two options:
    • Fixed Withdrawal : Where you specify amounts you wish to withdraw from your investment on a monthly/quarterly basis.
    • Appreciation Withdrawal : Where you can withdraw your appreciated amount on a monthly/quarterly basis.

Investor categories eligible to invest in Mutual Funds

  • Resident Individuals
  • Indian Companies
  • Indian trusts and charitable institutions
  • Banks
  • Non-banking Financial Companies (NBFC)
  • Insurance companies
  • Provident funds
  • Non-resident Indians (NRI)
  • Overseas Corporate Bodies (OCB)
  • SEBI registered FII’s

What is net assets value (NAV) of Mutual Funds

The NAV indicates the intrinsic worth of a scheme on a given date. NAV per unit represent the worth of each unit that investors hold.


Net Assets Value = Market Value of Investments + Current Assets and Other Assets + Accrued Income - Current Liabilities and Other Liabilities - Accrued Expenses

Example

Total Value of Securities(Equity, Bonds, Debentures etc.) INR 1,000
Cash INR 1,500
Liabilities INR 500
Total outstanding units 100
NAV = [(1000+1500-500)/100] INR 20 per unit

Different risk and return measures that are used to evaluate Mutual Fund schemes

  • Standard Deviation: Standard deviation is a statistical measure that is used to quantify the amount of variation or dispersion of a set of data from its mean. When SD is close to 0, it means that the data points are close to the mean, whereas when points are dispersed over a large range of value it indicates a high SD. Standard deviation is calculated as the square root of variance and is also known as historical volatility. Investors generally use the Standard Deviation method to meter the expected volatility of the market. For example, a volatile stock will have a high standard deviation while the deviation of a stable blue chip stock will be lower.
  • Sharpe Ratio: It is used to measure the risk-adjusted performance of a portfolio. The Sharpe ratio is calculated by subtracting the risk-free rate from the rate of return for a portfolio and dividing the result by the standard deviation of the portfolio returns. Sharpe ratio is used to gauge the influencing factors of a portfolio’s return i.e whether the returns were specifically a result of smart investment decisions or excess risk. A good risk adjusted performance is visible through a greater Sharpe ratio in a portfolio, whereas a negative Sharpe Ratio suggests that a risk-less asset would be better suited than the security being analysed.
  • Alpha Alpha is a performance evaluator on the basis of risk adjustment by taking a Mutual Fund’s fluctuation and comparing its risk adjusted performance to a benchmark index. The Alpha is the excess return that the fund has, in relation to the return of the benchmark index. When the fund’s performance surpasses its benchmark index by 1%, it indicates a positive alpha. On the other hand a negative alpha is when the figure remains below the 1% mark.
  • Beta It checks the degree of volatility or systematic risk of a given portfolio on the canvas of the market as a whole. When the security price moves with the market the beta remains at a neutral 1. Scoring below 1 means that security price oscillates less than the market, and beta over 1 means that the security's price will be more volatile than the market.

Costs involved in Mutual Fund investing

  • Total Expense Ratio (TER): Investors, in order to get professional assistance on certain areas of fund management seek the service of Asset Management Companies (AMCs). In lieu of their services, the AMCs charge the investors for not only professional fund management, but also some regular operational cost viz. advisory fees and fees for investment management, sales/ agent commissions and ongoing service fees, legal and audit fees, registrar and transfer fees, fund administration expenses and marketing and selling expenses. The entire gamut of these fees borne by the investor comes under the heading of “Total Expense Ratio” (TER) which is actually an annual charge on AUM expressed in percentage. As per SEBI’s guidelines, TER and AUM share a inversely proportional relation, i.e TER needs to be lower as AUM increases. The net of all liabilities, inclusive of TER comes under the corpus of the NAV of a Mutual Fund scheme. As per a recent circular by SEBI, service tax, which as earlier paid by AMCs now comes under the purview of “cost to investors”.

    Note: Recently SEBI has allowed AMCs to charge an additional 30bps in TER on the condition that the new inflows from beyond top 15 cities are at least 30% of gross new inflows in the schemes or 15% of the schemes AUM (year-to-date), whichever is higher. In other words, TER may go up to 2.8% instead of 2.5% for equity schemes. However, the additional TER will be clawed back if inflows beyond top 15 cities are redeemed within a period of 1 year from the date of investment.

  • Exit Load: Mutual Funds allow an investor to redeem/ sell his units prior to the maturity of the scheme. However, this can be done only when a charge is paid for the same. This charge or Exit Load is leveed basically to discourage the investor from leaving the scheme before a substantially long time period. Exit loads are charged by various categories based on predefined holding period cut offs. If the holding period is already short, as in case of liquid funds, exit load is not charged from investors. However, for most other categories, the exit load varies from 1%-3% as per the exit time frame specified for the funds.
  • Transaction Charges: As per SEBI guidelines w.e.f August 2011 AMCs have been authorized to collect a nominal one-time amount as transaction fee. For a first time investor, the fee is INR 150 for an investment amount exceeding INR 10000. For SIPs where the total fund value involved is greater than INR 10000 the transaction charge is INR 100 to be paid in four equal instalments spanning the time from the second to the fifth instalment.

Do all Mutual Funds have the same structure for expense ratio

Expense ratios differ from one fund to the other. Actively managed funds have a higher expense ratio when compared to passively managed funds like index funds or ETFs. SEBI recently petitioned that Mutual Funds could launch schemes under a single plan to facilitate new investors to be subject to a single expense structure. SEBI also requested that MFs should provide a separate plan option for direct investment (i.e investments will not be routed through any distributor) in all of their schemes- existing, as well as new. These separate plans will have an USP of a lower expense ratio eliminating the distribution expenses. Moreover, these plans shall be free from payment of commissions.

Tax Reckoner for financial year 2015-16

Individual / HUF Domestic Company NRI
Capital Gain Taxation
Long Term***
Equity Schemes (Listed) Nil Nil Nil
Equity Schemes (unlisted, exit by way of redemption of units) Nil Nil Nil
Debt Scheme(Listed) 20% with indexation + 12% surcharge** + 3% cess = 23.0720% 20% with indexation + 12% surcharge** + 3% cess = 23.0720% 20% with indexation + 12% surcharge** + 3% cess = 23.0720%
Debt Scheme(Unlisted) 20% with indexation + 12% surcharge** + 3% cess = 23.0720% 20% with indexation + 12% surcharge** + 3% cess = 23.0720% 10% without indexation + 12% surcharge*8 + 3% cess = 11.5360%
Short Term***
Equity schemes(if equity schemes are unlisted, exit is by way of redemption of units) 15% + 12% surcharge** + 3% cess = 17.3040% 15% + 12% surcharge* + 3% cess = 17.3040% 15% + 12% surcharge** + 3% cess = 17.3040%
Debt Schemes As per slab rates + 12% surcharge** + 3% cess 30% +12% surcharge* + 3% cess As per slab rates + 12% surcharge** + 3% cess
DIVIDENT DISTRIBUTION TAX****
Equity Schemes Nil Nil Nil
Debt Scheme 25% + 12% surcharge+ 3% cess 25% + 12% surcharge+ 3% cess 25% + 12% surcharge+ 3% cess

Tax Deduction at Source (Applicable to NRI Investors)

Short Term Capital Gain Long Term Capital Gain
Equity Oriented Schemes(Listed) 15% + 12% surcharge** + 3% cess = 17.3040% Nil
Equity oriented Schemes(unlisted, exit by way of redemption of units) 15% + 12% surcharge** + 3% cess = 17.3040% Nil
Other than equity oriented Schemes (Listed) 30% + 12% surcharge** + 3% cess = 34.6080% 20% with indexation + 12% surcharge** + 3% cess = 23.0720%
Other than equity oriented schemes (Unlisted) 30% + 12% surcharge** + 3% cess = 34.6080% 10% without indexation + 12% surcharge** + 3% cess = 11.5360%

Note:

* Surcharge at the rate of 12% is applicable on domestic companies where the income exceeds INR 10 crores and where income exceeds 1 crore but is less than 10 crores surcharge of 7% is applicable.

** Surcharge at the rate of 12% is applicable on individuals/HUF having total income exceeding INR 1 Crore

*** In order to qualify for long term capital asset, the units of Mutual Funds (other than units of an equity oriented fund) should be held for a period of more than 36 months. In the case of equity oriented funds, units would qualify for long term assets if held for more than 12 months.

****For the purpose of determining the dividend distribution tax payable, the amount of distributed income shall be increased to such amount as would after the reduction of dividend distribution tax on such increased amount at the specified tax rates be equal to the amount of income distributed by the Mutual Fund & rebate of up to INR 2000, available for resident individuals whose total income does not exceed INR 500000