How Mutual Funds Work in India – Basics of Mutual Funds

Investing in cash flow generating assets is a great way to make your money grow. Investing without carrying out the due investment research in the context of your investment objectives and risk propensity would however create a large degree of uncertainty with respect to investment risk and return. A mutual fund is one of India’s most popular investment options as it makes the process more accessible.

Investing in a market-related product like mutual funds can seem intimidating initially on account of the prevalent daunting volatility. However, when you understand how mutual funds work in India, it becomes easier to make an informed decision.

In this article, we’ll learn about the basics of mutual funds, including their function, types, and other details.

Also Read: How to Analyze & Track Mutual Fund Performance 

What are Mutual Funds?

Mutual funds are investment vehicles that pool together money from numerous investors and invest the proceeds in various types of financial assets.Some of the common constituents of these investment vehicles are company stocks, government bonds, treasury bills etc.

The fund portfolios are managed by professional fund managers. Fund managers usually indulge in active portfolio management wherein they choose securities with an objective to achieve the highest risk adjusted returns. In the process of doing so, they tend to incorporate varying degrees and kinds of diversification. This makes a fund’s performance significantly reliant on the concerned fund manager’s investment strategies and decisions. 

Each investor has units allotted in their investment portion, representing their holding of the fund. The profits/losses incurred by an investor are therefore directly proportional to the units they hold.

Also Read: Mutual Fund Taxation – How Mutual Funds Are Taxed?

How do Mutual Funds Work?

It is important to know the process of how mutual funds work step-by-step. It is a 3-step process, as explained below:

1. Pooling of money: The contributions made by the subscribers of mutual funds are pooled and jointly invested in the securities constituting the fund portfolio. The subscribers are empowered to invest in a larger variety and quantity of securities on account of this “pooling”. Each investor gets assigned units proportional to their contribution to the fund’s NAV (net asset value. The net asset value is basically the cumulative value of all underlying assets in the fund portfolio. 
2. Money is invested in securities: The pooled money is invested in various assets such as stocks, bonds, treasury bills, etc depending on the fund’s strategy. The fund’s manager usually incorporates diversification in terms of the nature of the security, exposure to industries etc strategically in order to maximise the fund’s risk adjusted returns.  
3. Returns on investment: The cumulative returns earned on the fund portfolio is distributed to the subscribers of the fund in proportion to their individual contributions. For growth funds, the generated profits are reinvested. Investors can redeem their fund units at the prevailing NAV, and if it’s higher than the purchase price, they make profits.

It is prudent to know that the fund manager often indulges in reconstituting and rebalancing the fund portfolio in order to ensure that the preset fund objectives are met.

Let us understand how mutual funds work with an example. Suppose Nikhil invested Rs. 10,000 in a mutual fund, ABC, which had a NAV of Rs. 10/unit. So, Nikhil has bought 1000 units of the fund. 

A year later, the ABC fund’s NAV increased to Rs. 15/unit. If Nikhil redeems his investment now, he will sell it at Rs. 15,000 (Rs. 15 x 1000 units) and make a profit of Rs. 5000. 

Also Read: Tax Harvesting: How to Save LTCG Tax on Mutual Funds?

Types of Mutual Funds

There are various types of mutual funds available. It is important to learn about them to understand how they work. Since one type does not cater to all sorts of investment objectives, it is essential to study the similarities and differences and choose the type that is most in line with your investment objectives and risk profile. 

Some of the popular types of mutual funds are:

• Equity Funds: They invest in stocks of publicly-listed companies and are most suited for aggressive long-term investors. They offer high returns. There are several types of equity funds based on market capitalisation, investment style, etc. 
  
  The following are the types of equity funds based on market cap:-
  • Large-Cap Funds: Funds that invest in companies ranking between 1-250 in terms of full market capitalisation
  • Mid-Cap Funds: Funds that invest in companies ranking between 251-500 in terms of full market capitalisation
  • Small-Cap Funds: Funds that invest in companies ranking above 500 in terms of full market capitalisation

• Debt funds: They invest in various debt instruments such as government securities, corporate bonds, certificates of deposits and treasury bills. They are considered low-risk investments as returns are relatively more stable and certain. These are good for conservative investors who are seeking regular returns
• Hybrid funds: They invest in both equity and debt instruments. They are a good option for investors looking for a diversified portfolio. Hybrid funds are usually considered safer than equity funds, and they tend to deliver better returns than debt funds.

Apart from the three types, as stated above, some other types of mutual funds are growth funds, multi-cap funds, dividend funds, and money-market funds.

Also Read: List of Mutual Fund Companies in India – Top Mutual Fund Schemes

Methods of Investing in Mutual Funds

While learning how mutual funds work, you should also know how to invest in one. There are two payment methods you can use for investing in mutual funds- lump sum or SIP (Systematic Investment Plan).

If investing a large amount of money at once isn’t feasible, you can consider choosing a SIP. In a SIP, you can invest small amounts of money at monthly intervals. They help in benefiting from the power of compounding. 

Also Read: How Are Brokerage Charges Calculated in the Stock Market?

Factors that Affect Mutual Fund’s Performance

There are multiple factors that can affect the performance of mutual funds. Some of the most relevant ones are:

• Fund manager’s strategy: A mutual fund’s performance relies highly upon the fund manager’s strategy. They need to be up-to-date with recent events, politics, the global economy, market trends, etc., to analyse and manage their portfolio efficiently since mutual funds are dynamic. Managers engage in reconstitution and rebalancing of fund portfolios to achieve the same.
• Expense ratio: Every mutual fund charges an expense ratio, a consolidated fee for the management, administration and promotion. The lower this fee, the higher will be your net returns. It is usually 0.5 – 2.25% of the fund’s NAV. For actively managed funds, this tends to be higher.
• Asset performance: Mutual funds are basically portfolios of financial assets. The values of such assets are always fluctuating. Therefore, the volatility of securities is a major factor that affects the performance of mutual funds.
• Government policy changes and the global economy: Changes in government policies directly affect business and trade. This hampers the functioning of the domestic and/or global economy as a whole and the various types of investment avenues. Mutual funds being amalgamations of distinct investments, tend to also be  subject to the implications of these changes. 

Also Read: Beginners Stock Market Guide – Start Investing in Stocks

Features and Benefits of Mutual Funds

Investment in mutual funds comes with multiple benefits. The following are some of the essential features and benefits of mutual funds investments.

• Diversified portfolio: Mutual Funds generally have diversified portfolios. This means they have investments in multiple-security options. This is beneficial since the markets are volatile. If some securities don’t perform well, the ones that do can compensate for those.
• Affordability: Mutual funds have been introduced as an affordable option available to many. In addition, unlike other investments such as real estate, it does not require large investments.
• Professional management: Mutual Funds are managed by experienced fund managers. The investors don’t have to worry or keep an eye out on the market, post-investment. This makes investing hassle-free, especially for beginners.
• Convenience: Investing in mutual funds is as easy as it gets. There is no paperwork to submit for investing in mutual funds. It can be done from the comfort of one’s home, on a computer.
• Power of compounding: Mutual fund investors can choose to benefit from compounding. This means that the interest earned by the investor on the principal amount gets reinvested and earns interest. 
• Transparency: Mutual Funds in India are regulated by SEBI (Securities and Exchange Board of India), offering investors a peace of mind. Mutual Fund Companies are required to update the funds’ performance regularly.

Read More: Best Mutual Funds for Beginners in 2022

Important Things to Consider Before Investing

There are many types of mutual funds, and investors must consider certain things before choosing an investment. Some of these factors are:

• Understanding your financial goals: The best mutual fund to invest in depends upon your financial goals. It may include retirement planning, buying real estate, paying for a child’s education or international travel. Such goals can be for the short, medium or long-term. 
  You will always want to invest in a fund whose investment objectives match your future plans. For instance, you wouldn’t invest in the same fund for planning a holiday trip next year and for your child’s education together.

• Budget calculation: You should have a good understanding of their financial standing before investing. It is important to consider factors such as age, income, expenses, debt (if any), etc. 
• Fund’s past performance: The fund of concern’s past performance is undeniably one of the most important factors that needs to be considered prior to investing as it gives the investor a fair idea about the efficacy of the investment strategies deployed. You should always assess a fund’s long-term returns, such as five-year returns, instead of short-term returns. If, in the long term, a fund seems better than its competitors, you can consider it as a good investment option. A smart investor should pay more consideration to the stability of returns rather than magnitude.
• Risk tolerance: Different funds carry different levels of risk. Therefore, you should assess how much risk you can take before making an investment. For instance, a person in their 20s with high income usually has a higher risk tolerance than someone with low income in their late 30s.

How are Mutual Funds Taxed?

Now, let’s learn about the taxation of mutual funds. . There are taxes on both dividends and capital gains.

• Taxation on dividends: According to the Union Budget 2020, dividends offered on mutual funds are taxed based on the investor’s income tax bracket.

When businesses paid the dividend distribution tax before sharing their profits with investors, dividends were tax-free. Now, the responsibility to pay dividend taxes rests with the investors.

• Taxation on capital gains: The tax on capital gains is based on the mutual fund’s holding period. The holding period is the duration of time between the purchase date and the sale date of NAV units. There are different tax rates for long-term and short-term investments.

• For equity funds, if the holding period is less than 12 months, short-term capital gains (STCG) are taxed at a flat rate of 15%. However, over a tax-free threshold of Rs. 1 Lac, long-term capital gains (LTCG) tax is applied at a rate of 10%.
• For debt funds’ investments lasting less than 36 months, STCG is taxed as a portion of the investor’s taxable income. LTCG from such funds is taxable at 20% with indexation.

Concluding Remarks

Mutual funds are really good investment options for investors seeking regular returns. They are easy to invest in and very accessible to anyone. Knowing how mutual funds work and other basic details will help you make an informed decision. Make sure to do thorough market research and select a mutual fund based on your own investment needs. 

Frequently Asked Questions