Mutual funds - Definition, benefits, types, and taxation
In the constantly changing financial landscape, many different kinds of investment products are available to suit the unique needs and risk profiles of different investors. Ranging from extremely risky products such as options and futures to highly safe traditional investment instruments such as fixed deposits (FDs) and public provident funds (PPFs), the plethora of investment avenues can often baffle investors. In investing, one always seeks an investment avenue that can provide good returns with a reasonable level of risk. A mutual fund is one such investment avenue that can offer an opportunity to build wealth with peace of mind. In this blog, let's look at what a mutual fund is and the different types of mutual funds that are available.
What are mutual funds?
A mutual fund is a type of investment vehicle that pools money from multiple investors, and they get units of a mutual fund depending on its net asset value (NAV). This pooled money is further invested in securities, bonds, money market instruments, government securities, and other investment instruments. This pooled money is then invested into different securities based on a fund manager’s discretion. In simpler words, you can think of mutual funds as a huge pot or a piggy bank where numerous investors put their money, and then the money is used to invest in stocks of a company and other securities. The fund manager will make the decision of where to invest.
How does a mutual fund work?
Regulated by the Securities and Exchange Board of India (SEBI), mutual funds provide numerous benefits to their investors, such as diversification, professional management, liquidity, and convenience. Mutual funds are available in various different types, catering to the unique financial needs of different investors. Let’s look at some of the benefits offered by mutual funds.
6 Benefits of investing in mutual funds
The following are the 6 inherent benefits of SIP -
- Diversification - Mutual funds invest in a basket of assets like stocks, bonds, and other securities. This spreads out the risk within the asset class and across different asset classes, hence mitigating the concentration risk of relying on a single stock or asset class.
- Accessibility - The simplicity and low barriers to entry of mutual funds make mutual funds an attractive investment avenue. Anyone can start investing in mutual funds through SIP, with the investment threshold being as low as Rs 100 for some funds.
- Professional management - Mutual funds are designed by professional fund managers who are seasoned in the field of finance and investment. They conduct in-depth research before making investment decisions.
- Liquidity - Generally, mutual fund units can be bought or sold on any business day at the fund's net asset value (NAV). This makes it relatively easy to access your money when needed, compared to other investments that might take some time to liquidate or even have longer lock-in periods.
- Transparency - Mutual funds are regulated by the Securities and Exchange Board of India (SEBI). The strict rules and regulations of SEBI ensure transparency, integrity, fairness, and investor protection in the mutual fund industry.
- Tax benefits - Equity-linked savings schemes (ELSS mutual funds) offer investors the benefit of tax savings under section 80c of the Income Tax Act. Hence, investors of ELSS get the dual benefit of tax saving and wealth building. However, these schemes come with a lock-in of 3 years.
Types of mutual funds
The types of mutual funds can be classified into different categories based on certain characteristics. These characteristics could depend on how a portfolio is managed, the fund's objective, the underlying portfolio and so on. Further on, these funds can be classified into different sub-categories. Let’s look at some of these categories and sub-categories.
1) Mutual funds based on Structure
- Open-Ended Funds - An open-ended mutual fund scheme continuously issues new units and redeems units based on the investor’s demand, regardless of the number of investors or the number of assets under management.
- Close-ended funds - As opposed to an open-ended fund, a close-ended fund issue units only for a limited period (During New Fund Offer), The units are issued in the primary market and redeemed only at the time of maturity. To allow investors to exit before maturity, such funds are listed in the secondary market, i.e. the stock market.
- Interval Based funds - As the name implies, these funds allow the purchase and redemption of funds during a specified transaction period, i.e. the interval. The difference between 2 intervals of such funds is at least 15 days, and the interval is at least 2 days long. Like close-ended funds, these funds are also traded in the stock market.
2) Classification based on fund management
- Active funds - Active mutual funds are mutual funds that are managed by professional fund managers who actively make decisions about which underlying assets to buy, hold, or sell in order to achieve the fund’s investment objectives. The goal of active management is to outperform a specific benchmark or index through strategic selection and timing of investments.
- Passive funds - Passive mutual funds are investment funds designed to replicate the performance of a specific market index or benchmark rather than actively selecting securities. The goal of passive mutual funds is to match the performance of the index they track rather than trying to outperform it.
- Rule-based funds - Rule-based mutual funds can be seen as a mix of active and passive funds. Such funds follow a systematic set of rules and algorithms to make investment decisions in order to outperform the benchmark. Rule-based funds offer a disciplined and systematic approach to investing, aiming for consistency, transparency, and eliminating fund manager’s biases.
3) Classification based on investment objective
- GrowthFunds - Growth funds aim to achieve long-term capital appreciation by investing primarily in stocks of companies with strong growth potential. Since these funds primarily invest in equities, they are volatile in the short term. However, equity as an asset class has the tendency to outperform all other asset classes in the long term. Hence, the ideal investment horizon in growth funds is long-term.
- Income Mutual Funds - Income funds are designed to provide regular income to investors by investing their underlying portfolio in fixed-income instruments like debentures, corporate bonds, and government securities. Such funds generate returns through interest income and capital gains of the underlying assets. The returns depend upon the credit quality and the tenor of underlying assets, and there is no guarantee of regular income.
- Liquid Mutual Funds/Overnight/Money market funds - Such funds are designed to provide investors with a high level of liquidity with very low risk, investing primarily in money market instruments such as treasury bills, commercial paper, and certificates of deposit. These funds aim to preserve the capital of investors. However, the returns of such funds are modest. It is appropriate for investors who want to park their funds for a short term.
4) Classification based on the underlying portfolio
- Equity Mutual Funds - Equity mutual funds primarily invest in stocks or equities. These funds aim to provide capital growth and potentially higher returns by investing in a diversified portfolio of shares. They are designed to capitalise on the growth potential of the stock market, making them suitable for investors with a higher risk tolerance and a longer investment horizon. Further, these funds are categorised based on their market capitalisation.
- Debt Mutual Funds - Debt mutual funds primarily invest in fixed-income securities, such as government and corporate bonds, debentures, and other debt instruments. The primary goal of debt mutual funds is to generate regular income and capital preservation while offering lower risk compared to equity investments.
- Hybrid Mutual Funds - Hybrid mutual funds invest in more than 1 asset class like equity, debt, gold, etc. The primary goal of hybrid funds is to offer a balanced approach by diversifying across asset classes, aiming to provide capital appreciation while minimising risk.
5) Solution-oriented mutual funds
Solution-oriented mutual funds are designed to address specific financial needs or life stages, such as retirement or children’s education, by offering a structured investment approach to achieving these objectives. These funds typically have a lock-in period. This approach helps investors manage their investments more effectively by focusing on long-term objectives.
6) Exchange-traded funds (ETFs)
ETFs are mutual funds that trade on stock exchanges, similar to individual stocks. They offer a diversified portfolio of assets, such as stocks, bonds, or commodities, and are designed to track the performance of a specific index, sector, or asset class. ETFs provide investors with the flexibility to buy and sell shares throughout the trading day at market prices. They often come with lower expense ratios compared to active mutual funds because they mirror benchmark performance.
7) Overseas funds/International funds
Overseas funds, also known as international mutual funds, provide exposure to foreign markets by investing in a diversified portfolio of international securities such as stocks, bonds, and other assets outside of India. These funds allow investors to capitalise on global growth opportunities and diversify their investment portfolio geographically. By investing in overseas funds, individuals can access international markets and benefit from economic growth and market trends abroad.
8) Fund of funds (FoF)
FoF invests across multiple mutual funds rather than directly investing in individual securities, depending on the investment objective of the FoF. This approach provides investors with diversified exposure to various asset classes, strategies, or fund managers through a single investment.
9) Other mutual funds
Other mutual funds include a range of niche mutual funds designed to cater to specific investment objectives. These funds include sector funds, thematic funds, contra funds, and Equity-Linked Savings Scheme (ELSS).
How to invest in mutual funds?
You can invest in mutual funds on your own through a direct plan or under the guidance of a mutual fund distributor through a regular plan. Let’s look at what these mean in detail.
What is a Direct Plan?
Investing directly in a mutual fund by purchasing units directly from the mutual fund company without involving intermediaries like mutual fund distributors or financial advisors is known as investing through a direct plan. Though the fund management cost is low, direct investment requires thorough research and analysis on part of the investor. Investors, in general, might lack the time and resources to conduct the research required; hence, we suggest they do it under the guidance of a mutual fund distributor.
What is a Regular Plan?
Investing in mutual funds through a mutual fund under their guidance means investing through a regular plan. Seeking the guidance of a mutual fund distributor and investing through a regular plan can be highly convenient for investors as it eliminates the need for thorough research and analysis on the investors' part. To invest in mutual funds under guidance, open an NJ E-Wealth account and get a dedicated mutual fund distributor to handhold you throughout your mutual fund investment journey.
Investment and withdrawal plans in mutual funds
1) Systematic Investment Plan (SIP)
What is SIP?
A systematic Investment Plan (SIP) is a disciplined investment strategy that allows investors to invest a fixed amount at regular intervals in mutual funds. SIPs are highly convenient as these investments are automated and investors don’t have to get into the hassle of investing every month. SIPs offer a structured approach to investing that can help investors build wealth gradually and achieve their financial objectives while minimising risk through rupee-cost averaging.
Advantages of SIP
- Rupee-cost averaging
- Power of compounding
- Affordability due to low minimum investment threshold
- Disciplined mode of investing
2) Top-up Systematic Investment Plan (Top-up SIP)
What is top-up SIP?
A top-up SIP is an extension of SIP that allows investors to increase their regular investment amount periodically. Top-Up SIPs are ideal for investors looking to progressively increase their investment amounts in line with their financial growth, making them a flexible and powerful tool for long-term wealth accumulation.
Advantages of top-up SIP
- Accelerated wealth building
- Automatic adjustment
- Gradual increase in saving and investment
- Inherent benefits of SIP
3) Systematic Withdrawal Plan (SWP)
What is SWP?
A Systematic Withdrawal Plan (SWP) is a financial strategy that allows investors to withdraw a fixed amount of money from their mutual fund investments at regular intervals. SWPs are used by individuals who want to receive a steady stream of income from their mutual fund investments, particularly in retirement.
Advantages of SWP
- Regular source of income
- Potential for capital appreciation
4) Systematic Transfer Plan (STP)
What is STP?
A Systematic Transfer Plan (STP) is a strategy used in mutual funds to transfer funds between different schemes or funds of the same fund house. This strategy helps investors allocate their investments systematically and can be used for various purposes, including managing risk, optimising returns, and achieving specific financial goals.
Advantages of STP
- Risk reduction
- Rupee-cost averaging
- Stability in investments
5) Lump sum Investment
What is lump sum investment?
As opposed to SIPs, lump sum investment is a one-time investment into a mutual fund. Lump sum investment is ideal for those who have a substantial amount of cash that is not earning significant returns; investing it as a lump sum might be a good way to put it to work. Moreover, lump sum investment in mutual funds is a powerful tool to build wealth in the long term.
Advantages of lump sum investment
- Potential for growth
- Ideal for long-term investment
- Simplicity
Taxation of mutual funds
As per the Union budget announced on July 23, 2024, by Smt. Nirmala Sitharam - Minister of Finance and Corporate Affairs, the taxation of mutual funds will be done as follows -
- Taxation of Equity Mutual Funds - Schemes investing in more than 65% in equities will be considered equity schemes. Long-term capital gains (LTCG) exceeding ₹1.25 lakh in a financial year will be taxed at 12.5%. Short-term capital gains (STCG) from equity mutual funds, realised within one year, will be taxed at 20%.
- Taxation of Debt Mutual Funds - Schemes investing in less than 35% equities will be considered debt funds. Regardless of whether a debt mutual fund investment is long-term or short-term, the tax rate applicable on debt mutual fund investment will be as per tax slab.
- Taxation of Hybrid Mutual Funds - Hybrid funds, which have a mix of equity and debt, will be taxed based on their predominant asset class. If more than 65% of the fund’s assets are invested in equities, the taxation will follow the equity mutual fund regime. If less than 65% and more than 35% is invested in equities, then long-term capital gain(more than 2 years) is charged at 12.5%, and short-term capital gain will be as per the tax slab. If less than 35% is invested in equities, taxation will be as per debt mutual fund schemes.
Conclusion - Seeking guidance for choosing the right product
Mutual funds stand out as a versatile and accessible investment avenue for anyone. With a vast array of mutual funds available, from equity and debt funds to hybrid funds, there truly is something for everyone. This variety allows you to tailor your investments based on your risk tolerance, time horizon, and financial objectives, ensuring that you can find a fund that aligns with your unique financial needs and financial position.
However, with such a wide range of choices, selecting the best mutual fund for you can be challenging. This is where the guidance of a mutual fund distributor becomes invaluable. A qualified distributor can provide personalised guidance, helping you navigate through the plethora of options, understand different funds, and make informed decisions that align with your financial needs. Hence, mutual funds are indeed for everyone, and with the right guidance, you can find the perfect fit for your investment journey.
Frequently Asked Questions (FAQs)
1) How to start investing in mutual funds?
You can open an NJ E-Wealth account and start investing in mutual funds with the guidance of a dedicated mutual fund distributor.
2) How much amount do I need to start investing?
You can start investing in mutual funds with as little as Rs 100 through SIPs (Minimum investment requirement differs from AMC to AMC).
3) What should I consider before investing in mutual funds?
Investors should focus on need-based investing. When selecting a mutual fund, you should consider factors such as your investment needs and risk profile. Based on these needs, investors should invest in mutual funds.
4) How do I choose the best mutual fund for me (out of so many available)?
As an investor, it might be difficult to get into the nitty-gritty of schemes. Moreover, the plethora of options available makes it difficult to choose where one should invest. Hence, investors should seek the guidance of a mutual fund distributor who can understand the financial needs and risk profile of investors to help them choose the most suitable mutual fund.
5) How to become a successful mutual fund investor?
To become a successful mutual fund investor, you should follow the following steps
- Quantify your financial needs
- Choose the right product
- Diversification and asset allocation
- Not chasing top performers
- Avoiding impulsive decisions
- Seeking guidance