What is a mutual fund: Meaning, types, and benefits

Posted On: 19 August 2024

Beginning your journey into investing might seem overwhelming due to the many options available. However, mutual funds have become a popular choice for both newcomers and seasoned investors alike. Understanding what mutual funds are, how they operate, and the benefits they offer can empower you to make informed decisions and potentially increase your wealth.

Table of contents

What are mutual funds?
How do mutual funds work?
How are NAVs priced in mutual funds?
Benefits of mutual fund Investments
Cons of mutual fund investing
Different types of mutual funds
How to invest in a mutual fund?
How to calculate mutual fund returns
Role of mutual funds in India
Fees and charges to invest in mutual funds
Benefits of mutual funds for self-employed individuals
Understand mutual fund taxation
Determine how much to invest in mutual funds
Learn the terminologies used in mutual funds
How to optimize mutual fund returns?

What are mutual funds?

Mutual funds are an investment vehicle that pool money from multiple investors to buy various assets like stocks, bonds, and money market instruments. Managed by investment professionals and regulated by the Securities and Exchange Board of India (SEBI), mutual funds offer diversification, which helps spread risk across different investments for potential returns. By pooling funds, they aim to provide investors with growth and reduce individual investment risk.

How do mutual funds work?

Mutual funds simplify investing by pooling funds from multiple investors, investing it in a diversified portfolio and employing finance professionals to manage the investments. Let us understand more about how they are structured and how they work:

Pooling of funds: Combines investor capital into a larger fund for access to stocks, bonds, and assets beyond individual reach.
Professional management: Fund managers analyse markets and select investments to meet fund objectives like potential growth or income.
Diversification: By spreading investments across different sectors, industries, and regions, mutual funds reduce the risk of significant losses from any single investment.
Investor units: When you invest in a mutual fund, you buy units of the fund. The value of these units is based on the fund's net assets divided by the number of units outstanding.
Net Asset Value (NAV): NAV represents the per-unit value of the mutual fund. It is calculated by subtracting the fund's liabilities from its assets and dividing the result by the number of outstanding units. NAV changes daily based on the performance of the fund's investments.
Liquidity: Mutual funds offer liquidity, allowing investors to buy or sell their units at any time (subject to market conditions). The ease of liquidity provides flexibility for investors who may need to access their money quickly.
Returns and distributions: Mutual funds generate potential returns through dividends received, interest income, or capital gains from the securities held in the portfolio. Investors may receive regular income from IDCW or benefit from capital appreciation when the fund's investments increase in value.

This structure offers simplicity and flexibility.

How are NAVs priced in mutual funds?

Net Asset Value (NAV) represents the per-unit price of a mutual fund, calculated at the end of every business day. It indicates the current market worth of your investment.

NAV Formula:

NAV = (Total Assets − Total Liabilities) / Number of Outstanding Units

Total assets: Current market value of investments (stocks, bonds, cash) + dividends/interest receivables.
Total liabilities: Fees, expenses, and borrowings.
Key notes: NAV may fluctuate with underlying securities' performance, among other factors. Investors can buy or sell units at the applicable NAV.

Benefits of mutual fund investments

Keeping your money in a savings account doesn’t hold much scope for potential capital appreciation. On the other hand, investing in the stock market requires substantial knowledge and understanding of how a stock market functions. Mutual funds are seen as the more approachable form of investment, offering higher potential returns while mitigating market risk and is deemed suitable for beginners. Here are some benefits of mutual fund investments:

Diversification: First of all, mutual funds spread your investment across various assets, reducing the risk compared to investing in individual stocks.
Professional management: Secondly, mutual funds are managed by experienced fund managers who optimize returns while managing risks.
Transparency: Investors can access detailed Scheme Information Documents and daily NAVs, ensuring clear insight into their investments' performance.
Liquidity: Mutual funds, especially open-ended ones, offer high liquidity, allowing you to redeem investments quickly, typically within 1-3 business days.
Well-regulated industry: Finally, mutual funds operate under strict regulations set by SEBI, ensuring investor protection, risk mitigation, liquidity, and fair valuation.

Cons of mutual fund investing

Mutual funds have become a popular investment option in India, but they come with its own set of risks. Here are a few downsides you may want to consider when investing in mutual funds:

Fees and commissions: Mutual funds often include management fees, exit loads, and administrative charges, which can impact your returns.
Market risks: Mutual funds are subject to market fluctuations, meaning the value of your investment can rise or fall based on market conditions.
Evaluating funds: Choosing the right mutual fund can be challenging due to the many options available. Investors must research and evaluate funds matching their financial goals and risk tolerance.

Also Read: Mutual Funds vs Equities: Key Differences

Different types of mutual funds

Some of the types of mutual funds are mentioned below:

Equity funds: These funds invest in stocks, including large-cap, mid-cap, and small-cap categories, to achieve long-term capital growth.
Debt funds: These funds focus on fixed-income securities like government and corporate bonds, offering regular income with relatively lower risk.
Hybrid funds: These funds invest in both equity and debt instruments, balancing growth potential with relative stability.
Index funds: These funds seek to replicate the performance of a specific stock market index, subject to tracking error, offering low-cost broad market exposure with minimal fees.
Sector funds: These funds focus on specific economic sectors, such as technology or healthcare, and provide targeted exposure to industries with growth potential.
Tax-saving funds (ELSS): Tax-saving funds, or ELSS, provide tax benefits under Section 80C of the Income Tax Act, 1961, and have a mandatory lock-in period of three years.
Retirement funds: Designed to help save for retirement, these funds often offer tax benefits and align with long-term retirement goals.
Dividend yield funds: These funds invest in stocks that offer high dividend payouts, aiming for regular income and potential capital growth.

How to invest in a mutual fund?

Once you choose a mutual fund, the next question is: How do you invest? There are two primary modes available to choose from when investing in mutual funds.

Lumpsum investment: A lumpsum investment means putting a large amount of money into a mutual fund all at once. For example, if you have ₹20 lakh, you can invest this entire amount in a single transaction. This method is simple and can be beneficial if you have a substantial amount ready and are confident in your investment choice.
Systematic Investment Plan (SIP): A Systematic Investment Plan (SIP) allows for regular, smaller investments over time. For instance, you might invest Rs. 2,000 per month for a year. SIPs encourage consistent investing and utilize rupee cost averaging, which helps mitigate market volatility by spreading your investments.

How to calculate mutual fund returns

Mutual fund returns can be measured using several methods, each suited to different investment patterns.

Absolute returns: Absolute returns measure the overall change in investment value over time. The formula is:
Absolute return = (Final Investment Value – Initial Investment) / Initial Investment * 100
Simple annualized return: Simple annualized returns convert absolute returns into an annual percentage rate, assuming a constant growth rate. Use this formula: Simple annualized return = [(1 + Absolute Rate of Return) ^ (365 / number of days)] – 1 This method helps you understand annual growth if the investment was held for less than a year.
Compounded annual growth rate (CAGR): CAGR provides a smooth annual growth rate, accounting for compound interest over time. The formula is:
CAGR = [{(Current Net Asset Value / Initial Net Asset Value) ^ (1 / Number of years)} - 1] * 100
For a more accurate assessment, you can use Excel's RRI function to calculate CAGR by entering the duration and NAV values.
Extended internal rate of return (XIRR): XIRR is suitable for calculating returns on SIPs because it handles investments made at different times. To use XIRR in Excel, list investment dates and amounts in two columns, add the redemption date and amount in the last row, and then apply the XIRR function to get your returns as a percentage. This method effectively tracks returns for investments made over time with varying amounts.
Mutual fund calculators: Free online tools from AMCs help estimate potential returns, helping compare schemes and plan investments.

The calculator is an aid, not a prediction tool. It may provide only an indicative picture.

Role of mutual funds in India

Mutual funds contribute significantly to India's economic development through the following functions:

1. Mobilizing savings

They channel public savings into productive investments in capital markets, driving economic growth and development.

2. Promoting financial inclusion

Mutual funds enable individuals with limited resources to invest in capital markets, broadening participation across a diverse population.

3. Diversification and risk management

Investing in diversified portfolios reduces risks for investors while aiming for better returns.

4. Professional management

Experienced fund managers handle investment decisions, ensuring informed and efficient portfolio management.

5. Long-term wealth creation

Through systematic investment and compounding, mutual funds provide a platform to build wealth over the long term.

6. Supporting capital formation

Mutual fund investments in Indian companies contribute to economic growth, infrastructure development, and job creation.

Fees and charges to invest in mutual funds

Mutual fund fees are charges levied by an asset management company (AMC) to manage and operate a mutual fund scheme, covering costs like administration, distribution, and fund management.

Types of mutual fund fees

1. Expense ratio

This annual percentage of a fund's assets covers management and operational expenses. Lower expense ratios generally lead to better returns.

2. Exit load

Charged when investors sell units before a specific period, this fee discourages short-term investments.

3. Switching fees

These apply when transferring investments between funds within the same fund family.

Also Read: How to File Income Tax Returns (ITR) for Mutual Fund

Benefits of mutual funds for self-employed individuals

Mutual funds may offer those who are self-employed a flexible investment option that can be aligned with both short-term needs and long-term financial goals. They may help build wealth gradually, create an emergency buffer or save taxes.

Regular investments with systematic investment plans (SIPs): SIPs allow investors to contribute a fixed amount at regular intervals, thus instilling financial discipline and reducing the burden of making lumpsum investment in mutual fund. Moreover, by consistently investing in mutual funds through SIPs, self-employed individuals may potentially benefit from the power of compounding and accumulate substantial potential wealth over time.
Emergency fund corpus with liquid funds: It’s deemed important for self-employed individuals to build an emergency fund to withstand unexpected financial setbacks. Mutual funds offer liquid funds, which provide the flexibility of quick and hassle-free redemptions.
Save taxes with investment in equity linked savings schemes (ELSS): Self-employed individuals could also get tax benefits by investing in Equity Linked Savings Schemes (ELSS) offered by mutual funds. ELSS offer tax benefits under Section 80C of the Income Tax Act, 1961 (old regime only)
Investing surplus incomes: Occasionally, self-employed individuals may receive surplus income. Mutual fund investments may prove to be a suitable option for deploying these surplus funds to generate potentially higher returns from the power of compounding.
Retirement planning: Self-employed individuals may also plan meticulously for their retirement years with the help of mutual funds.

Understand mutual fund taxation

The taxation of mutual funds in India has undergone significant changes recently. Here's a breakdown:

1. Equity-Oriented Funds:

Short-Term Capital Gains (STCG):

For units held for less than 12 months. Taxed at 20% + applicable cess and surcharge.

Long-Term Capital Gains (LTCG):

For units held for more than 12 months. Taxed at 12.5% on gains exceeding Rs. 1.25 lakh in a financial year. No indexation benefits are available for LTCG on equity funds.

2. Debt Funds:

Taxed at the applicable income tax slab of the investor, regardless of the holding period.

Equity-Linked Savings Schemes (ELSS):

Tax Deduction: Investments in ELSS are eligible for tax deductions under Section 80C of the Income Tax Act, up to a maximum of Rs. 1.5 lakh per year. They’re taxed in a similar way as equity funds.

Lock-in Period: ELSS funds have a mandatory lock-in period of 3 years.

Determine how much to invest in mutual funds

If you do not have a lumpsum to invest in mutual funds, you can start a Systematic Investment Plan for equity funds. While most mutual funds let you start with Rs. 500 or Rs. 1,000, it is recommended that you consult with your financial advisor to assess how much you can invest based on your goals and disposable income. Additionally, you must consider investing more as your income grows.

However, it is not a problem if you think that you want to get started with a small amount. SIPs are flexible and you can increase (or decrease) the instalment in the future. If you are not sure that you can invest in mutual funds each month, you can choose quarterly SIP instalments .

Learn the terminologies used in mutual funds

Term	Full Form & Definition
AMC	Asset Management Company: A SEBI-registered entity responsible for managing a mutual fund’s operations, including making investment decisions, ensuring regulatory compliance and providing investor-related services.
NAV	Net Asset Value: Per-unit price of a mutual fund scheme, calculated on every business day. It forms the basis for all buy/sell transactions.
SIP	Systematic Investment Plan: A fixed amount invested at regular intervals (weekly, monthly, quarterly etc) in a mutual fund scheme. It encourages disciplined investing and potentially helps build wealth over time.
NFO	New Fund Offer: The initial subscription period during which a mutual fund scheme is launched and units are offered to investors for the first time.
AUM	Assets Under Management: The total market value of the investments managed by a mutual fund scheme or fund house at a given point in time. AUM reflects the size of the fund and may change based on market movements and investor inflows or redemptions.
CAGR	Compound Annual Growth Rate: The annualised rate of return that shows how an investment would have grown each year over a specific period, assuming the profits were reinvested and growth occurred at a steady rate.
Exit Load	A fee charged by some schemes if redemptions are made within specified period (e.g., 1 year). This aims to encourage long-term investing.
XIRR	Extended Internal Rate of Return: Annualised return for irregular cash flows (such as through SIPs). Accounts for timing of each transaction.

How to optimize mutual fund returns?

1. Asset allocation strategy

Diversification across asset classes is important for managing risk and enhancing returns. Evaluating the risk tolerance and investment horizon helps in constructing a balanced portfolio. Equities offer growth potential but come with higher volatility, while debt instruments provide stability but lower returns. A diversified mix – including equities, debt, and other assets like commodities or real estate – helps spread risk and boost the overall return potential.

2. Regular monitoring

Consistent monitoring of fund performance, expense ratios, and portfolio diversification is crucial. Regular reviews allow investors to track the fund's progress against benchmarks, ensuring it remains aligned with their financial goals. Analysing expense ratios helps evaluate the cost efficiency of the scheme. Additionally, assessing portfolio diversification ensures a healthy spread across various sectors and industries to mitigate concentration risks.

It's important to note that even top-performing funds that have delivered exceptional returns in the past might not sustain their performance in the long term. Therefore, it's advisable to periodically assess your funds' performance. Compare their returns over the past year with those of similar funds and benchmark indices at least once annually. If your current funds consistently lag behind their peers and benchmarks for three consecutive years, it might be prudent to consider switching to better-performing funds.

3. Systematic investment plan (SIP)

SIPs offer a disciplined approach by investing fixed amounts at regular intervals. This strategy takes advantage of rupee cost averaging, where investors buy more units when prices are low and fewer units when prices are high, thus reducing the average cost per unit. SIPs help in sailing through the market volatility, improving the long-term return potential while also instilling financial discipline.

4. Tax-efficient investing

Utilising tax-saving mutual fund options like Equity-Linked Savings Schemes (ELSS ) offers the dual benefit of tax savings under Section 80C of the Income Tax Act and opportunities for long-term wealth creation. ELSS funds come with a lock-in period, encouraging investors to stay invested for the long haul while enjoying tax benefits.

5. Long-term perspective and patience

Maintaining a long-term investment horizon is vital for reaping the benefits of compounding and riding out market fluctuations. Frequent portfolio changes could lead to transaction costs and hamper the overall returns. Patience during market downturns is key as history shows that markets tend to recover, rewarding patient investors who stay the course.

Also Read: How to Invest in Mutual Funds Online?

Conclusion

Mutual funds are a flexible and accessible way to reach your financial goals. With diversification, professional management, and potential tax benefits, mutual funds offer a strong investment opportunity for investors.

FAQs

What are the tax implications of mutual funds?

Mutual fund tax implications vary by fund type and investment period: Equity funds face a 10% tax on long-term gains above Rs. 1 lakh, debt funds follow your income tax slab, but ELSS funds offer tax benefits under Section 80C.

Are mutual funds safe?

Mutual funds are regulated by SEBI to ensure safety and transparency. However, they are associated with market risks and may not guarantee returns.

Is investing in mutual funds a good idea?

Yes, investing in mutual funds offers diversification, professional management, and potential tax benefits, making it a strong choice for reaching various financial goals.

Are mutual funds better than stocks?

Mutual funds provide diversification and professional management, which can reduce risk compared to individual stocks, but the ideal choice depends on your risk tolerance and financial objectives.

How does mutual fund work and return money?

When an investor decides to redeem or sell their mutual fund units, the fund manager sells the underlying investments in the portfolio to generate the required cash. The redemption proceeds are then paid to the investor after deducting any applicable fees, charges, or taxes. The amount an investor receives upon redemption depends on the current NAV of the mutual fund and the number of units being redeemed.

Can I withdraw money from mutual fund?

Yes, you can. Here is a method:

Contact the mutual fund company or your financial advisor.
Request a redemption form or online redemption process.
Fill out the required information, including the amount you want to withdraw.
Specify the bank account details to receive the payment.
Submit the redemption form or complete the online redemption process.
Await processing of the redemption request by the mutual fund company.

Do mutual funds return monthly?

Mutual funds do not typically return the money on a monthly basis. Instead, mutual funds generate returns in the form of capital gains or Income Distribution cum Capital Withdrawal (IDVW) option from the underlying investments held by the fund.

How much return in mutual funds in 10 years?

The returns of mutual funds over a 10-year period can vary significantly and depend on various factors such as the type of mutual fund, the underlying investments, market conditions, and fees.

Can I invest Rs. 100 in a mutual fund?

In India, you can typically invest as little as Rs. 100 in a mutual fund. Lumpsum investments generally have a minimum of Rs. 100, while SIPs usually start at Rs. 500. Always check the specific fund's offer document for precise details, as requirements may vary.

What are the risks of mutual funds?

Mutual fund risks include market, fund manager, concentration, liquidity, inflation, interest rate, credit, currency, and expense ratio risks. Each of these can impact returns and investment value. It's crucial to thoroughly research and understand these risks before investing to make informed decisions.

Can a mutual fund go to zero?

While it’s unlikely, a mutual fund's value could decline significantly due to extreme market conditions or poor fund manager decisions. However, diversification and regulatory oversight (like SEBI in India) help reduce risks.

How do I buy mutual funds?

To invest in mutual funds, research funds based on goals, risk tolerance, and performance. Choose a platform (direct or regular plans) and complete KYC. Invest via lumpsum or SIP, monitor performance, and rebalance periodically.

How are mutual fund fees regulated in India?

In India, SEBI regulates mutual fund fees to protect investors. Key rules include limits on the Total Expense Ratio (TER) based on assets under management (AUM), a ban on entry loads, and transparency requirements for disclosing fees.

How is the cost of a mutual fund unit calculated?

The Net Asset Value (NAV) of a mutual fund unit is calculated by subtracting the fund's liabilities from its total asset value and dividing the result by the number of outstanding units. NAV is calculated daily and reflects the current value of the fund's investments, guiding buy and sell transactions.

Who manages a mutual fund?

Professional fund managers are responsible for selecting securities, constructing and managing the portfolio, and continuously monitoring market conditions. They use their expertise to make informed investment decisions and rebalance the portfolio to maintain the desired risk profile. Investors benefit from their experience and teamwork with analysts and traders.

Can I withdraw mutual funds anytime?

Most mutual funds allow withdrawals anytime, but there are a few important factors:

Lock-in periods: ELSS funds have a 3-year lock-in, while most other funds do not.

Exit loads: Some funds charge fees if redeemed within a certain period, usually up to 1 year.

Redemption process: A request is needed to redeem, with varying processing times.

Is mutual fund tax-free?

Mutual funds are not tax-free in India.

Are mutual funds profitable?

Mutual funds can be profitable, but past performance doesn't guarantee future results. Key factors for profitability include strong fund management, favourable market conditions, diversification, and long-term investing. Risks such as market volatility, high expenses, and tax implications can reduce returns.

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