What are Mutual Funds?

5paisa Research Team Date: 12 May, 2023 02:13 PM IST

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Introduction to Mutual Funds

Mutual Funds are not as complicated as it looks to beginners, instead, it's the best option contrary to keeping money in fixed deposits or in a bank account where a person gets limited gains. Mutual funds allow you to mitigate the risks associated with direct stock investment and give you the opportunity to earn higher returns in the long term.

Watch Mutual Funds or Index Funds? Which Is Best For Investing?

 

When you’re planning to invest in mutual funds you must know what mutual fund means? what are the types of mutual funds and how to invest in mutual funds?

While attempting to save money every day in our lives, we also feel like keeping it safe at the same time to gain returns over it. There are many ways to make your money grow by investing in various sectors. Banks provide the zero risk facility of fixed deposit where a limited interest is given on your money ranging from 4-6%. However, investment made in other sectors like real estate, etc does not give you the freedom to redeem the investments whenever needed. There comes the need for an investment vehicle like mutual funds. 

Mutual funds work by pooling money from various investors and investing it in stocks, and other market instruments that are called holdings. The collection of a variety of such holdings is the fund’s portfolio. Now let’s understand what is mutual fund investment? Mutual fund investment means buying fund units that represent the value of the actual holdings. Mutual fund investment is highly liquid, you can enter and exit the fund anytime you wish to.

However, ELSS mutual funds are an exception. In ELSS, the invested amount is locked in for a minimum period of three years. You cannot withdraw money till maturity and if you withdraw before maturity, heavy penalty charges are applicable.

What are the Types of Mutual Funds?

Based on the nature of the investment, mutual funds are broadly categorized into two heads- equity funds, debt funds, and hybrid funds.

Equity funds

Equity funds are the most popular types of mutual funds as they are preferred and given major space in the portfolio of most investors. As the name suggests, equity funds are the ones that invest majorly in stock market equities. For a fund to be called an equity fund, its overall investment should be at least 65% in equities and its derivatives. There are different types of equity funds as well based on the types of stocks they invest in. For example, if a fund majorly invests in IT companies, it is commonly known as a technology fund, or if a fund invests in big market cap companies, it is then called a bluechip fund.

Debt funds

Debt funds mainly invest in fixed-interest earning debt instruments. Atleast 65% of the total funds are invested in debt instruments like government and corporate bonds. The remaining can be invested anywhere. 

Hybrid funds

Hybrid funds can be called a combination of both equity and debt funds. They keep a subtle balance between equity, debt, and other securities as well to stabilize returns and minimize risks.

Now that you know about the major types of mutual funds, it is time to learn what are the ways through which you can invest in a mutual fund.

Ways of Investing in Mutual Funds

Lump-sum investment 

Lump-sum investment is when an investor invests a lumpsum amount of money at once in a mutual fund scheme. You will earn returns as per the performance of the fund. You can invest more in the same fund and withdraw anytime you want. 
For example, suppose you made a lumpsum investment of Rs 10 lakhs in a mutual fund that you expect to offer 15% annual returns, and you have planned to remain invested for 10 years. The corpus amount after 10 years would be Rs. 40,45,557.
You can use a lumpsum investment return calculator to learn about your returns.

However, investing a lot at once may sound risky to some of us.

Systematic Investment Plan or SIP 

SIPs are formulated to cater to investors who don’t want to invest lumpsum amounts in mutual funds at once. SIP allows investors to invest a fixed sum (can be as little as Rs 100) every month in the selected mutual fund scheme. The same can be automated with a bank e-mandate where the amount gets deducted every month at a fixed date automatically from your bank account. SIP allows you to build a solid investment habit and earn substantial returns in the long term.

You can use the SIP returns calculator to learn about your returns.

What Are The Documents Required To Invest In Mutual Funds?

To invest in mutual funds, you need to be KYC-compliant. Here is a list of all the documents required to be that – 

Identity Proof:

●    PAN Card with your current photograph (if possible). 
●    Any of these - aadhaar card, passport, voter ID, driving license 

Address Proof:

●    Passport
●    Ration Card
●    Utility Bills 
●    Aadhaar (Unique Identification Number)
●    Driving License 
●    Voters Identity Card
●    Bank Account Statement 

Non-resident investors have to submit a copy of their PAN card and a copy of their passport and overseas and permanent address. 
 

How Are Returns Calculated for Mutual Funds?

Returns from mutual fund investments are calculated by looking at the differences in NAVs between certain points in time. The main factors that contribute to returns include dividends, interest income, and capital gains. Dividends are paid out on a regular basis to investors based on the performance of the fund's holdings. Interest income is generated from bonds; it provides steady sources of cash flow for mutual funds. Capital gains refer to any profits realized when shares of stock or other assets held by a mutual fund are sold for higher prices than what was initially invested.

Suppose an investor purchased ₹1,000 worth of shares in a mutual fund with an initial NAV of ₹15. If the NAV of that same mutual fund rises to ₹20 and the investor sells their shares, they would have a capital gain of 33% (₹5/₹15). This gain is then used to calculate the overall return on the investor's mutual fund investment.

Mutual funds are priced, and returns are calculated according to the performance their portfolios generate day-to-day. By understanding this process, investors can make more informed decisions when selecting the right mutual funds to invest in. In addition, mutual funds provide investors with an accessible way to diversify their investments while still taking advantage of the expertise of professional money managers.
 

Benefits of Investing in Mutual Funds

Investing in mutual funds has a number of advantages over other investment options. The following are some key benefits of mutual fund investing:

Professional money management: 
Mutual funds offer access to the expertise of professional money managers who can make decisions about where to invest the fund’s assets. This eliminates the need for individual investors to manage their own portfolios and allows them to benefit from professional decision-making.

Diversification: 
Mutual funds provide diversified portfolios by investing in a range of different securities, such as stocks, bonds, and commodities. By investing in a variety of assets, mutual funds reduce the risk associated with any one particular investment and potentially maximize returns over time.

Lower risks: 
Mutual funds are typically less risky than individual investments because they spread out risk across a wider range of investments. Furthermore, mutual fund expenses are usually lower than other types of investments due to economies of scale and the management of investments by professionals.

Accessible: 
Mutual funds are a simple and accessible way to invest because they can be bought and sold easily through brokerages or financial institutions and require relatively small amounts of capital to get started.

Low fees and taxes: 
Mutual funds typically have lower fees than other investments and provide tax benefits that may help investors save money in the long run. This is because mutual funds are often managed in a tax-efficient manner and may offer tax advantages such as capital gains deferral.

Liquidity and convenience: 
Mutual funds are highly liquid, meaning that investors can easily convert their investments into cash. Furthermore, mutual funds can be bought and sold with ease through a variety of brokerages and financial institutions.

Variety of investment options: 
Mutual funds provide investors with a wide range of investment options to choose from, including index funds, sector funds, international funds, and more. This allows investors to tailor their portfolios according to their own goals and risk tolerance.

Potential for higher returns over time: 
Mutual funds have the potential to provide higher returns over time than other investments, thanks to professional money management, diversification, and access to a variety of securities.
 

How Much Return Can Mutual Fund Offer?

First of all, mutual fund returns are not guaranteed. However, it is seen that mutual funds perform fairly well and allow investors to earn a healthy sum. Returns from mutual funds investment usually range between 14-18% depending upon the type of fund. Considering the features of various schemes and the structure of investment chosen by an investor the returns are gained differently. The period of investment also affects the returns gained. Investing for a longer period generally yields higher gains on investment in mutual funds.

Taxes Applicable

Mutual fund investments are subject to different taxes as per the nature of capital gain.

Long term capital gains (LTCG): Long term capital gains up to Rs 1 lakh is tax-free. LTCG above Rs 1 lakh are taxed at 10%. 

Short term capital gains (STCG): STCG in mutual funds are taxed at 15%.

Note: In equity funds, LTCG are realized when investments are held for atleast 12 months, whereas in debt funds the period is 36 months.

Taxation of Mutual Funds

With mutual funds, you can gain tremendous profits. However, they are subject to taxation just like any other asset-class investments, and it is important that investors understand the taxes associated with them before investing in order to save money. Mutual fund taxes vary depending on the type of mutual fund and the investment strategy employed by the fund manager.

For example,

Depending on the length of time you hold your mutual fund and the type of mutual fund, the taxation rate for capital gains can vary immensely.

●    In the case of equity funds, they are taxed at a flat rate of 15%
●    In the case of debt funds, they are taxed at a flat rate of 20% after indexation
●    In the case of hybrid funds, they are taxed at a flat rate of 15%


 

Quick Tips on Investment

Know your type

Before investing, you should know what kind of investor you are.
If you have a lump sum amount to invest and you already have a fair knowledge on mutual funds, you can opt for a lump sum investment. However, if you are about to start your investment journey, it is best to go with SIP.

Choose a scheme you want to invest in

Once you know your type, you can check all the mutual funds available. Choose the type of fund and a plan according to your need, based on your current financial status and future projections.

Learn about the taxes applicable

Learn how you can make efficient tax planning through mutual fund investments. You can invest in ELSS and claim up to Rs 1.5 lakhs as a deduction every year from the same.

That’s pretty much all that you need to know about mutual funds. Interesting enough? It will be! Mutual funds are the proven and most capable investment instruments that give you the opportunity to earn healthy returns with fairly fewer risks. Want to explore it? Check out the best mutual funds at 5Paisa and kickstart your investment journey now!

How Are Mutual Funds Priced?

Mutual funds are pools of investments, such as stocks and bonds, that are managed by professionals. These funds offer investors a way to diversify their portfolios while still having access to the expertise of professional money managers. Mutual fund pricing is determined by the value of all of the assets in the mutual fund's portfolio minus any expenses incurred during its management.

Mutual funds are evaluated in terms of their Net Asset Value (NAV), which is calculated by dividing the total assets minus liabilities among all outstanding shares. The NAV serves as a guide for setting the price per unit of each fund share owned by its shareholders. Consequently, it determines how much value these investors gain from their mutual fund investments.

The Net Asset Value (NAV) of a fund fluctuates as the prices of stocks, bonds, precious metals, and commodities change during an active trading day. The NAV will be determined by the market rate at which these assets close for that particular day; in some cases, however, multiple valuations take place throughout one single trading session.
 

Terms Used in Mutual Funds

To make a well-informed investment decision, you must be aware of the terms used in mutual funds. Here are a few of them: 

NAV

Net Asset Value

 

It is a typical phrase for mutual funds that describes the cost of a mutual fund unit.

STP

Systematic Transfer Plan

With a systematic transfer plan, you have the autonomy to control how the funds are used.

AMC

Asset Management Company

AMC is a corporation that handles investor’s money or funds.

NFO

New Fund Order

The initial offer made by an AMC of a plan is known as a new fund order, or NFO.

SIP

Systematic Investment Plan

SIP is basically a way of mutual fund investment that allows you to make small, regular investments.

SWP

Systematic Withdrawal Plan

The accrued funds might well be withdrawn using SWP over time. After retiring, investors utilize this as a pension source.

XIRR

Extended Internal Rate of Return

It is utilized when investments have been made over time in a series of installments with breaks for withdrawals.

CAGR

Compound Annual Growth Rate

It is the proportional yearly growth rate for a mutual fund.

EXIT LOAD

 NIL

Exit loads are fees assessed by AMCs to participants who redeem their mutual fund holdings during the lock-in period.

 

Conclusion

Mutual funds provide Indian investors with a tried-and-true way to grow their capital more quickly than with conventional investment products. They may be more profitable, generate more income and capital growth, act as a buffer against inflation, and help generate funds for a range of both immediate and long-term demands.

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Frequently Asked Questions

Capital gains and dividends are two alternative methods to profit from mutual fund investments. Based on the market earnings of the purchased equities, the invested funds pay dividends. You get this sum if you decide to accept these dividends.

Risk is something that all investments have. Due to the potential decline in the worth of securities owned by a fund, making an investment in mutual funds has the risk of losing any or all of your money. 

Investment redemption is the refund of the investment funds to the security holders by the issuer prior to the maturity date. Investors have the option to redeem all or a portion of their assets.

Those wishing to diversify their portfolios may find mutual funds to be a beneficial investment. The choice of investing in mutual funds relies on your particular circumstances, but they provide convenience and diversification at a reasonable price.

Depending on your specific objectives and level of risk tolerance, you should decide whether mutual funds or stocks are preferable for your portfolio. When building a long-term retirement portfolio, when diversification and lower risk may be more crucial, it can sound right for several investors to choose mutual funds.

Investors must also pay any purchase-related costs, such as sales loads, in addition to the mutual fund’s per-share net asset value. Shares of mutual funds are “redeemable,” which means investors could sell them to the fund at any moment.