Here is a primer on mutual funds for beginners. Have a read before you start investing
Here is all that you wanted to know about mutual funds. Familiarise with this asset class and learn how to invest.
A mutual fund, as the name suggests, is a pool of money created by the contributions of several investors. It is managed by a company called an Asset Management Company (AMC). It is held separately from the funds of the AMC and hence is not directly affected by the financial health or profits of the AMC. In other words, a mutual fund will not go bankrupt if the AMC goes bankrupt. The AMC can invest this pool of money in different assets such as stocks, bonds and gold depending on the fund’s mandate. It is regulated by the Securities and Exchange Board of India (SEBI).
An Asset Management Company (AMC) is a financial institution which manages a mutual fund. It is regulated by the Securities and Exchange Board of India (SEBI) and is required to have a minimum net worth of Rs 50 crore. A few examples include HDFC AMC, Reliance AMC and Aditya Birla Sun Life AMC.
Net Asset Value of a fund is simply the value of its assets minus the value of its liabilities. It is the ‘price’ at which investors can buy units of a fund or sell units of a fund. The NAV of a fund is declared every day (except holidays) by the fund before 9 pm.
For liquid funds, if you submit your investment application before 2 pm you get the previous day’s NAV. Otherwise, you get the same day’s NAV.
For other funds, if you submit your investment application before 3 pm you get the same day’s NAV. Otherwise, you get the next day’s NAV.
For amounts greater than Rs 2 lakh, you must ensure that your funds are transferred by the cut-off timings mentioned above.
Fund distributors and intermediaries may impose earlier cut-off timings to give them time to process applications through their system.
A fund manager is an individual tasked with running a mutual fund. There can be more than one fund manager. He or she is also typically assisted by a team of analysts and other professionals.
A fund’s performance is strongly related to the skill and experience of a fund manager, especially in funds whose mandates give the manager wide discretion. Eg: Multi-cap Funds or Dynamic Bond Funds.
Equity funds are funds which predominantly invest in stocks. According to the Income Tax Act, a fund which invests more than 65% of its corpus in stocks is classified as an equity fund. The value of these funds fluctuates as per the value of the stocks it holds. The fund also receives dividends from the stocks it holds and these increase the value of the fund (technically called Net Asset Value or NAV).
Debt funds are funds which invest in bonds issued by companies or by the Government. Thus, they primarily make money by lending to various types of borrowers and earning interest on it.
Balanced funds are funds which invest in equity as well as debt. They are also known as Hybrid Equity Oriented Funds. They are classified as equity funds for tax purposes and they invest at least 65% of their corpus in stocks. However, the fund manager can typically vary the equity allocation above this limit according to his assessment of market conditions.
Equity Savings Funds or Balanced Advantage Funds invest in a mixture of equity, debt and derivatives in such a way that they are classified as equity funds for tax purposes. They take a lower equity exposure than balanced funds and thus carry a lower risk. However, they can be affected by changes to tax laws and poor fund manager decisions.
Also known as Tax Planning Funds, investing in these funds will get you a tax deduction under Section 80C up to Rs 1.5 lakh per annum. These funds are mandated to invest in equities and have a three-year lock-in. The returns on these funds are also exempt from tax, making them one of the most effective tax saving options available.
Arbitrage funds use arbitrage strategies to deliver returns to investors. The most common strategy they follow is to buy stocks and sell their futures. Their returns resemble debt funds but they are classified as equity funds for tax purposes. Invest in them if you have a time horizon of up to two years and are willing to assume some risk.
MIPs or Monthly Income Plans are funds which typically invest about 75% of their corpus in debt and 25% in equities. They are also classified as Hybrid Debt Oriented Funds. Despite the name, MIPs do not provide guaranteed monthly income. Their investment returns or income potential is related to market performance. However, their high debt allocation reduces the risk they carry by a substantial level.
Liquid funds are funds which invest in debt that matures within 91 days. They are the most short-term type of funds available. They typically do not carry any exit charge or exit load. You can use them to invest for short periods of time. Eg: a few days or few weeks.
Ultra short-term funds are one notch above liquid funds in terms of both risk and returns. They invest in debt ranging from 6 months to one year. Invest in them if your time horizon ranges from a few months to 1 year.
Short-term bond funds are debt funds which invest in securities typically ranging from a maturity of one year to three years. They are also known as ‘accrual funds’ because gains in them primarily accrue from the interest on the bonds they hold. Invest in them if your time horizon also ranges from 1-3 years.
Credit Opportunities funds are funds which invest in bonds of companies with relatively high yields. They earn their returns from relatively high-interest payments. They also do well if the credit rating on their holdings improves (which tends to increase the value of their holdings). These credit ratings are issued by agencies such as CRISIL, CARE and ICRA.
On the flip side, credit opportunities funds are more exposed than other debt funds to defaults by bond issuers (their borrowers). Invest in these funds if your time horizon is three to five years.
Income funds are debt funds that generate returns by investing in bonds. They generate these returns in various ways. These include interest payments on their bonds or by profiting from interest rate movements or from credit rating changes on their bonds. Income funds do not guarantee a regular income as the name suggests. Invest in these funds if you have a time horizon of more than three years.
Gilt funds are funds which invest in debt issued by the government. They thus suffer almost no risk of default. However, they are affected by changes in interest rates.
Dynamic bond funds invest in bonds of high or low maturity depending on the view of the fund manager. The credit risk of their holdings is dependent on the strategy followed by the fund manager. Invest in these funds if you have a time horizon of more than three years and have a high level of confidence in the ability of the fund manager.
Sector funds are funds which invest in specific sectors such as IT, FMCG or Pharma. You should invest in them if you are confident of the prospects of a particular sector.
Thematic funds are funds which invest according to a particular theme such as rural consumption, pharmaceuticals, infrastructure or multinational companies (MNCs). You should invest in them if you are confident about a particular theme or investment idea.
Dividend yield funds are funds which invest in companies that have high dividend yields. The dividend yield is the dividend per share divided by the price of the share. It measures whether a company pay out relatively high dividends in relation to its stock price. A high dividend yield can mean that a company is undervalued although this isn’t always the case.
Here’s a five-step guide to investing a mutual fund:
1) Get your KYC done: KYC or know your customer is a mandatory requirement for all fund investors. It is a one-time process and does not have to be repeated every time you invest in the fund or in a new fund. You need to furnish identity proof and address proof at an investment service centre run by CAMS or Karvy. Your details must also be verified ‘in person’ by a distributor or AMC representative who has the relevant NISM certification and completed the know-your-distributor (KYD) process. If you are investing less than Rs 50,000 per year, you can do an ‘E-KYC’ using your Aadhar Card and do not need a physical visit to an investor service centre. Alternatively, you can do webcam based KYC in which you verify your identity and documents via webcam with an authorized agent. This facility is offered by Karvy and a few mutual funds such as Quantum, Sundaram BNP Paribas and Reliance Nippon.
2) Select a Fund: You should select a fund based on your risk profile and time horizon. Go for equity funds if you have a time horizon of five years or more and are have a good risk appetite. Otherwise, stick to debt funds. If you have a long time horizon but not a very high-risk appetite go for hybrid funds such as Equity Savings Funds, Dynamic Equity Funds or Balanced Funds.
3) Select an option: Mutual Funds offer three types of options – growth, dividend payout and dividend reinvestment. In most cases, the growth option is more efficient from both an investment and a tax point of view. We provide a more detailed explanation of this, below.
4) Select a plan: You can choose a regular plan or a direct plan. A regular plan pays out a distributor commission while a direct plan does not pay out a commission. Thus a direct plan carries lower costs than a regular plan but comes without a distributor’s services. Pick the regular plan if you need these services such as information about funds, help in transacting and help with keeping records. If you do not need help, invest in a direct plan.
5) Invest: You can invest in a number of ways. You can fill up physical forms and submit them along with cheques at the local office of the mutual fund or the local office of the fund’s registrar (CAMS or Karvy). Alternatively, you can invest online here.
An SIP or a Systematic Investment Plan invests a fixed amount of money in a mutual fund every month. This technique averages out your investment in the market and protects you from catching a market high. Eg: If the mutual fund NAV is at Rs 10 in the first month and you invest Rs 5000, you get 500 units in the fund. If the NAV falls to Rs 8, you get 625 units. A market fall has thus automatically allowed to get more units and average out your buying price.
There are many types of SIPs such as weekly SIPs and SIPs over other time intervals. Some SIPs adjust the amount invested according to the market level. SIPs are also closely related to two other investing techniques – STPs and SWPs.
An SWP or Systematic Withdrawal Plan redeems a fixed sum from a mutual fund every month. It allows you to meet your monthly expenses without having to withdraw all your investment at once.
An SWP can be a highly efficient and low-tax method of funding your expenses in retirement. It allows you to withdraw only what you need in an automated fashion and leave the rest invested. This part-withdrawal also lowers your tax rate because each withdrawal is a combination of capital and income rather than just income. Eg: You invest Rs 100 in a fund and it grows to Rs 111. You then withdraw Rs 30. This is considered to be a combination of capital (Rs 27) and returns (Rs 3). Thus you are only taxed on a gain of Rs 3 and not your actual gain of Rs 11. This is quite unlike a bank FD where your entire interest income is taxed and TDS is deducted from it.
An STP or Systematic Transfer Plan moves a fixed amount of money from one mutual fund to another every month. It is most commonly used when you want to invest a lump sum in the market without incurring the risk of catching a market peak. You can invest in a debt fund instead (which carries a much lower risk) and automatically move a fixed sum from it to an equity fund each month. STPs can also be daily, weekly or other time intervals.
A regular plan pays out a distributor commission while a direct plan does not pay out a commission. Thus direct plans carry lower costs than regular plans, but they come without a distributor’s services. Pick the regular plan if you need these services such as information about funds, help in transacting and help with keeping records. If you do not need help with this, invest in a direct plan.
An open-ended fund is a fund which is available for subscription throughout the year. You can also take money out of it, throughout the year. It thus gives you a great deal of flexibility. Some open-ended funds do carry charges (called exit loads) if you redeem in a very short period. However, you can check the length of this period from the fund’s website before investing. Typically, exit loads are not charged after a one year period. In case of debt funds, this is even shorter at 3-6 months. In case of liquid funds, no exit load is charged.
The growth option of a fund prioritizes growth of your investment over income from it. It reinvests the returns from the fund back into the fund so that the fund’s value keeps growing. It is a highly efficient option for those who do not need regular income from their funds and can wait before they start withdrawing from the fund. It is also tax efficient for both equity and debt mutual funds. Equity funds become tax-free after a holding period of one year and debt funds move to a lower 20% tax rate and get the benefit of indexation after a 3 year holding period.
The dividend option provides you with dividends from your investments.
For equity funds, these are not guaranteed and depends on the performance of the fund and the fund manager’s decision to declare dividends. They are tax-free in your hands.
For debt funds, these are regular and can provide you with a regular income. However, this is not very efficient. The funds pay a dividend distribution tax of about 28.84% (including surcharge and cess) before paying out your dividend. This can significantly impact your returns.
Funds merge due to various reasons. It may be because the investment universe is too narrow and needs to be broadened. It may be due to poor performance or it may be some other reason altogether. In September 2017, SEBI announced new rules on fund classification which require the fund houses to only have one fund in a single category. This is also likely to trigger several fund mergers. A fund merger does not give rise to any tax liability if you stay invested in the new funds.
When a merger occurs, you must see if the mandate of the new fund is aligned with your investment objectives. If not, you have the option to exit without paying exit load which funds are required to give you.
A balanced advantage fund or an equity savings fund invests in equity, debt and derivatives in such a way as to reduce the equity allocation of the portfolio to less than that of an ordinary balanced fund. It does this by using derivatives and hence it is classified as an equity fund for tax purposes. A typical balanced advantage fund structure would be to invest 65% or more in equity and 35% or less in debt. However, a significant portion of the equity allocation is hedged using derivatives. This gives it a debt-like character and in effect reduces the equity allocation to less than 56%.
A dynamic asset allocation fund is a mutual fund which switches between assets such as equity, debt and gold based on their relative attractiveness. For example, if equity markets have risen sharply, a dynamic asset allocation fund is likely to move away from equity and into debt.
Gold funds, as the name suggests, invest in gold. They buy an equivalent amount of gold against the units they issue or they invest in a gold exchange-traded fund (ETF) which buys an equivalent amount of physical gold.
You do not have to worry about the purity of the gold and storage (the risk of theft). The fund does all this for you.
You do not get to see and touch the shiny metal unlike with physical jewellery or bars.
These funds are purchased just like any other mutual fund. They are a highly liquid method of investing in gold.
They are treated as debt funds for tax purposes. Holding them for three years or longer allows you to benefit from the lower rate on long-term capital gains tax and indexation.
Go for a fund with a low expense ratio. This type of fund isn’t actively managed and there is no reason for the manager to charge you a large cut.
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