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What are Mutual Funds? How Mutual Funds Work and its Definition

Mutual funds pool investor money to buy a mix of assets managed by professionals, offering diversification and potentially strong returns.

  • 10,234 Views | Updated on: Sep 24, 2024

Imagine being able to invest in a variety of stocks, bonds, and other securities without needing to spend countless hours researching each one. Mutual funds make this possible, offering a streamlined, accessible way to diversify your investments and grow your wealth.

Mutual funds help you invest in different classes, such as equity, debt, and other assets. The scheme provides liquidity, accessibility, flexibility, and expert management benefits. Moreover, it is the best tax-saving option, as it is safe and transparent.

Whether you are a novice investor or an experienced financial guru, mutual funds can be a powerful tool in your investment strategy. This blog will discuss what are mutual funds, how they work, and why they might be the perfect addition to your portfolio.

What are Mutual Funds?

A mutual funds scheme is a financial tool in which money is invested in various assets such as equity, debt, and/or other money-market instruments. Investors can choose a short-term, mid-term, or long-term investment plan according to their preferences. Since returns and capital gains directly depend upon market volatility, a solid allocation strategy is required to minimize risk. The funds are allocated in different securities according to the investor’s risk-taking appetite. The funds are managed by the fund manager (investment advisor).

How Mutual Funds Work in India?

In India, mutual funds come in various types, each categorized by the asset class they invest in, their structure, risks, and benefits. Investors can invest in mutual funds through a Systematic Investment Plan (SIP) or by making a lump sum investment.

Professional fund managers, supported by a team of skilled researchers, oversee the pooled money from investors. They allocate investments across different asset classes based on their expertise to achieve the fund’s objectives. Investors receive their share of the mutual fund in the form of units, and any returns generated by the fund are distributed among investors according to their investments.

Mutual funds fall into two categories: actively managed funds and passively managed funds. In actively managed funds, the fund manager conducts market research and adjusts the fund’s portfolio based on their analysis. Conversely, passively managed funds seek to replicate the performance of a stock market index or benchmark.

Let us delve into the process of mutual fund operation, starting from the launch of a mutual fund scheme to investing in and redeeming mutual funds.

Launch of New Fund Offer (NFO)

An asset management company (AMC) initiates a first-time subscription offer for a new mutual fund scheme, a new fund offer (NFO). Through the NFO, the fund house raises capital from the public and then invests in securities such as shares, bonds, etc., using the fund’s strategy. NFOs have a limited subscription period, after which investors can only purchase units of the fund.

Pooling of Funds

Mutual funds gather money from many investors, each contributing small amounts. This pooled investment allows investors to access diversified portfolios of securities.

Returns Distribution

The performance of a mutual fund scheme is evaluated based on its Net Asset Value (NAV), which represents the market value of all securities held by the scheme. NAV fluctuates daily in line with changes in the market value of securities. Returns generated by mutual fund schemes are distributed among investors or reinvested into the fund. In dividend-paying mutual fund schemes, returns are distributed to investors as dividends.

Redemption

Investors have the option to sell or redeem their mutual fund investments. To facilitate this, the fund manager utilizes the portfolio’s cash balance to fulfill redemption requests from investors.

Modes of Investing in Mutual Funds

When it comes to investing in mutual funds, there are two popular modes you can invest through:

Lump sum

Investing a lump sum in a mutual fund involves putting in a significant amount of money all at once. This approach can be ideal if you have a substantial amount of cash on hand, such as from a bonus, inheritance, or savings. It allows you to potentially benefit from market gains immediately but also exposes you to the risk of market volatility.

SIP (Systematic Investment Plan)

A Systematic Investment Plan (SIP) allows you to invest a fixed amount of money at regular intervals, such as monthly or quarterly. SIPs are popular because they promote disciplined saving and investing, and they help mitigate market timing risks by spreading your investments over time. This mode especially benefits those who prefer to start with smaller amounts and gradually build their investment portfolio.

Types of Mutual Funds

Mutual funds are categorized based on various factors, including the asset class they invest in and the investment objectives they aim to achieve. Understanding the different types of mutual funds can help investors make informed decisions about their investment portfolios.

Based on Asset Class

An asset class refers to a category of financial assets with similar characteristics and behaviors, such as stocks, bonds, real estate or cash equivalents. Discover diverse Mutual Funds categorized by an asset class.

Equity Funds

Equity Funds invest in shares of companies. For example, large-cap Equity Funds target well-established, large companies, while small-cap funds focus on smaller, high-growth businesses.

Debt Funds

Debt Funds invest in bonds, providing a steady income. They include categories like Government Bond Funds and Corporate Bond Funds.

Money Market Funds

Money Market Funds invest in low-risk, short-term securities, such as Treasury bills and commercial paper.

Hybrid Funds

Hybrid Funds blend stocks and bonds, like balanced funds, which aim for growth and stability in a single package.

Based on Investment Goals

These funds cater to specific financial objectives, offering diverse options to match the investors’ unique goals.

Growth Funds

Growth Funds focus on capital appreciation by primarily investing in stocks of companies with high growth potential. They are suited for long-term investors seeking substantial returns.

Income Funds

They emphasize regular income generation by investing in bonds, fixed-income securities, or dividend-yielding stocks. They suit investors looking for a steady income stream.

Liquid Funds

Liquid Funds prioritize liquidity and safety by investing in short-term debt instruments. They are ideal for investors seeking quick access to funds with minimal risk.

Tax Saving Funds

Tax-saving funds, or ELSS, offer tax benefits under Section 80C. They invest primarily in equities and serve as a tax-efficient investment option.

Aggressive Growth Funds

Aggressive Growth Funds target substantial capital appreciation and are willing to accept higher market risks. They suit investors with a long-term horizon and a risk-taking approach.

Capital Protection Funds

Capital Protection Funds focus on safeguarding the principal amount while generating modest returns. They are ideal for risk-averse investors looking to protect their investments.

Fixed Maturity Funds

Maturity Funds have a predetermined maturity date, providing investors with a clear investment horizon. They are suited for those looking for fixed returns and minimal interest rate risk.

Pension Funds

Pension Funds aim to create a corpus for retirement by investing in various assets. They cater to individuals planning for a secure financial future after retirement.

How to Invest in Mutual Funds?

Investing in mutual funds can be an excellent decision for long-term wealth generation. If you want to invest in mutual funds, follow these steps:

  • Determine Your Investment Goals: Identify your financial goals, risk tolerance, and investment horizon.
  • Choose the Right Mutual Fund: Research and select a mutual fund that aligns with your goals and risk profile. You can use online platforms, consult a financial advisor, or visit fund houses’ websites.
  • Complete KYC: Ensure you complete the Know Your Customer (KYC) process, which is mandatory for investing in mutual funds. This typically involves submitting proof of identity and address.
  • Open an Account: You can open an account directly with a mutual fund company, through a broker, or through an online investment platform.
  • Select the Mode of Investment: Decide whether you want to invest a lump sum amount or opt for a Systematic Investment Plan (SIP).
  • Make the Investment: Follow the steps on the platform or with the advisor to make your investment. You can do this online, through a physical application form, or via a broker.
  • Monitor Your Investments: Regularly review your mutual fund investments to ensure they are on track to meet your financial goals.

How are Earnings Calculated for Mutual Funds?

Earnings from mutual funds are calculated based on the Net Asset Value (NAV) of the fund. Let us see how it works:

NAV Calculation

The NAV represents the per-share value of the mutual fund and is calculated by dividing the total value of the fund’s assets minus liabilities by the total number of outstanding shares.

Growth or Appreciation

If the NAV of the mutual fund increases, your investment grows. For example, if you bought shares at an NAV of ₹100 and the NAV rises to ₹120, you’ve gained ₹20 per share.

Dividends and Distributions

Mutual funds may distribute earnings in the form of dividends (from interest or dividends earned by the fund’s assets) or capital gains (from the sale of securities). These distributions can be received as cash or reinvested in additional fund shares.

Total Returns

The total returns of a mutual fund include capital appreciation (increase in NAV) plus any dividends or capital gains distributions received.

Tax Implications of Mutual Funds

The tax implications of mutual funds refer to how the Indian government taxes the earnings you generate from mutual funds. Let us take a look at the tax implications of mutual funds:

Equity Mutual Funds

  • Short-term Capital Gains (STCG): Gains on investments held for less than 12 months are taxed at 15%.
  • Long-term Capital Gains (LTCG): Gains on investments held for more than 12 months are tax-free, up to ₹1 lakh per financial year. Gains above ₹1 lakh are taxed at 10% without the benefit of indexation.

Debt Mutual Funds

  • Short-term Capital Gains (STCG): Gains on investments held for less than 36 months are added to your income and taxed as per your income tax slab.
  • Long-term Capital Gains (LTCG): Gains on investments held for more than 36 months are taxed at 20% with indexation benefits, which adjust the purchase price for inflation.

Hybrid Funds

  • Equity-oriented Hybrid Funds: These funds, where equity exposure is more than 65%, are taxed like equity mutual funds.
  • Debt-oriented Hybrid Funds: These funds, where equity exposure is less than 65%, are taxed like debt mutual funds.

Dividend Income

  • Dividend Distribution Tax (DDT): Dividend income is added to the investor’s income and taxed according to their applicable income tax slab rate.

Securities Transaction Tax (STT):

  • An STT is levied at the time of redemption or switch of equity mutual funds.

What are the Benefits of Mutual Funds?

Mutual funds have become a cornerstone of modern investment portfolios, benefiting investors of all backgrounds and experience levels. These investment vehicles take funds from various investors to invest in a diversified portfolio of stocks, bonds, or other securities. Let us take a look at the benefits of mutual fund investments:

Liquidity

Unlike conventional investment options like fixed deposits, mutual fund schemes provide liquidity. As a result, one can redeem their units quickly at any point in time. However, an appropriate penalty or exit load is applicable on the withdrawal.

Diversification

Most people hesitate to invest due to the instability created by market fluctuations and volatility. However, putting all your eggs in one basket is never wise. Mutual funds are generally diversified in various securities depending on your plans and terms to minimize the risks of losses.

Expert Management

Experts manage mutual funds with a deep understanding and thorough market knowledge. They know where to put your money for the safest and maximum outcomes. In addition, fund managers take care of timely exits and new investments.

Flexibility and Accessibility

Investors have enormous flexibility regarding their investments, even when investing a comparatively low amount. One can invest monthly or quarterly using the Systematic Investment Plan (SIP) at convenience. Mutual funds can be easily traded in a brief period when needed. The excellent combination of low cost and ease of use makes mutual funds accessible. You can begin investing from anywhere in the world through brokerage firms, Asset Management Companies (AMC), or online investing platforms.

Transparency

Your financial advisors review the statistics, financial statements, and other crucial understanding of the company before investing so that you can rest assured. In addition, however, you can track the performance of your funds using regular Net Asset Value (NAV) updates and monthly fund factsheets.

Tax Benefits

You can avail of tax benefits under Section 80C of the Income Tax Act for investments in Equity Linked Saving Schemes or ELSS. This is because the government wants its citizens to be financially secure and encourages the investment culture, following which these tax benefits are provided not only on the amount invested but also on the amount earned as mutual funds returns. This is a win-win for the investor, where your money sits in mutual funds, makes profits, and saves you taxes.

Key Takeaways

  • Mutual funds are investment tools that gather money from multiple investors to build a diversified portfolio of stocks managed by professional fund managers.
  • They provide access to various investors, regardless of their financial expertise or capital.
  • Mutual funds offer diversification, spreading investments across different asset classes to minimize risk.
  • Professional fund managers conduct research and analysis to make investment decisions that align with the fund’s objectives.
  • Investors buy shares or units of the mutual fund, and returns are distributed based on the amount they hold.

Final Thoughts

Investing in mutual funds is an excellent choice as you can put your money to work and grow wealth with even novice market knowledge. Also, as experts manage the funds, you do not have to worry about understanding mutual funds and the financial market. In addition, you are provided transparency, liquidity, the lowest lock-in period, and tax benefits with the mutual funds.

FAQs on What are Mutual Funds


1

How are mutual fund returns generated?

Mutual fund returns are generated through capital gains and dividend income. Capital gains occur when the value of the fund’s investments appreciates, while dividend income is earned from dividends paid by the underlying securities held within the fund’s portfolio.



2

What are the different types of mutual funds?

Mutual funds come in various types, including equity, bond, money market, index, sector, and balanced funds. Each type of mutual fund has its own investment objectives, risks, and potential returns.



3

What is the difference between actively managed and passively managed mutual funds?

Actively managed mutual funds are overseen by fund managers who make investment decisions based on market research and analysis. In contrast, passively managed mutual funds seek to replicate the performance of a specific index or benchmark and typically have lower management fees.


4

How can investors invest in mutual funds?

Investors can invest in mutual funds through a Systematic Investment Plan (SIP), which involves investing a fixed amount regularly or via the lump sum route, where investors invest a single large amount at once. They can purchase mutual fund shares directly from the fund company or through a financial advisor or broker.


5

Can I Withdraw Money From a Mutual Fund Anytime?

Yes, you can withdraw money from an open-ended mutual fund anytime. However, withdrawals might be subject to exit loads and tax implications.


6

Can I Invest ₹100 in a Mutual Fund?

Yes, you can invest as little as ₹100 in some mutual funds through Systematic Investment Plans (SIPs), depending on the fund’s minimum investment requirements.

- A Consumer Education Initiative series by Kotak Life

Amit Raje
Written By :
Amit Raje

Amit Raje is an experienced marketer who has worked in various Fintechs and leading Financial companies in India. With focused experience in Digital, Amit has pioneered multiple digital commerce in India. Now, close to two decades later, he is the vice president and head of the D2C business department. He masters the skill of strategic management, also being certified in it from IIMA. He has challenged his challenges and contributed his efforts in this journey of digital transformation.

Amit Raje
Reviewed By :
Prasad Pimple

Prasad Pimple has a decade-long experience in the Life insurance sector and as EVP, Kotak Life heads Digital Business. He is responsible for developing user friendly product journeys, creating consumer awareness and helping consumers in identifying need for life insurance solutions. He has 20+ years of experience in creating and building business verticals across Insurance, Telecom and Banking sectors

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