- What are mutual funds?
- How do mutual funds work?
- Management of mutual fund portfolio
- Risk profile of mutual funds
- Types of mutual fund schemes
- Understanding the performance of mutual funds
- Taxation of mutual funds
- Why choose mutual funds?
What are mutual funds?
Mutual funds are investment schemes wherein money from different investors is pooled together in a fund. Thereafter, a fund manager uses the pooled money and allocates it to different types of stocks and securities. With investments in different types of assets, a portfolio is created and you are allotted units for your share of investment in the portfolio.
How do mutual funds work?
To understand the working of mutual funds, the following flowchart can be considered –
Management of mutual fund portfolio
A mutual fund scheme is expertly managed by experienced fund managers. These fund managers are hired by the mutual fund companies and one or more managers can be tasked to manage a fund. The fund managers, then, decide on –
- Where to invest
- When to invest
- How much to invest
Fund managers make decisions in the interest of the investors so that investors can earn maximum returns on their investments.
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Risk profile of mutual funds
Mutual funds invest in securities in the financial market. Returns are, therefore, market linked. If the value of the underlying assets increases, the fund grows and vice-versa. Mutual funds, therefore, are risky.
The risk profile of mutual funds depends on the fund that you choose. Equity mutual funds have a very high risk profile while debt funds have a very low risk.
Types of mutual fund schemes
Mutual funds come in different variants to suit the investment preference of different investors. There are, mainly, three types of mutual fund schemes which are –
- Equity mutual funds which invest at least 65% of their portfolio in equity
- Debt mutual funds which invest a majority of their portfolio in debt
- Balanced mutual funds which invest in both equity and debt
Here are the characteristics of these funds –
|Type of mutual fund||Characteristics|
|Equity mutual fund||· High risk high return profile
· Minimum 65% portfolio is invested in equity stocks and securities
· Investment objective is long term capital appreciation
· Further sub-divided into large cap funds, small cap funds, ELSS schemes, mid cap funds, etc.
|Debt mutual funds||· Invest in fixed income instruments
· Have a low risk low return profile
· Since investment and redemption of debt instruments are done at different intervals, there is no fixed return
· Further sub-divided into liquid funds, short term debt funds, long term debt funds, dynamic bond funds, fixed maturity plans, etc.
|Balanced funds||· Have a moderate risk moderate return profile
· Invest in both equity and debt
· Funds which invest primarily in equity are called aggressive hybrid funds
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ELSS mutual funds
ELSS mutual funds are one of the most popular mutual fund schemes given their tax advantage. ELSS stands for Equity Linked Saving Scheme and it is an equity mutual fund. Investments into ELSS funds qualify for deduction under Section 80C of the Income Tax Act, 1961 up to Rs.1.5 lakhs. There is a lock-in period of 3 years during which redemption and switching is not allowed.
Systematic Investment Plans (SIP)
SIP stands for Systematic Investment Plans. SIPs are not a type of mutual fund but a mode of investing in a mutual fund scheme. If you choose SIPs, you can invest regularly into a mutual fund scheme rather than in one lump sum. You can choose the amount to be invested, the frequency of investment and the investment tenure over which the SIP would continue.
SIP investments are affordable, disciplined and give you the benefit of rupee-cost averaging wherein you don’t have to time the market every time you invest.
Here is a FREE SIP Calculator tool which will help you to calculate an estimated earnings at the end of a specified tenure.
To choose a SIP, you must, first understand the type of mutual fund scheme that you want and then invest in it through SIPs. When choosing the type of mutual fund scheme, you should consider –
- Your risk appetite
- Past investment experience
- Your disposable income
- Financial goals
- Investment horizon
- Number of dependents, etc.
Once you know which type of mutual fund scheme would be suitable, you can invest through SIPs. You should, however, compare similar mutual fund schemes of different houses on their returns and consistency and then invest. Make sure you compare similar mutual funds with each other so that you can get the best results.
Taxation of mutual funds
Mutual funds are taxed based on the composition of their portfolio and the period for which you stay invested in the fund. If the fund invests at least 65% of its portfolio in equity, there would be equity taxation on the returns earned. If, however, the fund does not have at least 65% of its portfolio in equity, there would be debt taxation. Here’s how equity and debt taxation are applied –
- Equity taxation
- If the fund is redeemed within 12 months of investment, the returns earned would be termed short term capital gains. Such gains would be taxed @15% + cess
- If the fund is redeemed after 12 months of investment, the returns earned would be termed long term capital gains. Long term capital gains are tax-free up to Rs.1 lakh. Returns exceeding Rs.1 lakh are taxed @10%
- Investment in equity mutual funds, except ELSS schemes, form a part of your taxable income
- Debt taxation
- If the fund is redeemed within 36 months of investment, the returns earned would be termed short term capital gains. Such gains would be taxed at your income tax slab rate
- If the fund is redeemed after 36 months of investment, the returns earned would be termed long term capital gains. Long term capital gains are taxed @20% with the benefit of indexation
- Investment in debt mutual funds form a part of your taxable income
Balanced funds would be taxed as equity or debt depending on their asset allocation.
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Why choose mutual funds?
Now that you know what mutual funds are and their various aspects, you should also know the benefits of investing in mutual fund schemes. Mutual fund schemes are ideal for investment because of the following reasons –
- Professional management helps you invest in the right securities
- Diversified portfolio helps in minimizing risk and maximizing returns
- They are easily available
- Different types of mutual fund schemes to suit your investment objective
- They are liquid and tax efficient
- You can invest in a disciplined manner through SIPs
Mutual fund investments are, therefore, popular and suitable for all types of investors. Before you begin your mutual fund journey you should take this FREE course on Mutual Funds and understand mutual funds in depth so that you can choose your preferred scheme and maximize your wealth.