Today mutual funds are my bread and butter. Thanks to brilliant marketing, most of us have atleast heard of mutual funds and we also mostly nod our heads when we see or hear “Mutual Funds Sahi Hai”. But beyond that, many of us falter at knowing what it really is and how can you make a start in your journey. While reams and reams have been written about this easy financial product, sometimes the basic elements can slip through the cracks. Hence, this all easy guide to take you through everything that you need to know before you take the plunge or just to even chisel that understanding.

What are mutual funds?

The AMFI website does a good job of an initial definition with “A mutual fund is a pool of money managed by a professional Fund Manager. It is a trust that collects money from a number of investors who share a common investment objective and invests the same in equities, bonds, money market instruments and/or other securities”.

But before the jargon scares you off, let’s break down some of the aspects. Mutual Fund simply refers to a product where a large number of investors’ funds are pooled together by professionals to buy and trade securities – be it stocks, bonds or precious metals. While there is a whole team behind the well-oiled machinery, the front-end face to a mutual fund is the fund manager. Often, people correlate a fund’s performance to its’ manager.

The two main asset classes traded in financial markets are debt and equity (more on this in the next segment). However, these can be complicated to analyse and choose especially which one to invest in and the points of entry or exit. That is where a Fund Manager enters who is aided by a research team and together they traverse the complicated landscape to decide where to put the fund money. All of this is managed or overseen by a Trust or AMC (Asset Management Company) working for the benefit of investors.[4] 

To sum it up, mutual funds are an easy, liquid (quickly tradable[5] ) route to growing your money over time without getting into the nitty gritties of the assets being invested in.

 Why should you invest in Mutual Funds?

Traditionally, Indians have always loved three assets – Fixed Deposits, Real Estate and our blingy favorite Gold. On the other spectrum are those who love anything exotic when it comes to financial products. However, gradually people are beginning to see the benefits of moving over to mutual funds:

1. Liquid

Mutual funds are one of the most liquid (ability to be converted back to cash) assets that you can invest in. At any time, within three market days you are due to have the money back in your bank account. When I say this, I am excluding black swan events like the Franklin India debt debacle which meant investor money was stuck in so-called lower risk debt funds.

2. Convenient

Today, there are insane number of platforms and avenues which allow you to invest in mutual funds. Even the KYC (Know Your Customer) to start that journey has become quite easy with just a PAN and Aadhaar required to get you started. This can even be done completely online. Most importantly, you don’t need a very high amount to start with either considering most AMC’s keep the benchmark pretty low at Rs. 1000.

3. Professionally managed

One big barrier for people to invest in a high-return asset like equities is the lack of knowledge or awareness. That’s where mutual funds are the best option considering the team of researchers and well trained fund managers to tend to that money. In today’s hyper competitive world of performance, they are almost always on the gas and held to responsibility.

4. Low cost

Unlike a lot of invisible costs that go in other investing options like real estate and gold, all mutual fund costs are grouped under a single terminology called Total Expense Ratio. Now, with the advent of index funds, the cost range starts even lower at 0.10{76b947d7ef5b3424fa3b69da76ad2c33c34408872c6cc7893e56cc055d3cd886}. It really can’t get better than that.

5. Transparent

This to me is one of the biggest advantages of mutual funds, especially when compared to exotic products like AIFs or Alternate Investment Funds. With the SEBI mandate of each AMC having to declare their portfolios in all funds at the end of the month, anyone can download and have a very clear idea of the constituent units. Not just that, the performance can be easily tracked on a daily basis (although in my books, that’s not very advisable).

6. Tax efficient

All three of the traditional products mentioned above – FD, real estate and gold lose their luster in comparison to mutual funds on this parameter. Although real estate still gets the benefit of indexation, equity mutual funds offer a much better deal in terms of taxation. If the words are swimming in front of you in their foreignness, read on till the end where the section on taxation will clear it all. 

Important Terms to Know

One of the scary things about investing to someone wanting to dip their toes in is all the jargons and abbreviations. But, why fear when I am here.

1. NAV or Net Asset Value

NAV was one of the terms which I didn’t know before I started investing. NAV is the price at which the mutual fund is currently trading. Unlike with individual stocks where the price changes by the minute, the NAV changes only at the end of the trading hours.

It’s an easy calculation too. Just divide the funds’ net worth (cash and assets minus liabilities) with the number of Mutual fund units outstanding. However, if you are looking to deep dive into the concept, this handy guide helps.

However, know that NAV is meant only as a reference point in terms of tracking performance and taxation. The reason I say this is that I have now met many investors who love the idea of NFOs or new funds simply because they start from square one, or NAV 10 in this case. They seem to believe that it is an easier jump from Rs. 10 to Rs. 15 rather than Rs. 600 to Rs. 900. But, the movement of the NAV depends on the performance of the fund and for that reason NAV is just a reference point. It is not a commentary or an indicator for future performance.

2. Units

The NAV that is quoted refers to one unit of the mutual fund in question. A unit is the parameter in which mutual funds are denoted and they are uniform irrespective of your purchase price.

Let’s take an example. Suppose you invest Rs. 5,000 in a mutual fund on a day that the NAV is Rs. 50. You are allotted 100 units. Five years later, you decide to add on Rs. 5000 but the NAV has moved to Rs. 100. In this case, you will get 50 units. Altogether, you now have 150 units with an NAV of Rs. 100 and total market value of Rs. 15000 (that’s because your initial investment has moved with the market to double to Rs. 10,000). Further, to seal the example, you look at your fund after another five years when the NAV has moved up to Rs. 200. To know the market value of your investment simply multiply it by the number of units (150) to land at the sum of Rs. 30,000.

Unlike stocks where fractional shares were revolutionary, units are mostly allotted fractionally (upto 4 decimal points) in the case of mutual funds.

3. AMC or Asset Management Company

The company managing the mutual fund is called an AMC or Asset Management Company simply because they are the ones managing the assets bought from investor funds. Alternately in regular parlance, they are even referred to as Fund Houses. So, companies like Axis Mutual Funds, DSP Blackrock, Motilal Oswal etc. are all AMCs or Fund Houses.

4. AUM or Assets under management

AUM is the total market value of the funds being managed under a particular Mutual Fund. Generally, the AUM of a fund keeps growing with the number of years of existence, unless there is a major market downturn.

 There are two ways to look at an AUM. One, if the fund has been in existence for many years and yet it’s AUM is a pitifully small number (as compared to others in the category) then you may want to introspect whether it’s the right fund for you. Two, for categories like Small Cap and even Mid Cap, sometimes bigger AUMs prove to be a hindrance for the fund rather than a blessing. The reason is that as you go down the market cap totem pole, stocks are less liquid. As the fund AUM bloats up, any change in position becomes that much more challenging.

5. Folio Number

Folio number is like a Mutual Fund account number. It is a unique identifying number for an investor with a particular AMC. It serves as a unique number for any communication with the fund house.

In one AMC, you can have multiple funds within the same folio. But, from my experience, it is advisable to keep it to one folio per fund for organizational simplicity.

6. Total Expense Ratio

As mentioned earlier, this professional expertise of managing your money to invest and trade in securities comes at a cost. As per SEBI the total expense ratio for equity mutual funds is capped at 2.5{76b947d7ef5b3424fa3b69da76ad2c33c34408872c6cc7893e56cc055d3cd886}, for debt funds at 2.25{76b947d7ef5b3424fa3b69da76ad2c33c34408872c6cc7893e56cc055d3cd886} and for index funds at 1.5{76b947d7ef5b3424fa3b69da76ad2c33c34408872c6cc7893e56cc055d3cd886}.

 While these numbers might seem miniscule right now, check out this example to see how these small numbers can make a big difference.

7. Exit Load

Almost all mutual funds come with an exit load in case you end up redeeming very early into the investment. For instance, most open ended mutual funds charge a 1{76b947d7ef5b3424fa3b69da76ad2c33c34408872c6cc7893e56cc055d3cd886} exit load if redeemed in less than one year since investing. The reason is simple. Ideally, equity mutual funds should be invested into with a minimum three year horizon as it lets you ride the volatility cycle that inevitably comes with the terrain.

Types of Mutual Funds

A few years back, SEBI streamlined mutual funds with clearly defined categories. Within those, there are three broad types of mutual funds that any investor should know of:

1. Equity

This is what is commonly referred to as the stock market and a lot of people mistakenly assume this to be the only category of mutual funds. Equity essentially allows you to buy a super-miniscule part of the underlying company. The prices move depending on a lot of factors including company performance, relative performance as compared to industry peers, industry forecast, macroeconomics as well as broader investor sentiment.

Equity is a high risk high reward game. 2020 is witness to the crazy swings that this asset class can take going from one extreme to the other. Within equity there are ten (eleven if you include the newly introduced Multi Cap category) types of funds with varying degrees of risk. Read this detailed guide before heading into this direction.

2. Debt

Also referred to as Fixed Income, this is an asset where investors earn from the interest income of institutional borrowers, be it governments or corporates. This is done through varied assets like bonds, debentures and money market instruments. Debt Mutual Funds allow investors to put in their money into portfolios of varied debt instruments mostly divided on the basis of the term or type of borrower.’

Debt is lower risk and lower returns than equity. Returns are generally inversely proportional to the interest rate movement in the economy. So, when interest rate goes down (like it did from mid-2019 to mid-2020), debt fund returns are higher and vice versa. However, returns are generally range bound in the space of 3.5-12{76b947d7ef5b3424fa3b69da76ad2c33c34408872c6cc7893e56cc055d3cd886} (12{76b947d7ef5b3424fa3b69da76ad2c33c34408872c6cc7893e56cc055d3cd886} being in the situations of rapid interest rate cuts). Read this in-depth guide to get a good idea of the 16 SEBI defined types before you choose to invest.

3. Hybrid

As the name suggests, hybrid funds have a mix of debt and equity which then gives options to different risk profiles. Within hybrid funds, one main distinction is equity oriented or debt oriented hybrid funds. In the former, the fund at all times has a weight of more than 65{76b947d7ef5b3424fa3b69da76ad2c33c34408872c6cc7893e56cc055d3cd886} equity in the portfolio whereas in the latter it can go lower than that. This distinction assumes utmost importance when it comes to knowing the tax profile of your fund. Read on to know about the hybrid fund variants in this guide.

Some choices to make while investing

Apart from the terms mentioned above, we in financial services like to complicate things further so that we can keep the industry thriving. Below are some of the choices you need to make while investing and knowing about it will serve while to lay the foundation.

1. Mode of Investment – Lumpsum, SIP or STP?

If you are in India, there is little chance you have not heard of SIP. Many people tend to get confused as to whether SIP is a different category altogether of Mutual Funds.

There are three routes for an investor to invest in Mutual Funds, with respect to frequency. They can either invest a lump sum in one-go, stagger a large sum through STP (Systematic Transfer Plan) or invest smaller amounts every month directly from their bank account through SIP (Systematic Investment Plan).

 STP works well for large sums of money that are available and handy. Instead of putting in that money in one go dependent on the market price that day itself, it is ideal to stagger and distribute the amount over a longer period. As an example, if you are looking to invest Rs. 10 Lakh each in two funds. You could choose to put this amount in the same AMC’s liquid fund or arbitrage fund and initiate switch on it. My preference is a weekly frequency. So, in this case I would choose Fund 1 to be switched on Tuesday and Fund 2 to be switched on Thursday every week, for 10 weeks. Funnily enough, a lot of funds even offer daily STP which you could consider if you expect the markets to be really choppy.

SIP or systematic investment plan refers to the mechanism where investors can automatically invest an equal amount every month. So, you can easily make investing a habit by carving out a chunk from your monthly salary which would be automatically debited from your bank account and into the chosen funds. SIP has a lot of benefits since it is automated and gets the investor to make more and more investments. Most mutual funds have a minimum investment requirement of Rs. 5000 for a one-time investment and Rs. 500 or maximum Rs. 1000 per month for SIP. Read more about SIP in my detailed guide here.

2. Type of scheme – Dividend or Growth

As mentioned earlier, the money from Mutual Funds is used to buy securities. Most securities give some income from time to time – be it dividend declared by company stocks or interest income from bonds. Mutual Funds can either reinvest the dividends that they receive or pay it out to investors. The former is called a Growth scheme where the dividends are reinvested and allowed to compound and grow. The latter makes up the Dividend scheme.

Personally, I have never been in favor of Dividend schemes considering their erosion of principal. However, a lot of people like timely cashing into their mutual fund investments and dividend were a popular instrument. So much so, that in the last bull run of 2017, a lot of fund houses introduced monthly dividend schemes in the lower volatility hybrid categories. However, most good things come to an end. In 2018, the first blow came with a 10{76b947d7ef5b3424fa3b69da76ad2c33c34408872c6cc7893e56cc055d3cd886} tax implication. 2020 will probably be the death knell for it whereby all dividends are now to be taxed as per the investor tax bracket.

My suggestion would be to always always choose Growth schemes. Even if you want regular payouts from your fund, then SWP or Systematic Withdrawal Plans make for a much better option.

3. Type of expense ratio – Regular or Direct

 Off late, another distinction that has emerged within mutual funds is that of regular and direct. As we all know, there is no free lunch in this world. Managing a Mutual Fund comes with a host of expenses including the salary of the Fund Manager as well as the technology and the other human resources supporting the efficient running of the fund. All Mutual Funds thus charge a TER or Total Expense Ratio which is of two types.

Regular Mutual Fund is the old-school style of mutual funds since inception. It includes expenses which comes with an in-built cost to the distributor as that used to be the only route to investing in mutual funds. Today, regular remains the default and if there is no specific mention with a mutual fund name then it is the regular variant being talked about.

SEBI realised that there are some investors now investing on their own (probably using a digital platform but no advice per se) and still ending up paying a distribution cost. Hence, in 2013, they mandated that all AMCs were to provide an option where such direct investors could invest without having to pay distribution charges. Hence, Direct mutual funds have a lower TER than regular mutual funds whereby the difference becomes substantial over years of compounding. Although there are many platforms like Kuvera, MoneyFront ET Money etc that help invest in direct mutual funds, do so only if you have a clear understanding of the subject matter. Else, go with an advisor even if it means regular schemes with in-built brokerage.

4. Time limit to the mutual fund? Open or close ended

Close-ended funds are a new development in the Indian Mutual Fund scenario. These are funds which have a limited period New Fund Offering and are also traded on the market. However, they have a timeline to maturity as well. You cannot redeem the units before maturity but you can trade them on the market.

 With close-ended stocks there is no historical trend that can be considered and if there is a market downturn. Also, you and in most cases the fund management has no control over when the redemption happens. It’s almost like market timing because it depends on what cycle the fund matures in. Only in exceptional cases like the HDFC Housing Opportunities Fund which was to mature on 18th January, 2020, the fund management made it open ended at the last minute. Meaning investors could stay on and hope for the fund to recover before they chose to redeem.

Ideally, stick to the tried-and-tested open-ended funds which have a historical trend to show for themselves. The good news is there are more than enough good options that fall under this lens.

 Taxation on Mutual Funds

 There are two types of taxes levied on Mutual Fund investments in India on the basis of how long they have been held – the period being defined as short term and long term with the returns being termed as capital gains. As for the definition of equity and debt (especially when it comes to hybrid), any fund which has more than 65{76b947d7ef5b3424fa3b69da76ad2c33c34408872c6cc7893e56cc055d3cd886} invested in equity as part of it’s structure is taxed as equity.

Debt Fund Tax Norms

For debt funds, short-term is defined as 3 years. Short-Term Capital Gains or STCG are treated as income and taxed accordingly.

So, if you invested in Debt Fund A for Rs. 50,000 and sold it for Rs. 70,000 after 28 months, Rs. 20,000 is considered to be an additional source of income. If you fall in the 30{76b947d7ef5b3424fa3b69da76ad2c33c34408872c6cc7893e56cc055d3cd886} income tax bracket, you end up paying Rs. 6000 (30{76b947d7ef5b3424fa3b69da76ad2c33c34408872c6cc7893e56cc055d3cd886} of Rs. 20,000) as income tax.

If you redeem your debt funds after 3 years, it is considered as a Long Term Capital Gain or LTCG. The gains are then taxed at 20{76b947d7ef5b3424fa3b69da76ad2c33c34408872c6cc7893e56cc055d3cd886} after factoring in inflation by defined indexation numbers as released in the CII or the Cost Inflation Index. To get a detailed idea, check out my earlier post clarifying all you may need to know for capital gains.

Equity Fund Tax Norms 

For equity funds, short-term is defined as 1 year. Short-Term Capital Gains or STCG is taxed at 15{76b947d7ef5b3424fa3b69da76ad2c33c34408872c6cc7893e56cc055d3cd886}. So, if you invested Rs. 50,000 in Equity Fund X and sold it at Rs. 60,000 in 10 months, you are liable to pay Rs. 1,500 (15{76b947d7ef5b3424fa3b69da76ad2c33c34408872c6cc7893e56cc055d3cd886} of the gain of Rs. 10,000) as tax.

For a long time, long-term capital gain or LTCG on Equity funds was tax exempt which was a great boost to get people to invest. From April 1, 2018, LTCG on equity funds is taxed at 10{76b947d7ef5b3424fa3b69da76ad2c33c34408872c6cc7893e56cc055d3cd886} beyond Rs. 1,00,000 gain in a single financial year. The prices are grandfathered until Jan 31, 2018. The capital gains post provides you with all that you need to know in this regard, too

How to start investing in Mutual Funds in India?

Today, investing in Mutual Funds is really easy in India. Just googling “Invest in Mutual Funds in India” gave me about 10 Crore results in 0.89 seconds.

However, take a call whether you want to do it with an advisor who also guides you through market volatility or wing it on your own. Ensure you are well-versed with the cost structure of your arrangement, be it regular or direct. Most importantly, go with a trustworthy name and ensure it is SEBI certified. After all, this is your money that you are entrusting someone else with. In case you are planning to fly solo, focus more on the UI/UX of the platform and the kind of reports you can generate. Opening an account is no longer a barrier if you have your PAN card and Aadhaar card handy.

Investing is simple when we take some effort to know the details about the options. If you read this thoroughly, you dear reader are definitely ready to make informed decisions in your Mutual Fund investment journey.