21 Facts about Mutual Funds that You Must Know Before Investing

It’s time to move over from Public Provident Fund (PPF), Fixed Deposits (FD), Gold and other safe investment options. The market is hitting a new high and financial gurus are predicting a more than satisfying returns from investments. This should be enough to get you out of the safe investment mode and develop an appetite for risk and an interest in mutual funds and equities as an investment option. But before you take the big investment plunge, get your facts correct and make a sound investment choice.

We will help you in learning the ropes of the financial investment asset mutual fund. We are sure with information in your stride; chances of your making a mistake will be minimal.

Here’s laid out before you 21 important and interesting facts about mutual funds.

The Basics:

Mutual Funds are operated under a 3 tier structure in India. The three tier structure is formed by a Sponsor, Trust and the Asset Management Company. We define the 3 tier structure simply for you.

A Sponsor is the person responsible for the operations of the mutual fund.

The sponsor who operates the responsibilities and duties of a mutual fund creates the Trust. The Trust is governed by the law of Indian Trusts Act, 1882. The money of the investors is held under the Trust.

The collective decision of the Sponsor and the Trust results in the appointment of an Asset Management Company (AMC). The AMC manages the money of all the investors or shareholders under the supervision of the Trust.

Types of Investing:

An investor can opt for two variants of investment type when it comes to Mutual Fund investing; one is Actively Managed Funds and the other Passively Managed Fund.

The actively managed funds generate higher returns for its investors by trying to beat the index benchmark of Sensex and Nifty. However, the lieu of higher returns also brings in the additional cost of research and an active fund management team to ensure investors remain satisfied and aligned with the fund.

The passively managed funds have the sole aim of replicating the returns of the index benchmark to any possible extent. However, these funds never make an attempt to create new benchmark returns records or anything similar.

*All index funds are passively managed.

Value of the Mutual Fund:

The value of a mutual fund can be determined by its net asset value or NAV. The net asset value in a mutual fund is determined for each unit number and this the total NAV of the fund is calculated by taking into account the value of all the investments made by the fund minus all the expenses made by it.

Equity or Debt?

It is to be noted that the returns on the mutual funds attract tax and based on this mutual funds are divided into a broader classification of equity or debt.

A fund investing more than 65% of its portfolio in equity and equity related assets is classified as an Equity mutual fund while investment of less than 65%, is considered as debt mutual fund. The tax laws are applicable on the returns on the basis of this broad classification of funds.

Tax Benefits

Equity Fund: Since the above broad categories is based on tax, now get to know the nitty gritty of the tax rules applicable on Equity mutual funds. These are subject to capital gains and also enjoy related tax benefits. There is no long-term capital gains tax levied on an investor on the equity fund if he remains invested in the fund for more than 1 year. A Lower short-term capital gains tax of 15% is charged if the investor sells his equity mutual fund within a year. Dividend Distribution tax is not applicable to equity funds.

Debt Fund: A short-term capital gains tax is levied for selling the debt fund within a short period of three years. This tax is levied at the marginal income tax rate. The long-term capital gains tax is applicable if the investor sells his shares in the fund post the maturity of three years. The tax rate for the long-term capitals gain is charged at 20% with indexation. On declaration of dividend a debt fund is obliged to pay the dividend distribution tax at the rate of 25% + surcharges (effectively 28.84%). However, the relief for the investor is that the dividend he receives is already post the tax applied and therefore he does not have to bother with the tax post the returns.

Balanced Funds: Also known as hybrid funds, a balanced fund achieves a perfect harmony of investments by investing money in both debt as well as equity funds. Interestingly, it is not necessary for a hybrid fund to invest an equal share or a 50:50 in equity and debt. Some of them have 65% or more exposure to equity and they enjoy the tax benefits under the ambit of equity funds.

Wealth Tax:

Wealth tax isn’t calculated on mutual funds and therefore they do not classify as wealth.

Investment Rules:

It is important to understand that the entire amount invested in a mutual fund is never invested in assets. Each mutual fund has a mandate as decided upon by its fund manager and his team. While some of the money invested could be diverted to buy assets some could be retained in liquid/cash, so as to provide for redemptions / withdrawals or meeting short term expenses. Lack of good investment opportunities could also result in funds holding the money in hand.

Sectoral Funds:

Funds specific about investing in certain sectors do exist. Some funds will invest only in specific sectors like auto, ancillary, banking, cement, pharma, etc. A sectoral fund can face the challenge of a limited universe of stocks to invest in and can be forced in the future to invest in opportunities just to complete the mandate because of the lack of good options available to invest in.

Investment Style: There are three ways of investment in Mutual Funds ,

Growth: Invests in high growth companies

Value: Invests in companies at a price less than their value

Hybrid: A healthy mix of both investments in Growth and Value.

Portfolio Turnover:

Do you need to be worried for an overhaul in the portfolio done by your fund manager? Yes and no.

If a mutual fund consistently goes for a portfolio turnover, it would result in high brokerage costs as well as it depicts an unsteady investment style. However, this may not be the case always. Sometimes major changes are done in the portfolio by the fund manager as a part of a new investment strategy. This temporarily could cause a spike in turnover ratio. Portfolio turnover is high when fund managers invest in very short period instruments for liquid funds and are constantly into buying and selling.

International Funds:

Certain fund managers follow the mandate of investing in international stocks or stocks of other countries to add a layer of diversification to the portfolio. However, there are two risks involved with investment in an international fund- one is exposure to the international markets and the other the constant change in the rate of currency.

Monthly Income Plan:

A Monthly Income Plan (MIP) does not offer a monthly income as the name suggests. It is a debt oriented hybrid mutual fund where the larger portion of investments is in debt mutual fund and a lesser portion of investment is in equity mutual fund. The equity component of this mutual fund typically does not exceed 30% investments of the total portfolio. MIPs are taxed as debt funds.

Fixed Maturity Plan:

A Fixed Maturity Plan or FMP is similar to a fixed deposit only that the investment here takes place through a mutual fund. The Fixed Maturity Plan sees an investment for a fixed time period and a fixed interest rate.

FMPs are available generally for an investment period of 3, 6, 12 or 24 months. FMPs offer higher returns than a Bank FD. Ultra-short term funds could also be an alternative to Bank FDs for those who plan to invest their money for a short time frame of more than a year.

Interest vs Value:

The relationship between interest rates the value of debt funds is inversely proportional. A rise in the interest rates affects the value of debt funds bringing in a fall and vice versa.

Tracking Error:

A tracking error is the margin by which the fund trails the index. This is tracked to identify a good index fund for an investment. The tracking error is a result of the transaction costs incurred to adjust the fund to the index.

Gold ETF:

Gold ETF is a great financial asset for investment with no storage costs, no insurance premiums, no risk of theft and high liquidity benefits. While physical gold remains the premium choice for investments, it is to be noted that anything apart from the personal jewellery is subject to wealth tax. Gold ETFs are exempted from wealth tax and it can be easily bought through a trading account for as low as half a gram.

Growth vs Dividend:

An investment in mutual funds offers the following two options: Growth & Dividend. The Growth option allows investments to grow and this is clearly reflected with an increase in NAV. With Dividend option, the fund allows you to receive dividends at regular intervals which an investor chooses to receive or reinvest in the same fund. The reinvestment of dividend causes an increase in units and for those looking for tax relief from high tax bracket category, should invest the money in debt funds and select the dividend option to save on taxes.

Regular vs Direct Plan:

Regular plans are sold by distributors and they offer commission payouts from the investment.

There are no commission payouts in the direct plans and therefore there is more money on the table and indirectly higher returns for the investor.

SIP & STP:

Systematic Investment Plan or SIP is often mistaken for a fund but ideally it is a monthly plan which allows the investor to invest regularly at installments in a selected mutual fund of the investor’s choice. The Systematic Transfer Plan or STP is another method to invest money. Systematic Withdrawal Plan allows withdrawing of money in installments.

With the knowledge of these 21 facts about mutual funds, get set roaring to make investments with a solid foundation on mutual funds.