Mutual Funds

What are Mutual Funds

M utual funds perform different roles for the different constituents that participate in it. Their primary role is to assist investors in earning an income or building their wealth, by participating in the opportunities available in various securities and markets.

It is possible for mutual funds to structure a scheme for different kinds of investment objectives. Thus, the mutual fund structure, through its various schemes, makes it possible to tap a large corpus of money from diverse investors.

As a large investor, the mutual funds can keep a check on the operations of the investee company, and their corporate governance and ethical standards.

Mutual funds can also act as a market stabilizer, in countering large inflows or outflows from foreign investors. Mutual funds are therefore viewed as a key participant in the capital market of any economy.

Advantages of Mutual Funds for Investors

Professional Management
Mutual funds offer investors the opportunity to earn an income or build their wealth through professional management of their investible funds.
There are several aspects to such professional management viz. investing in line with the investment objective, investing based on adequate research, and ensuring that prudent investment processes are followed
Affordable Portfolio Diversification
Investing in the units of a scheme give investors exposure to a range of securities held in the investment portfolio of the scheme. Thus, even a small investment of Rs. 500 in a mutual fund scheme can give investors ownership of a portion of a diversified investment portfolio.
Consequently, the investor is less likely to lose money on all the investments at the same time. Thus, diversification helps reduce the risk in investment.
Economies of Scale
The pooling of large sums of money from so many investors makes it possible for the mutual fund to engage professional managers to manage the investment. Individual investors with small amounts to invest cannot, by themselves, afford to engage such professional management.
Large investment corpus leads to various other economies of scale. For instance, costs related to investment research and office space get spread across investors. Further, the higher transaction volume makes it possible to negotiate better terms with brokers, bankers and other service providers.
At times, investors in financial markets are stuck with a security for which they can’t find a buyer – worse, at times they can’t find the company they invested in! Such investments, whose value the investor cannot easily realise in the market, are technically called illiquid investments and may result in losses for the investor.
Investors in a mutual fund scheme can recover the value of the moneys invested, from the mutual fund itself. Depending on the structure of the mutual fund scheme, this would be possible, either at any time, or during specific intervals, or only on closure of the scheme.
Tax Deferral
Mutual funds are not liable to pay tax on the income they earn. If the same income were to be earned by the investor directly, then tax may have to be paid in the same financial year.
Mutual funds offer options, whereby the investor can let the moneys grow in the scheme for several years. By selecting such options, it is possible for the investor to defer the tax liability. This helps investors to legally build their wealth faster than would have been the case, if they were to pay tax on the income each year.
Tax benefits
Specific schemes of mutual funds (Equity Linked Savings Schemes) give investors the benefit of deduction of the amount subscribed (upto Rs. 150,000 in a financial year), from their income that is liable to tax. This reduces their taxable income, and therefore the tax liability.
Dividends received from mutual fund schemes are tax-free in the hands of the investors. However, dividends from certain categories of schemes are subject to dividend distribution tax, which is paid by the scheme before the dividend is distributed to the investor. Long term capital gains arising out of sale of some categories of schemes are subject to long term capital gains tax, which may be taxed at a different (and often lower) rate of tax or even entirely tax exempt.
Convenient Options
The options offered under a scheme allow investors to structure their investments in line with their liquidity preference and tax position.
There is also great transaction conveniences like the ability of withdraw only part of the money from the investment account, ability to invest additional amounts to the account, setting up systematic transactions, etc.
Investment Comfort
Once an investment is made with a mutual fund, they make it convenient for the investor to make further purchases with very little documentation. This simplifies subsequent investment activity.
Regulatory Comfort
The regulator, Securities & Exchange Board of India (SEBI), has mandated strict checks and balances in the structure of mutual funds and their activities. Mutual fund investors benefit from such protection
Systematic Approach to Investments
Mutual funds also offer facilities that help investor invest amounts regularly through a Systematic Investment Plan (SIP); or withdraw amounts regularly through a Systematic Withdrawal Plan (SWP); or move moneys between different kinds of schemes through a Systematic Transfer Plan (STP). Such systematic approaches promote investment discipline, which is useful in long-term wealth creation and protection. SWPs allow the investor to structure a regular cash flow from the investment account.

Types of Mutual Funds

Based on your goals and your investment horizon, Mutual Funds give you the option to invest your money across various asset classes like equity, debt and gold. This allows you to diversify your investments and strive to reduce your portfolio risk. .

The portfolio of a mutual fund scheme will be driven by the stated investment objective of the scheme. A scheme might have an investment portfolio invested largely in equity shares and equity-related investments like convertible debentures. The investment objective of such funds is to seek capital appreciation through investment in these growth assets. Such schemes are called equity schemes.

Schemes with an investment objective that limits them to investments in debt securities like Treasury Bills, Government Securities, Bonds and Debentures are called debt funds.

Hybrid funds have an investment charter that provides for investment in both debt and equity. Some of them invest in gold along with either debt or equity or both.

Other funds, such as Gold funds, Real estate funds, Commodity funds and International funds, ETF etc create portfolios that reflect their investment objectives.

For Further details on type of funds click on the category links below:

Equity Funds

The portfolio of a mutual fund scheme will be driven by the stated investment objective of the scheme. A scheme might have an investment portfolio invested largely in equity shares and equity-related investments like convertible debentures. The investment objective of such funds is to seek capital appreciation through investment in these growth assets. Such schemes are called equity schemes.

Types of Equity Funds

Equity funds invest in equity instruments issued by companies. The funds target long-term appreciation in the value of the portfolio from the gains in the value of the securities held and the dividends earned on it. These funds can be categorized based on the type of equity shares that are included in the portfolio and the strategy or style adopted by the fund manager to pick the securities and manage the portfolio.
Diversified equity fund
Diversified equity fund is a category of funds that invest in a diverse mix of securities that cut across sectors and market capitalization. The risk of the fund’s performance being significantly affected by the poor performance of one sector or segment is low.
Market Segment based funds
Market Segment based funds invest in companies of a particular market size. Equity stocks may be segmented based on market capitalization as large- cap, mid-cap and small-cap stocks.

Large- cap funds invest in stocks of large, liquid blue-chip companies with stable performance and returns.

Mid-cap funds invest in mid-cap companies that have the potential for faster growth and higher returns. These companies are more susceptible to economic downturns and evaluating and selecting the right companies becomes important. Funds that invest in such companies have a higher risk of the companies selected not being able to withstand the slowdown in revenues and profits. Similarly, the price of the stocks also fall more when markets fall.

Small-cap funds invest in companies with small market capitalisation with intent of benefitting from the higher gains in the price of stocks. The risks are also higher.

Sector funds
Sector funds invest in only a specific sector.

For example, a banking sector fund will invest in only shares of banking companies. Gold sector fund will invest in only shares of gold-related companies.

The performance of such funds can see periods of under-performance and out-performance as it is linked to the performance of the sector, which tend to be cyclical.

Entry and exit into these funds need to be timed well so that the investor does not invest when the sector has peaked and exit when the sector performance falls. This makes the scheme more risky than a diversified equity scheme.

Thematic funds
Thematic funds invest in line with an investment theme.
For example, an infrastructure thematic fund might invest in shares of companies that are into infrastructure construction, infrastructure toll-collection, cement, steel, telecom, power etc. The investment is thus more broad-based than a sector fund; but narrower than a diversified equity fund and still has the risk of concentration.
Strategy-based Schemes
Strategy-based Schemes have portfolios that are created and managed according to a stated style or strategy.

Equity Income / Dividend Yield Schemes invest in securities whose shares fluctuate less, and the dividend represents a larger proportion of the returns on those shares. They represent companies with stable earnings but not many opportunities for growth or expansion. The NAV of such equity schemes are expected to fluctuate lesser than other categories of equity schemes.

Value fund invest in shares of fundamentally strong companies that are currently under-valued in the market with the expectation of benefiting from an increase in price as the market recognizes the true value. Such funds have lower risk. They require a longer investment horizon for the strategy to play out.

Growth Funds portfolios feature companies whose earnings are expected to grow at a rate higher than the average rate. These funds aim at providing capital appreciation to the investors and provide above average returns in bullish markets. The volatility in returns is higher in such funds.

Focussed funds hold portfolios concentrated in a limited number of stocks. Selection risks are high in such funds. If the fund manager selects the right stocks then the strategy pays off. If even a few of the stocks do not perform as expected the impact on the scheme’s returns can be significant as they constitute a large part of the portfolio.

Equity Linked Savings Schemes (ELSS)
Equity Linked Savings Schemes (ELSS) are diversified equity funds that offer tax benefits to investors under section 80 C of the Income Tax Act up to an investment limit of Rs. 150000 a year. ELSS are required to hold at least 80% of its portfolio in equity instruments. The investor’s the investment is subject to lock-in for a period of 3 years during which period it cannot be redeemed, transferred or pledged.
Rajiv Gandhi Equity Savings Schemes (RGESS) too, offers tax benefits to first-time investors. Investments are subject to a fixed lock-in period of 1 year, and flexible lock-in period of 2 years.

Debt Mutual Funds

Debt Mutual Funds mainly invest in a mix of debt or fixed income securities such as Treasury Bills, Government Securities, Corporate Bonds, Money Market instruments and other debt securities of different time horizons. Generally, debt securities have a fixed maturity date & pay a fixed rate of interest.

The returns of a debt mutual fund comprises of

Interest income

Capital appreciation / depreciation in the value of the security due to changes in market dynamics

Debt securities are also assigned a 'credit rating', which helps assess the ability of the issuer of the securities / bonds to pay back their debt, over a certain period of time. These ratings are issued by independent rating organisations such as CARE, CRISIL, FITCH, Brickwork and ICRA. Ratings are one amongst various criteria used by Fund houses to evaluate the credit worthiness of issuers of fixed income securities.
There is a wide range of fixed income or Debt Mutual Funds available to suit the needs of different investors, based on their:

Investment horizon

Ability to bear risk

Different types of Debt Mutual Funds

There are different types of Debt Mutual Funds that invest in various fixed income securities of different time horizons. Some of the debt based & blended category products (which have both debt and equity allocation) are as follows -
Liquid Funds / Money Market Funds
These funds invest in highly liquid money market instruments and provide easy liquidity. The period of investment in these funds could be as short as a day.
They aim to earn money market rates and could serve as an alternative to corporate and individual investors, for parking their surplus cash for short periods. Returns on these funds tend to fluctuate less when compared with other funds
Ultra Short Term Funds
Earlier known as Liquid Plus Funds, they invest in very short term debt securities with a small portion in longer term debt securities. Most ultra short term funds do not invest in securities with a residual maturity of more than 1 year. Also referred to as Cash or Treasury Management Funds, Ultra Short Term Funds are preferred by investors who are willing to marginally increase their risk with an aim to earn commensurate returns. Investors who have short term surplus for a time period of approximately 1 to 9 months should consider these funds.
Floating Rate Funds
These funds primarily invest in floating rate debt securities, where the interest paid changes in line with the changing interest rate scenario in the debt markets. The periodic interest rate of the securities held by these products is reset with reference to a market benchmark. This makes these funds suitable for investments when interest rates in the markets are increasing.
Short Term & Medium Term Income Funds
These funds invest predominantly in debt securities with a maturity of upto 3 years in comparison to a Regular Income Fund. These funds tend to have a average maturity that is longer than Liquid and Ultra Short Term Funds but shorter than pure Income Funds. These funds tend to perform when short term interest rates are high and could potentially benefit from capital gains as liquidity comes back to the market and interest rates go down. These funds are suitable for conservative investors who have low to moderate risk taking appetite and an investment horizon of 9 to 12 months.
Income Funds, Gilt Funds and other dynamically managed debt funds

These funds comprise of investments made in a basket of debt instruments of various maturities & issuers. These funds are suitable for investors who willing to take a relatively higher risk as compared to corporate bond funds, and have longer investment horizon. These funds tend to work when entry and exit are timed properly; investors can consider entering these funds when interest rates have moved up significantly to benefit from higher accrual and when the outlook is that interest rates would decrease. As interest rates go down, investors can potentially benefit from capital gains as well. A few types of dynamically managed debt funds are mentioned below

Income funds invest in corporate bonds, government bonds and money market instruments. However, they are highly vulnerable to the changes in interest rates and are suitable for investors who have a long term investment horizon and higher risk taking ability. Entry and exit from these funds needs to be timed appropriately. The correct time to invest in these funds is when the market view is that interest rates have touched their peak and are poised to reduce

Gilt Funds invest in government securities of medium and long term maturities issued by central and state governments. These funds do not have the risk of default since the issuer of the instruments is the government. Net Asset Values (NAVs) of the schemes fluctuate due to change in interest rates and other economic factors. These funds have a high degree of interest rate risk, depending on their maturity profile. The higher the maturity profile of the instrument, higher the interest rate risk.

Dynamic Bond Funds invest in debt securities of different maturity profiles. These funds are actively managed and the portfolio varies dynamically according to the interest rate view of the fund managers. These funds Invest across all classes of debt and money market instruments with no cap or floor on maturity, duration or instrument type concentration.

Corporate Bond Funds
These funds invest predominantly in corporate bonds and debentures of varying maturities that offer relatively higher interest, and are exposed to higher volatility and credit risk. They seek to provide regular income and growth and are suitable for investors with a moderate risk appetite with a medium to long term investment horizon.
Fixed Maturity Plans (FMPs)
Fixed Maturity Plans (FMPs) are closed ended Debt Mutual Funds that invest in debt instruments with a specific date of maturity that is less than or equal to the maturity date of the scheme. Securities are redeemed on or before maturity and proceeds are paid to the investors.
FMPs are similar to passive debt funds, where the portfolio manager buys and holds the debt securities for the entire duration of the product. FMPs are a good option for conservative investors, as they do not carry any interest rate risk provided the investor stays invested until the maturity of the product. They are also a tax efficient investment option.

Hybrid Funds

Hybrid funds invest in a combination of asset classes such as equity, debt and gold. The combination of asset classes used will depend upon the investment objective of the fund. The risk and return in the scheme will depend upon the allocation to each asset class and the type of securities in each asset class that are included in the portfolio. The risk is higher if the equity component is higher. Similarly, the risk is higher if the debt component is invested in longer-term debt securities or lower rated instruments.

Different types of Hybrid Funds

Debt-oriented Hybrid funds
Debt-oriented Hybrid invest primarily in debt with a small allocation to equity. The equity allocation can range from 5% to 30% and is stated in the offer document. The debt component is conservatively managed to earn coupon income, while the equity component provides the booster to the returns.
Monthly Income Plan
Monthly Income Plan is a type of debt-oriented hybrid fund seeks to declare a dividend every month. There is no guarantee that a dividend will be paid each month. The term ‘Monthly Income’ is a bit of a misnomer and investor needs to study the scheme properly, before presuming that an income will be received every month.
Balanced Fund
.Equity-oriented Hybrid funds invest primarily in equity, with a portion of the portfolio invested in debt to bring stability to the returns. A very popular category among the equity-oriented hybrid funds is the Balanced Fund. These schemes were historically launched for the purpose of giving an investor exposure to both equity and debt simultaneously in one portfolio. The objective of these schemes was to provide growth and stability (or regular income), where equity had the potential to meet the former objective and debt the latter. The balanced funds can have fixed or flexible allocation between equity and debt. One can get the information about the allocation and investment style from the Scheme Information Document.
Capital Protected Schemes
Capital Protected Schemes are close-ended schemes, which are structured to ensure that investors get their principal back, irrespective of what happens to the market. This is ideally done by investing in Zero Coupon Government Securities whose maturity is aligned to the scheme’s maturity. (Zero coupon securities are securities that do not pay a regular interest, but accumulate the interest, and pay it along with the principal when the security matures).
As detailed in the following example, the investment is structured, such that the principal amount invested in the zero-coupon security, together with the interest that accumulates during the period of the scheme would grow to the amount that the investor invested at the start.

Suppose an investor invested Rs 10,000 in a capital protected scheme of 5 years. If 5-year government securities yield 7% at that time, then an amount of Rs 7,129.86 invested in 5-year zero-coupon government securities would mature to Rs 10,000 in 5 years. Thus, by investing Rs 7,129.86 in the 5-year zero-coupon government security, the scheme ensures that it will have Rs 10,000 to repay to the investor in 5 years.
After investing in the government security, Rs 2,870.14 is left over (Rs 10,000 invested by the investor, less Rs 7129.86 invested in government securities). This amount is invested in riskier securities like equities. Even if the risky investment becomes completely worthless (a rare possibility), the investor is assured of getting back the principal invested, out of the maturity moneys received on the government security.

Some of these schemes are structured with a minor difference – the investment is made in good quality debt securities issued by companies, rather than Central Government Securities. Since any borrower other than the government can default, it would be appropriate to view these alternate structures as Capital Protection Oriented Schemes rather than Capital Protected Schemes.
Asset Allocation Funds
These funds do not specify a minimum or maximum limit for each of the asset classes. The fund manager allocates resources based on the expected performance of each asset class.
Arbitrage funds
Arbitrage funds take opposite positions in different markets / securities, such that the risk is neutralized, but a return is earned. For instance, by buying a share in BSE, and simultaneously selling the same share in the NSE at a higher price. Most arbitrage funds take contrary positions between the equity market and the futures and options market.
(‘Futures’ and ‘Options’ are commonly referred to as derivatives. These are designed to help investors to take positions or protect their risk in some other security, such as an equity share. They are traded in exchanges like the NSE and the BSE.
Although these schemes invest in equity markets, the expected returns are in line with liquid funds.

Other Types of Funds

Real Estate Funds / Real Estate Investment Trusts.
Real Estate Mutual Funds invest in real estate either in the form of physical property or in the form of securities of companies engaged in the real estate business. SEBI’s regulations require that at least 35% of the portfolio should be held in physical assets. Securities that these funds can invest in include mortgage-backed securities and debt issuances of companies engaged in real estate projects. Not less than 75% of the net assets of the scheme shall be in physical assets and such securities. Assets held by the fund will be valued every 90 days by two valuers accredited by a credit rating agency. The lower of the two values will be taken to calculate the NAV. These funds are closed-end funds and have to be listed on a stock exchange.

Real Estate Investment Trusts (REIT) are trusts registered with SEBI that invest in commercial real estate assets. The REIT will raise funds through an initial offer and subsequently through follow-on offers, rights issue and institutional placements. The value of the assets owned or proposed to be owned by a REIT coming out with an initial offer will not be less than Rs. 500 crore and the minimum offer size will not be less than Rs.250 crore. The minimum subscription amount in an initial offer shall be Rs. 2 lakh. The units will be listed on the stock exchange.
Gold Funds

These funds invest in gold and gold-related securities. They can be structured in either of the following formats:

Gold Exchange Traded fund, which is like an index fund that invests in gold, gold receipts or gold deposit schemes of banks. Each ETF unit typically represents one gram of gold. For every unit of ETF issued, the fund holds gold in the form of physical gold of 99.5 % purity or gold receipts. They are also allowed to invest in the gold deposit schemes of banks to a limit of 20% of the net assets of the scheme. The NAV of such funds moves in line with gold prices in the market.

Gold funds invest in the units of Gold Exchange Traded Funds. They operate just like other mutual funds as far as the investor is concerned.

Gold Sector fund will invest in shares of companies engaged in gold mining and processing. Though gold prices influence these shares, the prices of these shares are more closely linked to the profitability and gold reserves of the companies. Therefore, NAV of these funds do not closely mirror gold prices.
As with gold, such funds can be structured as Commodity ETF or Commodity Sector Funds. In India, mutual fund schemes are not permitted to invest in commodities, other than Gold (which was discussed earlier). Therefore, the commodity funds in the market are in the nature of Commodity Sector Funds, i.e. funds that invest in shares of companies that are into commodities. Like Gold Sector Funds, Commodity Sector Funds too are a kind of equity fund.
International Funds
International funds invest in markets outside India, by holding certain foreign securities in their portfolio. The eligible securities in Indian international funds include equity shares of companies listed abroad, ADRs and GDRs of Indian companies, debt of companies listed abroad, ETFs of other countries, units of index funds in other countries, units of actively managed mutual funds in other countries. International equity funds may also hold some of their portfolios in Indian equity or debt. They can also hold some portion of the portfolio in money market instruments to manage liquidity. The overseas investment limit for resident individuals has gone up to US$ 125,000 per year.

One way for the fund to manage the investment is to hire the requisite people who will manage the fund. Since their salaries would add to the fixed costs of managing the fund, it can be justified only if a large corpus of funds is available for such investment.

An alternative route would be to tie up with a foreign fund (called the host fund). If an Indian mutual fund sees potential in China, it will tie up with a Chinese fund. In India, it will launch what is called a feeder fund. Investors in India will invest in the feeder fund. The moneys collected in the feeder fund would be invested in the Chinese host fund. Thus, when the Chinese market does well, the Chinese host fund would do well, and the feeder fund in India will follow suit.
Such feeder funds can be used for any kind of international investment, subject to the scheme objective. The investment could be specific to a country (like the China fund) or diversified across countries. A feeder fund can be aligned to any host fund with any investment objective in any part of the world, subject to legal restrictions of India and the other country.
In such schemes, the local investors invest in rupees for buying the Units. The rupees are converted into foreign currency for investing abroad. They need to be re-converted into rupees when the moneys are to be paid back to the local investors. Since the future foreign currency rates cannot be predicted today, there is an element of foreign currency risk.
It is clear that the investor's total return in such schemes will depend on how the international investment performs, as well as how the foreign currency performs. Weakness in the foreign currency can pull down the investors' overall return. At the same time, appreciation in the respective currency will boost the portfolio performance.
Fund of Funds
A Fund of Funds (FoF) is a mutual fund that invests in other mutual funds. It does not hold securities in its portfolio, but other funds that have been chosen to match its investment objective. These funds can be either debt or equity, depending on the objective of the FoF. A FoF either invests in other mutual funds belonging to the same fund house or belonging to other fund houses. FoFs belonging to various mutual fund houses are called multi-manager FoFs, because the AMCs that manage the funds are different. A FoF looks for funds that fit into its investment objective. It specialises in analyzing funds, their performance and strategy and adds or removes funds based on such analysis. A FoF imposes additional cost -on the investor, as the expenses of the underlying funds are built into their NAV.
Exchange Traded Funds
Exchange Traded funds (ETF) are open-ended funds, whose units are traded in a stock exchange. Investors buy units directly from the mutual fund only during the NFO of the scheme. Al further purchase and sale transactions in the units are conducted on the stock exchange where the units are listed. The mutual fund issues further units and redeems units directly only in large lots defined as creation units.

The unique structure of ETFs, make them more cost-effective than normal index funds, although the investor would bear a brokerage cost when he transacts with the market maker and need to have a demat account into which the units of the ETF will be credited.


Capital Gains Tax Rates on Mutual Funds for FY 2016-17 (AY 2017-2018)

Capital Gains Tax Rates on Mutual Fund Investments of a Resident Indian are as below :

• The STCG (Short Term Capital Gains) tax rate on equity funds is 15%.
• The STCG tax rate on Non-Equity funds (or) Debt funds is as per the investor’s income tax slab rate.
• The LTCG (Long Term Capital Gains) tax rate on equity funds is NIL.
• The LTCG tax rate on non-equity funds is 20% (with Indexation benefit)
Capital Gains Tax Rates on NRI Mutual Fund Investments for the Financial Year 2016-17 (Assessment Year 2017-18) are as below;

• The STCG tax rate on equity funds is 15%.
• The STCG tax rate on Non-Equity funds (or) Debt funds is as per the investor’s income tax slab rate. (Tax Deducted at Source – TDS @ 30% is applicable)
• The LTCG tax rate on equity funds is NIL.
• The LTCG tax rate on non-equity funds is 20% (with Indexation) on listed mutual fund units and 10% on unlisted funds.
Dividend Taxation
Dividends on Equity Mutual Funds, The dividend received in the hands of unit holder for an equity mutual fund is completely tax free. The dividend is also tax free to the mutual fund house.

Dividends on Debt Funds : The dividend income received by a debt fund unit holder is also tax free. But, the mutual fund company has to pay a dividend distribution tax (DDT) before distributing this dividend income to its Unit-holders. DDT on Debt Mutual Funds is 28.84% for Individuals & 34.608 % for Companies.
NRI Mutual Fund Investments & TDS Rate
Below are the TDS rate applicable on MF redemptions by NRIs for AY 2017-18.