Mutual Funds

To many people, Mutual Funds can seem complicated or intimidating. We are going to try and simplify it for you at its very basic level. Essentially, the money pooled in by a large number of people (or investors) is what makes up a Mutual Fund. This fund is managed by a professional fund manager.

It is a trust that collects money from a number of investors who share a common investment objective. Then, it invests the money in equities, bonds, money market instruments and/or other securities. Each investor owns units, which represent a portion of the holdings of the fund. The income/gains generated from this collective investment is distributed proportionately amongst the investors after deducting certain expenses, by calculating a scheme’s “Net Asset Value or NAV. Simply put, a Mutual Fund is one of the most viable investment options for the common man as it offers an opportunity to invest in a diversified, professionally managed basket of securities at a relatively low cost.

Mutual funds being into the multiple investment concepts for different objectives, anyone who have the extra surplus which can be parked with a defined time period aligning the objective of investment. The investment in mutual fund can start from minimum of Rs.500/- and can go upto any amount.

1. Single investment or lump sum investments
2. Systematic investment plan or SIP
3. Systematic transfer plan or STP
4. Dividend transfer plan or DTP
5. Systematic withdrawal Plan or SWP

These plans are designed to help you find the mode of investment that best suits your income and investment goals.

1. How Do You Earn Returns in Mutual Funds?

Mutual funds offer investors with returns in two forms; dividends and capital gains. Dividends are profits shared by companies when they are thriving. When the companies are left with surplus cash, they may decide to share the same with investors in the form of dividends. Investors receive dividends proportional to the number of units held by them. A capital gain is the profit realised by investors if the selling price of the security held by them is greater than the purchase price. In simple terms, capital gains are realised due to the appreciation in the price of the fund units in mutual funds. Both dividends and capital gains are taxable in the hands of investors..

2.Taxation of Dividends Offered by Mutual Funds

As per the amendments made in the Budget 2020, dividends offered by any mutual fund scheme are taxed in the classical manner. That is, dividends received by all investors are added to their overall income and taxed at their respective income tax slab rates. Previously, dividends were made tax-free in the hands of investors as the companies paid dividends distribution tax (DDT) before sharing their profits with investors in the form of dividends. During this regime, dividends (received from domestic companies) of up to Rs 10 lakh a year were made tax-free in the hands of investors. Any dividends in excess of Rs 10 lakh attracted dividends tax at 10%.

3. Taxation of Capital Gains Offered by Mutual Funds

The rate of taxation of capital gains provided by mutual funds depends on the holding period and type of mutual fund. The holding period is the duration for which the fund units were held by an investor. In simple words, the holding period is the timeframe between the date of the purchase and sale of fund units. Capital gains realised on selling units of mutual funds are categorised as follows:

The short-term and long-term capital gains offered by mutual funds are taxed at different rates.

4. Taxation of Capital Gains of Equity Funds

Equity funds are those funds whose portfolio’s equity exposure exceeds 65%. As mentioned above, you realise short-term capital gains on redeeming your equity fund units within a holding period of one year. These gains are taxed at a flat rate of 15%, irrespective of your income tax slab rate. You make long-term capital gains on selling your equity fund units after a holding period of one year. These gains of up to Rs 1 lakh a year are made tax-exempt. Any long-term capital gains exceeding this limit attract a tax at the rate of 10%, and there is no benefit of indexation provided.

5. Taxation of Capital Gains of Debt Funds

Debt funds are those funds whose portfolio’s debt exposure is in excess of 65%. As mentioned in the table above, you get short-term capital gains on redeeming your debt fund units within a holding period of three years. These gains are added to your overall income and taxed at your income tax slab rate. Long-term capital gains are realised when you sell units of a debt fund after a holding period of three years. These gains are taxed at a flat rate of 20% after indexation. Read more about indexation here. Also, you are levied with applicable cess and surcharge on tax.

6. Taxation of Capital Gains of Hybrid Funds

The rate of taxation of capital gains offered by hybrid or balanced funds is dependent on the equity exposure of the portfolio. If the equity exposure exceeds 65%, then the fund scheme is taxed like an equity fund, if not then the rules of taxation of debt funds apply. Therefore, it is essential to know the equity exposure of the scheme you are investing in, if not then you might be in for an unpleasant surprise upon redemption of your fund units. The following table summarises the rate of taxation of capital gains offered by mutual funds:

The rate of taxation of capital gains offered by hybrid or balanced funds is dependent on the equity exposure of the portfolio. If the equity exposure exceeds 65%, then the fund scheme is taxed like an equity fund, if not then the rules of taxation of debt funds apply. Therefore, it is essential to know the equity exposure of the scheme you are investing in, if not then you might be in for an unpleasant surprise upon redemption of your fund units. The following table summarises the rate of taxation of capital gains offered by mutual funds:

7. Taxation of Capital Gains When Invested Through SIPs

Systematic investment plans (SIP) are a method of investing in mutual funds. They are designed in such a way that investors can invest a small sum periodically. Investors are given the complete liberty to choose the frequency of their investment. It can be weekly, monthly, quarterly, bi-annually, or annually. You purchase a certain number of fund units through every SIP you invest. The redemption of these units is processed on a first-in-first-out basis. Consider investing in an equity fund through an SIP for one year, and you decide to redeem all your investment after 13 months. In this case, the first units purchased through the first SIP are held for a long-term and you realise long-term capital gains on these units. If the long-term capital gains are less than Rs 1 lakh, then you don’t have to pay any tax. However, you make short-term capital gains on the units purchased through the SIPs from the second month onwards. These gains are taxed at a flat rate of 15% irrespective of your tax slab. You will have to pay the applicable cess and surcharge on it.

8. Securities Transaction Tax (STT)

Apart from the tax on dividends and capital gains, there is another tax called the Securities Transaction Tax (STT). An STT of 0.001% is levied by the government (Ministry of Finance) when you decide to buy or sell your units of an equity fund or a hybrid equity-oriented fund. There is no STT on the sale of debt fund units.

Conclusion: The longer you hold onto your mutual fund units, the more tax-efficient they become. The tax on long-term gains is comparatively lower than that of the tax on short-term gains.

Liquidity

The most important benefit of investing in a Mutual Fund is that the investor can redeem the units at any point in time. Unlike Fixed Deposits, Mutual Funds have flexible withdrawal but factors like the pre-exit penalty and exit load should be taken into consideration.

Diversification

The value of an investment may not rise or fall in tandem. When the value of one investment is on the rise the value of another may be in decline. As a result, the portfolio’s overall performance has a lesser chance of being volatile.

Diversification reduces the risk involved in building a portfolio thereby further reducing the risk for an investor. As Mutual Funds consist of many securities, investor’s interests are safeguarded if there is a downfall in other securities so purchased.

Expert Management 

A novice investor may not have much knowledge or information on how and where to invest. The experts manage and operate mutual funds. The experts pool in money from investors and allocates this money in different securities thereby helping the investors incur a profit.

The expert keeps a watch on timely exit and entry and takes care of all the challenges. One only needs to invest and be least assured that rest will be taken care of by the experts who excel in this field.  This is one of the most important advantages of mutual funds

Flexibility to invest in Smaller Amounts 

Among other benefits of Mutual Funds the most important benefit is its flexible nature. Investors need not put in a huge amount of money to invest in a Mutual Fund. Investment can be as per the cash flow position.

If You draw a monthly salary then you can go for a Systematic Investment Plan (SIP). Through SIP a fixed amount is invested either monthly or quarterly as per your budget and convenience.

Schemes for Every Financial Goals

The best part of the Mutual Fund is the minimum amount of investment can be Rs. 500. And the maximum can go up to whatever an investor wishes to invest.

The only point one should consider before investing in the Mutual Funds is their income, expenses, risk-taking ability, and investment goals. Therefore, every individual from all walks of life is free to invest in a Mutual Fund irrespective of their income.

Safety and Transparency

With the introduction of SEBI guidelines, all products of a Mutual Fund have been labeled. This means that all Mutual Fund schemes will have a color-coding. This helps an investor to ascertain the risk level of his investment, thus making the entire process of investment transparent and safe.

This color-coding uses  3 colors indicating different levels of risk- 

1. Blue indicates low risk
2. Yellow indicates medium risk, and
3. Brown indicates a high risk.

Investors are also free to verify the credentials of the fund manager, his qualifications, years of experience, and AUM, solvency details of the fund house.

Lower cost

In a Mutual Fund, funds are collected from many investors, and then the same is used to purchase securities. These funds are however invested in assets which therefore helps one save on transaction and other costs as compared to a single transaction. The savings are passed on to the investors as lower costs of investing in Mutual Funds.

Besides, the Asset Management Services fee cost is lowered and the same is divided between all the investors of the fund.

1. Indian residents above the age of 18,either individually or jointly (not exceeding 3 people)
2. Non-resident Indian (NRIs)and person of Indian origin (PIOs) residing abroad, on a full repatriation basis
3. Parents or lawful guardians on behalf of minors
4. Hindu Undivided families (HUFs) in the name of HUF or Karta
5. Companies (including public sectors undertakings) , corporate bodies , trusts (through trustees) , and cooperative societies
6. Banks and financial institutes
7. Religious and charitable trusts (through trustees) and private trusts authorized to invest in mutual funds schemes under their trust deeds
8. Foreign institutional investors registered with SEBI on the basis of repatriation
9. Special purpose vehicles approved by an appropriate authority (subject to RBI approval)
10. International multilateral agencies approved by the govt of india
11. Army/navy/air force/paramilitary units and other eligible institutions
12. Unincorporated bodies of persons as specified by asset management companies
13. Partnership Firms
14. Qualified Foreign Investors (QFIs)

Risks associated with mutual funds are as below which can affect mutual fund investments.

a. Market Risk

Market risk is a risk which may result in losses for any investor due to the poor performance of the market. There are a lot of factors that affect the market. A few examples are a natural disaster, inflation, recession, political unrest, fluctuation of interest rates, and so on. Market risk is also known as systematic risk. Diversifying a person’s portfolio won’t help in these scenarios. The only thing that an investor can do is to wait for the things to fall in place.

b. Concentration Risk

Concentration generally means focusing on just one thing. Concentrating a considerable amount of a person’s investment in one particular scheme is never a good option. Profits will be huge if lucky, but the losses will be pronounced at times. The best way to minimise this risk is by diversifying your portfolio. Concentrating and investing heavily in one sector is also risky. The more diverse the portfolio, the lesser the risk is.

c. Interest Rate Risk

Interest rate changes depending on the credit available with lenders and the demand from borrowers. They are inversely related to each other. Increase in the interest rates during the investment period may result in a reduction of the price of securities.

For example, an individual decides to invest Rs.100 with a rate of 5% for a period of x years. If the interest rate changes for some reason and it becomes 6%, the individual will no longer be able to get back the Rs.100 he invested because the rate is fixed. The only option here is reducing the market value of the bond. If the interest rate reduces to 4% on the other hand, the investor can sell it at a price above the invested amount.

d. Liquidity Risk

Liquidity risk refers to the difficulty to redeem an investment without incurring a loss in the value of the instrument. It can also occur when a seller is unable to find a buyer for the security. In mutual funds, like ELSS, the lock-in period may result in liquidity risk. Nothing can be done during the lock-in period. In yet another case, exchange-traded funds (ETFs) might suffer from liquidity risk. As you may know, ETFs can be bought and sold on the stock exchanges like shares. Sometimes due to lack of buyers in the market, you might be unable to redeem your investments when you need them the most. The best way to avoid this is to have a very diverse portfolio and to select the fund diligently.

e. Credit Risk

Credit risk means that the issuer of the scheme is unable to pay what was promised as interest. Usually, agencies which handle investments are rated by rating agencies on these criteria. So, a person will always see that a firm with a high rating will pay less and vice-versa. Mutual Funds, particularly debt funds, also suffer from credit risk. In debt funds, the fund manager has to incorporate only investment-grade securities. But sometimes it might happen that to earn higher returns, the fund manager may include lower credit-rated securities. This would increase the credit risk of the portfolio. Before investing in a debt fund, have a look at the credit ratings of the portfolio composition