Understanding Mutual Funds: Types, Advantages & Investment Methods

Everyone wishes to grow their savings and build a substantial financial corpus, and mutual funds are an ideal investment option to do both. If you have started earning more than enough cash to cover necessities, consider keeping aside a small sum to invest in mutual funds. It will help you create wealth in a disciplined way and fulfil all your financial objectives.

In this blog, we will discuss some important details about mutual fund investments, including types, methods, and pros and cons. 

Overall, NSCs are excellent options for low-risk investors. They are easy to investa

Moreover, as they provide stable returns during the investment horizon, these financial assets can be suitable for individuals who are new to investing. 

A mutual fund is a professionally managed investment vehicle where money is pooled from various investors and invested in assets such as equities, bonds, money market instruments, etc. In other words, it is an investment option run by Asset Management Companies (AMCs), also referred to as fund houses, which manage investors’ money on their behalf.

These schemes are managed by financial experts called 'fund managers' who have the knowledge and expertise to manage asset allocation. They choose the financial assets and invest according to the fund's objective. Fund houses charge investors a fee known as the expense ratio for the management of a fund.

Each investor owns a specific number of units of a mutual fund representing their proportion of investment. After the fund makes profits from dividends, interests and capital gains, returns are divided among investors in the proportion of the number of fund units they own.

In India, the Securities and Exchange Board of India (SEBI), the capital markets regulator, has introduced various guidelines to facilitate the development of the mutual fund industry. 

Suppose a fund house is offering a mutual fund. Let us look at how it will work: 

• First, the fund house will launch a New Fund Offer (NFO) where it will declare the securities which will be a part of the mutual fund’s portfolio. 
• After the NFO launch, you can begin your investment in this scheme. The AMC will assess the investment value after the initial investment has been cut off. 
• The pooled-in money is then invested in the securities mentioned in the NFO. The proportion of the underlying securities will follow the ratio mentioned during the time of the NFO.
• Finally, the fund managers track the mutual fund’s performance and change the asset allocation depending on data analysis, regulations and other external factors. It helps to maximise mutual fund returns.
• The investment portfolio of a mutual fund is priced at its NAV (Net Asset Value). Redemptions made from the AMC at the NAV per unit determine the profits made by an investor.

Now, let us look at a concept that is essential to understand the working of mutual funds, which is the NAV.

• NAV

Net Asset Value (NAV) is the market value of each mutual fund unit. In other words, it is the per-unit value of all the underlying securities of a scheme. NAV enables investors to understand how a mutual fund is performing on a daily basis. When you begin mutual fund investments, you can use the percentage increase or decrease of a scheme’s NAV to understand the rise and fall in its value. 

As per SEBI's guidelines, every AMC must calculate and display their NAV on their official website at the end of each business day.

• Example of NAV Calculation 

Generally, the AMC or the fund house hires an accounting firm to calculate the NAV of a mutual fund. The formula which is used to calculate the NAV of a mutual fund is as follows: 

Net Asset Value = [Total Value of All Assets - Expense Ratio] / Number of Outstanding units

Here, the total asset value stands for the market value of every underlying security, i.e. the closing price on the stock exchange where the scheme is listed. The expense ratio is the fund management cost and includes operating costs, custodian and audit charges, distribution and marketing expenses, and transfer agent costs.

Suppose a fund house offers a mutual fund with each unit priced at ₹20. Without considering the expense ratio, the following is the calculation of the NAV.

Now, suppose the fund house accumulates ₹2,000 crore from investors. If the fund house issues 200 crore fund units, its NAV would be (₹2,000 crore / 200 crore units), and the NAV for every fund unit would be ₹10.

There are many different mutual funds in the Indian market. These can be categorised into many types based on their underlying assets, investment goals and investors' risk profiles, among other factors. 

Detailed below are the various types of mutual funds: 

1. Based on Investment Objective

   Based on your investment goals, you can invest in the following types of mutual funds:

   • Growth funds

   Capital appreciation is the main aim of growth funds, and these schemes primarily invest in high-performing equities. You can consider investing in growth funds if you want high returns over a long investment tenure. 

   Remember that medium to long investment horizons are ideal for investing in these funds. 

   • Liquidity-based funds

   You can consider investing in liquid funds, money market funds and overnight mutual funds if you want high liquidity and principal protection. 

   Generally, these schemes invest in money market instruments where the maturity period is short and ranges from 1 to 91 days. You can consider these schemes if you wish to invest your excess funds for a short tenure. 

   • Tax-saving funds

   Equity-Linked Savings Scheme (ELSS) is also known as a tax-saving mutual fund because it is the only mutual fund eligible for tax deductions under Section 80C of the Income Tax Act (ITA). 

   If you invest in an ELSS, you can claim tax deductions of up to ₹1,50,000 annually, thus saving ₹46,800 in taxes in a year. But remember, there is a lock-in period of 3 years. 

   • Capital protection funds

   These mutual funds partly invest in fixed-income assets, while the remaining portion of the fund corpus is invested in equities. With these funds, you will benefit from capital protection and a minimal chance of losses.

   • Pension funds 

   These mutual funds are usually hybrid schemes with the potential to yield stable returns in the future. The underlying concept of pension funds is the generation of regular returns after a prolonged investment period. You can consider investing in these schemes to build a corpus for retirement. 

   • Fixed maturity funds (FMF)

   These mutual funds invest in debt instruments with the same maturity period as that of the FMF. For instance, a fixed maturity fund with a maturity period of 3 years will invest in securities with similar maturity tenures. 

2. Based on asset class

   Detailed below are the different categories of mutual funds based on the asset class they invest in: 

   • Equity mutual funds

   You can consider investing in equity mutual funds if you have a high-risk appetite and can remain invested for a long tenure. These funds invest a minimum of 65% of their corpus in company shares and generate returns based on market movements. 

   Based on the shares of the companies they invest in, equity funds can be classified as large-cap funds, mid-cap funds, small-cap funds, etc.

   • Debt funds

   Debt mutual funds are mutual funds that invest in fixed-income instruments like government securities, treasury bills and corporate bonds. 

   As a result, these mutual funds generate stable and regular returns which are not subject to market movements. Compared to equity schemes, debt mutual funds are a less risky investment. Its examples include credit risk funds, overnight funds, gilt funds etc.

   • Hybrid funds

   The portfolio of a hybrid fund combines various asset classes, including equities and debt instruments. The fund house offering a hybrid scheme determines whether the investment ratio would be fixed or varied. The sub-types of hybrid funds include conservative hybrid funds, balanced funds, dynamic asset allocation funds and multi-asset allocation funds. 

   • Solution-oriented funds

   These mutual funds are designed to cater to specific goals and have a lock-in period of 5 years. Its examples include children's funds and retirement funds.

3. Based on ease of investment 

   Detailed below are the different types of mutual funds based on ease of investment:

   • Open-ended mutual funds

   These schemes do not have any specifications with respect to the number of mutual fund units one can purchase and tenure. You can invest and redeem your mutual fund units at any time of your convenience at the prevalent NAV. Open-ended mutual funds will be an ideal option if you seek liquidity.

   • Close-ended mutual funds 

   You can subscribe to the units of a close-ended mutual fund only during its initial offer period. It has a specific tenure and fixed maturity date, i.e. you can redeem these mutual fund units only after maturity. Close-ended mutual funds are mandatorily listed on stock exchanges after their NFOs, which facilitates liquidity.

   • Interval funds 

   These mutual funds combine the features of both open-ended and close-ended schemes. Here, investors are allowed to engage in transactions only at pre-specified periods. So, you can invest or redeem your units only after the trading window opens up.

4. Based on risk appetite of investors 

   Based on the risk tolerances of investors, mutual funds can be categorised into:

   • High-risk funds

   You can invest in high-risk mutual funds if you are not averse to risk and wish to earn high returns through capital gains and dividends. Due to the high risk of losses, you may need to stay invested for a long time in these funds. The maximum annual returns from these mutual funds can go up to 20%.

   • Medium-risk funds

   Fund managers of these schemes allocate a portion of their portfolio to debt. The remaining portion is for equity funds. Investors with moderately high-risk appetites will find these funds suitable. Medium-risk funds generate an average return in the range of 9% to 12%.

   • Low-risk funds 

   These mutual funds are ideal investment avenues during unforeseen circumstances like a national crisis or rupee depreciation. Financial experts advise conservative investors to invest in either one or a combination of ultra-short-term funds, liquid funds or arbitrage funds. Returns generated are usually between 6% and 8%.

The following are the investment modes with 

• SIP 

Systematic Investment Planning (SIP) involves regularly investing small amounts of money to build a substantial corpus over time. It inculcates financial discipline and can help you make goal-oriented investments. 

A systematic investment plan will let you invest with different frequencies such as daily, weekly, monthly and quarterly.

An important advantage of investing via SIPs is the rupee cost averaging, which averages out the cost of buying fund units over time. Moreover, you can start your SIP investment with even ₹500, although this amount varies from one fund house to another.

• Lump-sum

When you opt for a one-time investment and lock in a bulk amount, it is referred to as a lump-sum investment mode. It is an ideal investment mode for people who have a high-risk appetite and substantial funds to invest. 

Investors who are knowledgeable about the state of the market can build a large corpus if they invest correctly via the lump sum mode.

You can easily invest in mutual funds by filling up an application form and submitting it with a bank draft or cheque at your nearest Investor Service Centre (ISC) of a fund house or Registrar and Transfer Agents (RTA) of your chosen scheme.

Apart from that, you can also invest in your preferred mutual fund through a financial intermediary such as an AMFI-registered mutual fund distributor. Examples of mutual fund distributors include banks, distribution channel providers or brokerage houses. 

But, the most convenient way of investing in mutual funds is through the official website of the respective fund house.

Given below are the steps to invest in mutual funds: 

Step 1: Visit the official website of the AMC and register yourself.

Step 2: Complete all your KYC formalities.

Step 3: Fill up every required detail on the designated space. 

Step 4: Navigate to the scheme you wish to invest in under the ‘Mutual Funds’ section. 

Step 5: Click on the mutual fund’s name, fill up the required details and submit your confirmation. 

Step 6: Transfer the investment amount to initiate the investment. 

Step 7: If you have chosen the SIP mode of investment, provide the standing instruction to your bank to debit the investment amount every month.

Completing the KYC (Know Your Customer) procedure before investing in a mutual fund is essential. A financial entity such as a fund house or a bank uses the KYC process to establish a person’s identity as per regulations.

Here is a list of officially valid documents that fund houses generally consider as proof of identity and address. You can keep them ready before investing in mutual funds: 

• PAN card
• Passport-size photo 
• Aadhaar card
• Voter ID card
• Driving licence 
• Passport
• Ration card 
• Bank passbook or bank account statement
• Utility bills such as gas bills and electricity bills 

Like any other investment, profits from mutual funds are taxable. For dividends, these gains are added to your taxable income and taxed as per your applicable tax rate. 

For capital gains, the holding period and mutual fund type determine its taxation. The duration over which you hold the units of a mutual fund is referred to as the holding period, i.e. the time between purchasing and selling of mutual fund units. 

The table below provides the classification of capital gains earned after redeeming a mutual fund investment: 

While short-term capital gains (STCGs) of equity funds are taxed at 15% along with cess and surcharge, long-term capital gains (LTCGs) are tax-exempt up to ₹1 lakh. When the LTCGs exceed the threshold limit, a tax rate of 10% will be applicable. 

For debt funds, STCGs will be taxed according to your income tax slab rate. LTCGs are taxed at 20% after indexation. 

When it comes to hybrid funds, if the equity exposure of the portfolio is more than 65%, equity fund taxation rules will be applicable. Otherwise, the capital gains earned from a hybrid scheme will be taxed like a debt fund. 

Here is a tabular representation of the taxation of mutual funds: 

Now, let us take a look at the pros and cons of mutual fund investments:

Pros

Detailed below are the benefits of investing in mutual funds:

• Liquidity

It is quite easy to invest and redeem open-ended mutual fund units. Most funds do not have any lock-in period, and you can easily sell off your equity fund units when the stock market is performing well to earn high returns.

• Portfolio diversification

Portfolio diversification is a major benefit of mutual fund investment. Fund managers invest in stocks ranging across various sectors, market capitalisations and investment styles. 

This reduces the risk level and improves the chances of receiving optimised returns. If one asset class fails to perform well, others will make up for it. 

• Ideal for all financial goals

An important benefit of mutual funds is that it has something to offer to all kinds of investors. 

So, irrespective of your income, you should set aside a particular amount each month to invest in your preferred scheme, depending on your investment objectives and risk appetite. 

• Expert management 

Asset management companies hire fund managers and research analysts to look after a mutual fund. These are financial experts who track the fund’s performance and decide upon asset allocations to provide investors with optimised returns. 

As a result, mutual funds are ideal for investors who lack the time or the expertise to pick the right assets at the right time.

Cons

As a result, mutual funds are ideal for investors who lack the time or the expertise to pick the right assets at the right time.

It is a good idea to be mindful of the limitations of mutual funds before investing: 

• Fund management cost

Often, expense ratios of mutual funds can be higher than 1.50%, which can considerably affect your net profits. 

Such high expense ratios lead to the mutual fund investment being quite expensive. Moreover, higher fund management costs do not always translate to good fund performance. 

• Dilution 

It is true that portfolio diversification reduces the risk level of an entire investment portfolio. But, it is also true that it dilutes profits. 

Many aggressive investors with sufficient market knowledge prefer to invest directly in their preferred stocks in the hopes of earning higher returns.

• Exit load 

If you wish to redeem your investments before the maturity period, you might have to pay an exit load. Often, the amount is quite high, which discourages people from redeeming their investment when they need it the most. 

While an exit load helps fund houses maintain the stability of a fund, it acts as an indirect lock-in period.  

A major advantage of mutual fund investments is that it offers something to every investor. So, irrespective of whether you are a beginner or an experienced investor, you can invest in equity, debt or hybrid mutual funds based on your risk profile and financial objectives. 

While mutual funds levy an expense ratio and an exit load, the benefits of expert financial management and portfolio diversification more than make up for it.