Mutual Funds

“Someone’s sitting in the shade today because someone planted a tree a long time ago!”
-Warren Buffet (Business Magnate, Investor, Philanthropist)

Markets can be risky and simply investing in them wouldn’t help in creating wealth. Thus the foremost benefit and a fundamental element making mutual funds preferable an investor not looking to trade is that the funds are being professionally managed by the AMC ensuring your funds are being properly channeled as the market fluctuates. Mutual Funds also provide the following benefits:

Mutual Funds are investment instruments that give the investor an option to accumulate their savings and create wealth. They are skillfully handled investment schemes where money from numerous investors are pooled by a Company (Asset Management Company-AMC) and invested in diverse instruments such as debt, equity and other money market securities. The profits made from the investments, after such deductions by the company (AMC), are given back to the investors as dividends or capital appreciation.

The most appealing factor about investing in mutual funds is that the money invested is managed by an Asset Management Company, which is statutorily registered with the Securities and Exchange Board of India (SEBI), the custodian of the Financial markets in India. This gives a sense of relief as well as security to the investors as they are assured that the funds invested will only be managed by qualified professionals who are legally registered for the purpose.

Mutual Funds can be classified on a number of criterion such as the type of Fund Scheme, type of Assets Invested and the Objective of Investment. An investor may opt to choose any of the mutual fund/s based on their investment preference, risk profile (will be explained further) and choice of liquidity.

  • Based on Fund Scheme:

    Based on the type of the Fund Scheme, Mutual Funds can be classified into 2 categories:

    1. Open Ended Mutual Funds: Allows the investor to withdraw the investment anytime and pull out their funds immediately. These funds provide high liquidity to the investors.
    2. Close Ended Mutual Funds: They have a fixed maturity period. Investors do not have the option to pull out before the maturity period.
  • Based on Investment Objective:

    Based on the investment objective, investors may choose any of the following three Funds:

    1. Systematic Investment Plan: The objective of an investor investing in such a fund is Wealth Growth over a period of time. Investors can invest small amount of money over time to build a corpus. By doing so, over a period of time the investor’s purchase cost is averaged, making it profitable over a long period of time.
    2. Systematic Withdrawal Plan: The objective of an investor investing in such a fund is Income. The investor makes a lump-sum investment at first and withdraws a stipulated amount periodically. The amount withdrawn is in the form of dividends or profits, while the principle amount remains in the fund. This fund is apt for people looking for a steady income post-retirement.
    3. Systematic Transfer Plan: The objective of an investor investing in such a fund is to have a balanced fund. Here the investor invests a lump-sum at first in one scheme and periodically transfers a fixed amount to another scheme. By doing so investors avoid the risk of getting into market at its peak.
  • Based on Assets Invested

    Based on the type of assets invested in, investors may opt to choose the following funds:

    1. Equity Funds: These funds are Schemes that Invest at least 65% of its corpus into equity & equity related instruments. The AMC invests a major portion of the funds received from investors into the Equity Market. The Gains/Losses arising from market fluctuation determine the performance of the fund. Equity Funds can be further classified into:
      1. Large Cap Equity Funds: Funds investing a large portion of their corpus in companies with large market capitalization. Offers stability and sustainable returns, over a period of time.
      2. Mid-Cap Equity Funds: Funds investing in stocks of mid-size companies, which are still considered developing companies. Likewise, funds investing in small-size companies are small cap equity funds.
      3. Diversified Equity Funds: Funds investing in companies across different sectors – Lesser risk. Diversification helps prevent events that could affect a single sector for affecting the fund, and hence reduce risk.
      4. Thematic Equity Funds: Funds investing in securities of specific sectors. (Sector will be specified) Performance of schemes depends on performance of respective sector. May give higher returns, but also come with higher risk. An example of this fund is Shariah-Compliant Funds which are Investment funds meeting requirements under Shariah Law & Principles articulated in “Islamic Finance”. They can invest only in Shariah- compliant companies, with a Shariah Board, that carries out an Annual Shariah Audit and purifying certain prohibited types of income, such as income, by donating them to charity. Eg: Goldman Sachs CNX Nifty Shariah BeES Fund, Tata Ethical Fund, Taurus Ethical Fund
      5. Equity Linked Savings Scheme: ELSS give you tax savings. Investors lock in funds for 3years in ELSS, and work as a good investment option for those who want to invest as well as get tax savings.
    2. Debt Funds: These funds mainly invest in a mix of debt or fixed income securities. They have a fixed maturity date & pay a fixed rate of interest. They are various types of Debt Funds available to investors based on Investment Horizon & Risk Factor. Eg: Treasury Bills, Government Securities, Corporate Bonds, Money Market instruments.

      Debt Funds can be further classified into:
      1. Gilt Funds: Invests the Corpus in securities issued by Govt; They carry Zero Default Risk but are associated with Interest Rate Risk.
      2. Income Funds: Invests major portion in bonds, corporate debentures & Government Securities.
      3. Monthly Income Plan (MIP): Invests major portion in Debt instruments & minimum in Equities in 80:20 ratio. It gives monthly income in form of dividends. However, returns are not guaranteed as its market linked and depend on fund performance.
      4. Short Term Plans: Funds for an investment horizon of 3-6months. Primarily invest in Certificate of Deposits & Commercial Papers as well as some portion in Corporate Deposits.
    3. Liquid Funds: Invests the funds in securities with a residual maturity up to 91 days. Investors may also choose to invest lump-sum receipts in liquid funds and opt for a Systematic Transfer Plan. Investors have the option to invest like any other Mutual Funds in Lump-sums as small as Rs.5000/-
    4. Balanced Funds: Invests in both Equity & Debt instruments and maintains a balance which enables the Scheme to keep risk under control. Nonetheless, the returns yielded are also lower as compared to pure Equity Schemes. Investors, however, enjoy growth and income at regular intervals making it a suitable option for various investors. These funds are also called Hybrid Funds, and generally own both Stocks and Bonds (usually in 65%:35% ratio)

    The following table depicts the returns generated by various funds throughout the years;

    Type of Mutual Fund 1yr (%) 2yr (%) 3yr (%) 5yr (%)
    Equity Large-Cap 26.6 20.5 16.1 21.7
    Equity Small & Mid-Cap 33.4 28.5 24.7 30.9
    Equity Diversified 35.5 28.0 21.9 28.2
    Thematic Infrastructure 50.4 32.9 22.9 23.7
    Debt Long Term 8.7 10.8 10.8 11.6
    Hybrid 24.3 18.7 14.2 19.4
    Liquid 8.7 9.0 8.7 8.8

    *Data based on annualized returns of past 5yrs performance of selected funds in the respective categories;

  • Capital Gains on Mutual Funds

    The profit (if any) that you make on your mutual fund investments when you redeem or sell the units is referred to as Capital Gains. It can be a Short Term Capital Gain (STCG) or a Long Term Capital Gain (LTCG) depending upon the ‘Period of Holding’. The tax that is applicable on these profits is known as ‘Capital Gains Tax’ (CGT). The tax rate on Mutual Funds depends on 3 factors, namely:

    1. Residential Status: Resident Indian or Non-Resident Indian (NRI)
    2. Type of Fund: Equity Oriented (schemes that invest at least 65% of its fund corpus into equity and equity related instruments) or Non-Equity Oriented Mutual Funds (schemes that invest less than 65% of its fund corpus into equity and equity related instruments)
    3. Period of Holding: It could be either a;
      1. Short Term Capital Gain (STCG) – are gains from Equity Mutual Funds held for a period less than 1 year / are gains from Non-Equity Mutual Funds held for a period less than 3 years; OR
      2. Long Term Capital Gain (LTCG) – are gains from Equity Mutual Funds held for a period more than 1 year / are gains from Non-Equity Mutual Funds held for a period more than 3 years

    The tax rates applicable are as follows:

    Residential Status Type of MF Scheme STCG Tax Rate* LTCG Tax Rate**
    Resident Indian Equity Funds 15% NIL
    Non-Equity Funds As per Tax Slab 20% (w/Indexation***)
    Non-Resident Indian Equity Funds 15% NIL
    Non-Equity Funds As per Tax Slab Listed Funds - 20% (w/Indexation***)
    Unlisted Funds - 10% (w/o Indexation***)

    *STCG on Equity Funds is on units held for 1yr and on Non-Equity Funds is on units held for 3yrs
    **LTCG on Equity Funds is on units held for >1yr and on Non-Equity Funds is on units held for >3yrs
    *** Indexation adjust income payments by means of a price index, in order to maintain the purchasing power of the public after inflation

  • Dividends on Mutual Funds

    Dividends that are received by the unit holder on any Equity Mutual Fund is completely Tax Free.

For investors looking to take advantage of tax returns by investing in Mutual Funds, must opt to invest in an Equity Linked Savings Scheme (ELSS). Tax planning may seem like a tedious activity requiring a lot of effort. Equity Linked Savings Scheme (ELSS) offers a simple way to get tax benefits. Equity Linked Savings Scheme (ELSS) is an open-ended Equity Mutual Fund that help to grow your money and save tax at the same time as it qualifies for tax exemptions under section under Section 80C of the Income Tax Act, 1961.

Let’s take a look at how ELSS works out:

Particulars(In Rs.) Without ELSS With ELSS
Gross Total Income 6,50,000 6,50,000
Less: 80C deduction (ELSS) - 1,50,000**
Total Income 6,50,000 5,00,000
Tax on Total Income (Including Cess)* 43,775 12875
Tax Saved(Including Cess)* - 30900

*Without ELSS, the investor falls in Rs.5-10Lakhs Income Tax Slab making the Tax rate at 20% + 3% of Income Tax as Cess; While with ELSS the investor falls in Rs. 2.5-5Lakhs Income Tax Slab making the Tax rate at 5% + 3% of Income Tax as Cess after the deduction under Section 80C of the Income Tax Act, 1961.
**The Maximum amount that can be claimed for Tax Deduction under Section 80C is Rs. 1,50,000/-

- Also note, no other Tax deductions have been considered; a more detailed tax calculation could show a much more substantial tax saving with ELSS. Calculate your Income Tax payable here.

Though Banks and other financial institutions also provide for Tax saving Fixed Deposits, ELSS is certainly the better option as the Lock-in period is only 3 years as opposed to 5 years in Bank Fixed Deposits.

Before making any investment decision, it’s important to understand one’s attitude towards risk. This helps identify an appropriate mix of investments that one is comfortable with. A Risk Profiling Tool will help understand the ability to bear risk and identify the asset classes to match investment needs. Risks in investing mutual funds is much lower than directly investing in Equity shares. The basic Risk Profiles are as below:

  • High Risk: Customers who are willing to take high risks can opt for 85% in Equity funds, 10% in Debt funds & 5% in Gold funds.
  • Medium Risk: Customers who are willing to take moderate risk can opt for 60% in Equity Funds,30% in Debt Funds, 5% in Gold Funds & 5% in Liquid Funds
  • Low Risk: Customers who are willing to take low risk can opt for 30% in Equity Funds, 50% in Debt funds, 10% in Gold funds & 10% in Liquid Funds

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