Mutual funds for beginners - 21 facts you must know

The interest in Mutual Funds, as an investment option, is growing. But there are several questions you want answered before you take that plunge.

That’s the right thing to do as well. By improving your own knowledge, you significantly reduce the chances of making a mistake.

So, let’s go through these basic but important and interesting facts about mutual funds.

A matter of Trust: Mutual Funds in India operate in a 3 tier structure. First, a Sponsor who is responsible for the operations of the mutual fund creates a Trust. The Trust is governed by the Indian Trusts Act, 1882. Your money is effectively held under the Trust. The Sponsor and the Trust appoint an Asset Management Company (AMC). The AMC manages the money on behalf of the unit-holders under the supervision of the Trust.
Active vs Passive Investing: Mutual Fund investing has two variants. Actively managed funds are those that try to beat an index benchmark such as Sensex or NSE 500 and generate additional returns for the investor. This also results in additional expenses of doing research and having a fund management team. The Passively managed funds have only one purpose – to replicate the returns of an index benchmark to the best extent possible. There is absolutely no attempt to beat the benchmark returns. All index funds are passively managed.
NAV: The most common reference to determine the value of a mutual fund investment is NAV or Net Asset Value. It is quite like the Net Worth of a company and is indicated as a per unit number. The NAV is calculated by taking into account value of all the investments made by the fund LESS all expenses.
Equity or Debt: From a tax point of view, your fund is as an equity fund if it invests more than 65% of its portfolio in equity and equity related assets. If it is less than 65%, it is treated as a debt fund. The related tax laws apply to a fund basis this definition.
Taxes smile for Equity funds: Equity mutual funds are subject to capital gains and related tax benefits. There is NO long-term capital gains tax (if you remain invested in the fund for more than 1 year) and a LOWER short-term capital gains tax of 15% (if you sell your equity mutual fund in less than a year). There is NO dividend distribution tax applicable to equity funds. (Update 2018-19: Equity funds gains over Rs. 1 lakh in a financial year are now taxed at 10%. Dividend distribution is also taxed at the same rate.)
Tax axe on Debt funds: If you invest in a debt fund and sell within 3 years, you pay short-term capital gains tax at your marginal income tax rate. If you invest and sell after 3 years, then long-term capital gains tax rate applies. Currently the tax rate is 20% with indexation. If a debt fund declares dividend, then it also has to pay dividend distribution tax at the rate of 25% + surcharges (effectively 28.84%). The dividend is tax free in the hands of the investor.
Balanced or best of both the worlds: Å balanced fund is one which invests your money in both debt as well as equity thus bringing to you best of both the worlds. These funds are also called Hybrid funds. It is not necessary that the amount invested is 50:50 in equity and debt. Some of them also have 65% of more exposure to equity to get the tax benefit of equity funds. These are known as Hybrid – Equity funds.
Mutual funds are not counted as your wealth: They are your wealth, of course. It is just that investment in mutual fund units is not counted in wealth for the purpose of calculation of wealth tax.
Not 100% invested: All the money that you give to a mutual fund may not be invested as per the mandate of the fund. It can hold some part of its assets in liquid/cash, so as to provide for redemptions / withdrawals or meeting short term expenses. Some funds may also hold cash when they don’t find the right investment opportunities.
Sector Funds calling: As an investor, you can invest in funds that invest in specific sectors such as banking, pharma, etc. A sectoral fund can face the challenge of a limited universe of stocks to invest in. The downside – it may be forced to invest in not so good opportunities just to complete its mandate.
Investing Style: Mutual Fund investing style comes in 3 variants: Growth, Value and Hybrid. You can invest in a Growth fund, which invests in high growth companies. The other is a Value fund, which invests in companies available at a price less than their value. Then there are Hybrid funds, which do a mix of Growth and Value. The essential point to understand is that all good investing is about buying something at a price less than its worth. Would you agree?
Impact of Portfolio Turnover: If your mutual fund has a consistently high portfolio turnover rate, it could mean higher brokerage costs as well as an unsteady investment style. Does the fund manager know what he is doing? However, that may not be the case always. Sometimes the fund manager may make major changes in the portfolio as a part of a new investment strategy and hence cause a temporary spike in turnover ratio. Remember, portfolio turnover is high for liquid funds since they invest in very short period instruments and hence do constant buying and selling.
International Funds: Some mutual funds have the mandate to invest in international stocks or stocks of other countries. This allows you to add another layer of diversification to your portfolio. Now, when you invest in an international fund, you end up taking two additional risks – one is related to the exposure to the international markets; the other is that of the currency exchange rate.
Monthly Income: MIP or a Monthly Income Plan is a debt oriented hybrid mutual fund; It is a combination of a larger portion of debt and a lesser portion of equity. However, contrary to the name, it does not necessarily offer a monthly income. The equity component typically does not exceed 30% of the portfolio, that too for the aggressive ones. MIPs are taxed as debt funds. Please note, the monthly income is not guaranteed by mutual funds. (Update 2018-19: MIPs are now known as Hybrid Funds – Conservative)
Like Fixed Deposits: FMP or a Fixed Maturity Plan is like a fixed deposit but through a mutual fund. It is offered for a fixed time period and a fixed coupon or interest rate. Your money is locked in for the duration of FMP. FMPs are typically available for 3, 6, 12 or 24 months. Generally, FMPs could offer a higher return than a Bank FD. Ultra short term funds can also be an alternative to Bank FDs. If you are planning to deploy your funds for over 1 year, you can go for an ultra short or short term debt fund. Else, go for liquid funds.
Interest vs Value: There is an inverse relationship between interest rates and the value of the debt fund. When interest rates rise, the value of debt funds fall and vice versa.
Tracking Error: You can identify a good index fund for your investment by looking at its tracking error. It is the margin by which the fund trails the index which it tracks. This error is a result of the transaction costs incurred to adjust the fund to the index. For example, a Sensex based index fund should closely track the performance of the Sensex. Most index funds are traded on the stock exchange and are known as Exchange Traded Funds.
Gold ETF: A Gold exchange traded fund (ETF) is a great way to take exposure to Gold as an asset class. No storage costs, no insurance premiums, no risk of theft and high liquidity are a few of the benefits of a Gold ETF compared to owning physical Gold. Also, unlike physical Gold where everything, apart from your personal jewellery, is subject to wealth tax, Gold ETFs are totally exempt from wealth tax. You can buy it like your stock through your trading account for as low as half a gram. However, Sovereign Gold Bonds are stealing the show currently.
Growth vs Dividend: When you invest in a mutual fund, you have a choice between these two options. With Growth option, you allow your investment to grow. This is reflected purely by an increase in NAV. With Dividend option, the fund at various times, declares dividends that you either choose to receive or reinvest in the same fund. In latter case, your units increase because of reinvestment. For those in the highest tax bracket and investing in debt funds, they can choose dividend option to save on taxes. For long term equity investing, growth option is preferred. Read more here.
Regular vs Direct Plan: Put simply, regular plans are sold by distributors and result in commission payouts from your investment. In case of direct plans, there are no commission payouts and this leaves more money on the table. This means higher returns for you, the investor. Know more here.
SIP is not a fund: The Systematic Investment Plan or SIP is a method of investment in which you give a predefined mandate to invest regularly in a selected mutual fund. There is a misconception that SIP is a mutual fund. It is not. It is just a method. You can use SIP to invest in any mutual fund. The other method to invest is a Systematic Transfer Plan. A method to withdraw money in instalments is Systematic Withdrawal Plan.