What Is A Mutual Fund And How Does It Work?

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A mutual fund is an investment vehicle that pools investors’ money and invests it in stock market-linked financial instruments such as stocks and bonds to generate returns. The combined holding of the fund is known as its portfolio. 

Imagine a non-stop bus called V1, which travels across India, going from one city to another, along a specific route. V1, just like every other bus, has a driver and many passengers. During the journey, some passengers board the bus if its route includes their desired destination and some passengers alight once their destination has been reached.

If we relate this to a mutual fund, the bus will be a mutual fund scheme; the travel route is the fund objective; the bus driver is the fund manager and investors’ money would be passengers.

V1 would travel through various places and on its journey, it would get stuck in traffic at times. There will be times when it traverses empty roads, enabling it to reach great speed. There is also the possibility that the tyres get punctured.

Now, in spite of all this, V1 will not stop. It will continue to follow its path and make sure that it reaches various cities sooner or later. The experiences encountered by V1 are similar to volatility in the stock market. There will be times when the market goes down but it will eventually reach the highway. V1 is an example of just one fund. Like we have multiple buses travelling across the nation, there are many different mutual funds as well, whose aim and route could be different.

Structure of Mutual Funds

The structure of mutual funds in India is very unique and robust. All the constituent entities involved function based on rules and regulations laid down by the Securities and Exchange Board of India (SEBI). In the year 1992, SEBI was formed with the objective to protect the interest of the investors and to regulate and promote the development of the securities market. With respect to mutual funds, SEBI controls and manages the functioning of mutual funds. 

There are various stakeholders involved in a mutual fund but the core structure is three-tiered: 

  1. Sponsor
  2. Trustee
  3. Asset Management Company (AMC)

This three-tier structure has been framed by SEBI. 

Sponsor – The Sponsor is the promoter of the mutual fund. When the Sponsor decides to start a mutual fund business, it must first approach SEBI. The eligibility of the sponsor is vetted and verified by SEBI, based on the criteria which are laid down. 

Trust and Trustees – A mutual fund is formed as a Trust, which comprises – the sponsor(s), Trustees and an asset management company (AMC). The Trustees are the guardians of mutual fund investors. Their role is to ensure that all the funds are managed as per the defined objective and that the investors’ interest is protected. They appoint an asset management company (AMC) to manage the funds of the investors.

Asset Management Company (AMC)– The third major entity is the AMC. The AMC is the money manager/investment manager/fund manager, which manages the money of the investors and charges a fee for its service. The day-to-day operations are handled by the AMC. The AMC launches various mutual fund schemes in the market as per the needs of the investors and the nature of the market and also oversees the development of these funds. 

The design for a mutual fund scheme is initially given to SEBI for verification and final approval. Only after SEBI’s approval, the AMC can roll out the scheme. In order to maintain integrity and trust and prevent misuse of investor money, SEBI has strict rules, regulations and guidelines for running the business and the AMC has to function based on these. Along with this, the AMC also undertakes operational activities like customer services, accounting, marketing and sales functions for the schemes.

Other entities in the mutual fund industry:

Custodian – Custodians are responsible for maintaining the investment account of the mutual fund and for the transfer and delivery of units and securities. Third-party financial institution’s role involves safeguarding the assets of the mutual fund. It also keeps a record of corporate actions like dividend, bonus and rights declared by the companies in which the mutual fund has invested. Custodians are also regulated by SEBI.

RTA – Registrar and Transfer Agents (RTA) help mutual fund companies to maintain records of all their transactions. The RTAs perform many administrative tasks, like processing of investors applications, creating units when new investments are made, removing units when investors make redemptions, keeping a full record of investors transactions, processing dividend pay-outs, etc. 

The RTA also gives investors a single- place reference for all information about new offers, maturity dates, etc. and does all the processing of mails that need to be sent to the investors. RTAs have to govern under guidelines issued by SEBI for them.

Distributors – The distributors bridge the gap between the AMC and the investors. The AMC is already involved in Fund Management and its legalities, but along with this they also need someone who can market the products, provide requisite knowledge to the investors, solve investors’ queries, etc. This is where the distributors come into the picture and provide their services for a smooth transaction between the AMC and the investors. The distributor community is the sales force of the industry, driving it forward.

Investor – With the presence of regulatory bodies, like SEBI and the Association of Mutual Funds in India (AMFI), investment in mutual funds has become very reliable for all retail investors. If any investor has any discrepancy regarding mutual fund investment, they can contact the AMC. 

If the mutual fund company is not able to solve the investor’s grievances, then the investor can reach out to SEBI to solve the issue. SEBI has launched ‘SEBI Complaint Redress System’ (SCORES) to address investor complaints.

Types of Mutual Funds

Broadly, mutual funds are classified into two categories: Open-ended and closed-ended funds. Open ended mutual funds are those in which investors can invest and redeem their money at any point of time, whereas closed ended funds do not have this option. Once an investor has invested their funds, they can withdraw the money only at the time of maturity. 

SEBI has further classified open-ended mutual funds as below:

Equity Funds

We have tried to simplify the major categories as defined by SEBI in the below table.

Based on Market Capitalization:

Based on Market Cap*Large Cap (80%), Mid Cap (65%), Small Cap (65%), Large & Mid Cap (35% each in large cap and mid cap) and Multi Cap (25% each in large, mid & small cap).The percentage in brackets indicates the minimum mandated exposure required for that specific market cap company. The level of risk increases as you go from large to mid to small cap.
Flexi CapMinimum 65% in equity across market cap.It has the flexibility to invest in large, mid and small cap companies according to the market situation. Increases diversification.
ELSSMinimum 80% in equity instruments across market cap.Investors mainly look at this category to avail a tax deduction under section 80C of the Income Tax Act. There is a lock-in of 3 years.
FocusedMinimum 65% in equity with max 30 stocks.Concentrated portfolio with maximum 30 stocks. It can invest across market cap. Risk is high due to limited stock exposure.
Dividend YieldMinimum 65% in equity instruments across market cap.It invests predominantly in dividend yielding stocks.
Value and ContraMinimum 65% in equity instruments across market cap.It follows a value/contrarian investment strategy.
Sectoral / ThematicMinimum 80% assets in equity instruments of a particular sector/theme. For eg: Banking is an example of a sector and Infrastructure is a theme.Schemes in this category invest in specific sectors/themes based on their strategy. The risk involved in this type of scheme is high due to exposure to a single sector/theme.
InternationalMinimum 95% in underlying overseas Stocks/Fund/Index/ETF.It invests in underlying entity/stocks which have exposure to regions outside India.
*As per SEBI’s market capitalization the companies ranking from 1st to 100th are termed as large cap, 101st to 250th are mid cap and from 251st onwards all are small cap companies

Debt Funds

SEBI has classified the debt funds on the basis of duration and quality of debt instruments.

CategoryDuration of Paper/ Credit QualityDescription
Parking Idle moneyOvernight (1 day), Liquid (3 months), Ultra Short Duration (3 to 6 months).Ideal instruments for parking funds for short duration. Negligible interest rate risk and extremely low credit risk.
Duration basedLow (6 to 12 months), Short (1 to 3 years), Medium (3 to 4 years), Medium to Long (4 to 7 years) and Long (more than 7 years).The papers held in these types of schemes are based on the duration specified by each category.
Corporate BondMinimum 80% in AA+ & above corporate bonds.Invests majorly in corporate bonds. Also, the lower the credit rating, the higher the credit risk. The higher the risk, the higher would be the expected returns.
Credit RiskMinimum 65% in AA rated & below corporate bonds.Invests majorly in corporate bonds. Also, the lower the credit rating, the higher the credit risk. The higher the risk, the higher would be the expected returns.
Banking & PSUMinimum 80% in banks & PSU’s debt instruments.Invests mainly in banking and public sector undertaking (PSU) papers.
Government SecuritiesMinimum 80% in G-secs.There are of 2 types: 1 – Invests in any G-sec, 2 – Invests in G-sec with 10-year of duration. Interest rate risk is high but there is no credit risk as these securities are issued by the government itself.

Hybrid Funds

SEBI has classified the hybrid funds on the basis of asset allocation.

CategoryAsset AllocationDescription
Conservative HybridDebt – 75% to 90%, Equity – 10% to 25%.Ideal for retired investors who are looking at slightly higher returns due to less exposure to equity. The taxation of conservative hybrid funds is the same as debt funds while that of equity saving funds is like an equity fund.
Equity SavingsEquity – 65%, Debt – 10% and rest in hedged instruments.Ideal for retired investors who are looking at slightly higher returns due to less exposure to equity. The taxation of conservative hybrid funds is the same as debt funds while that of equity saving funds is like an equity fund.
Aggressive HybridDebt – 20% to 35%, Equity – 65% to 80%.Ideal for investors with a reasonably conservative risk profile who are investing in equity markets for first time.
Dynamic Asset AllocationManage exposure to Equity & Debt dynamically. The allocation to pure equity changes based on the market situation.Ideal for investors with a reasonably conservative risk profile who are investing in equity markets for first time.
Multi Asset AllocationInvestment in at least three asset classes with a minimum allocation of at least 10% each in all three asset classes.Ideal for investors with a reasonably conservative risk profile who are investing in equity markets for first time.
ArbitrageEquity – 65% and all are hedged and Debt & cash – 35%.It is an alternate option for parking idle money but with taxation similar to equity funds.

These major categories comprise over 80% of the industry. Every category of mutual funds has its own risk associated with it; low, low to moderate, moderate, moderately high, high, and very high. Further, each AMC is allowed to have only one scheme in each category. 

Benefits of Investing in Mutual Funds

  1. Diversification – One of the main advantages of investing in mutual funds is the kind of diversification it gives to the investor’s portfolio at a low cost. By investing in only one fund, an investor can get an exposure to at least 30-40 stocks with an investment amount of as low as INR 500.
  2. Professional Management – For every investor, especially retail investors who do not have much knowledge about the capital market, mutual funds can be a boon. Every scheme has an expert who manages the allocation of funds to financial instruments. Mutual fund companies hire experts that have vast experience and spend dedicated time in the capital market to manage the money of the investors.
  3. Transparency – Mutual funds are the only instrument which disclose all the details on a regular basis. Portfolio disclosure enables investors to understand exactly what proportion of fund money is investment in which particular instruments. Also, the portfolios are updated on a monthly basis. This makes investing in mutual funds reliable and transparent. 

How to Transact in a Scheme of a Mutual Fund?

Buying and selling mutual fund units takes place at the net asset value (NAV) of the scheme, which is simply the price of a single unit of that mutual fund scheme. It is calculated by dividing the total value of all the cash and securities in a fund’s portfolio, minus any liabilities, by the number of outstanding units.

Following are the ways through which an investor can transact in schemes of a mutual fund:

  1. Lump Sum: Also called a one-time investment, this format involves the investor depositing their entire desired investment amount at one go.
  2. SIP and STP: A Systematic Investment Plan (SIP) is an investment mode wherein one can invest a fixed set of amounts periodically. This can be monthly, quarterly or semi-annually, etc. Investors can start their SIP with a small amount of as low as INR 500. Using the technological benefit of the auto-debit service of banks, the money can be invested automatically every month from the investor’s registered bank account.

In a Systematic Transfer Plan (STP), one can mandate the transfer of a fixed amount from one’s balance in a particular scheme to another destination/target scheme of the same AMC on a periodic basis.

  1. Redemption and SWP: Redemption is a process where an investor can withdraw their investments by selling their mutual fund units from the invested scheme. One can initiate redemption by specifying the number of mutual fund units or amount. The redeemed amount is directly credited to an investor’s bank account.

In a Systematic Withdrawal Plan (SWP), one can withdraw a regular income (fixed amount) on a periodic basis from the invested scheme.

  1. Switch: In this, one can transfer one’s entire balance in a particular scheme, or part of it, to another scheme of the same AMC.

Options for Investment in Mutual Fund

There are primarily 3 options in which one can invest in a scheme of a mutual fund:

  1. Growth: In this, all the profits made by the scheme are reinvested in the scheme.
  2. Income Distribution and Capital Withdrawal (IDCW): By selecting this option, one can get income at the discretion of the scheme.
  3. Income Distribution & Capital Withdrawal – Reinvestment (IDCW-R): In this option, the declared income by the scheme is reinvested in the same scheme instead of being disbursed to the investor.

Taxation of Mutual Funds

TaxationEquity Oriented FundsDebt Oriented Funds
Short Term Capital Gains15% (held for 12 months or less)As per tax slab (held for 36 months or less)
Long Term Capital Gains10% above Rs. 1 lac (held for more than 12 months)20% with indexation (held for more than 36 months)

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