What is Mutual Funds?
Simply put, mutual funds is where a pool of money is stored and is managed by a professional Fund Manager.
Basically, mutual funds is a trust that gathers money from several investors with a common investment objective and invests the same in bonds, equities, securities and money market instruments.
Mutual funds in India, like in any other country, pool the amounts of many investors and put them in a variety of securities depending upon the aim of the fund. There is a wide range of mutual fund options available for Indian citizens to choose from and it depends completely on the need and requirements of the investors. The numerous available options involve investments in equities, stocks, bonds or debt securities. Popularly called “schemes” in the Indian market, Indian debt funds invest in government or corporate debt instruments and money market securities. Another option is a portfolio offering investments in both equities and debt instruments. These mutual funds serve both the purposes- offer the stability of profits and also leave scope for significant gains in the future.
In India, mutual funds are managed by the Securities and Exchange Board of India, which have fixed rules about who can enter the market. A fund sponsor, according to the SEBI, is required to have been in the market for a minimum of five years and should have a positive net worth for the past five years. At the same time, open-ended schemes are required to have a minimum start-up capital requirement of Rs 500 million whereas close-ended schemes need a requirement of Rs 200 million.
For investing in a mutual fund, the investor needs to register with the SEBI post the approval of which, he needs to form a trust to hold the assets. A board of trustees which ensures that the mutual fund operates with the best interests of its shareholders in mind is also required to be formed. Simultaneously, an asset management company, responsible for managing the fund’s portfolio is chosen for maximizing profits.
People earn by investing in mutual funds in three ways.
Firstly, income is earned through the dividends on stocks and interest on bonds. Almost all the income received by the fund over the year is divided amongst the owners of the fund in proportion to their investment.
Secondly, there can be a capital gain if the price of the securities increases and the fund sells them. Most of the mutual funds pass on these gains to their investors.
Thirdly, if the price of the fund holdings increase but they are not sold, the funds’ shares increase in price. You can then sell your fund shares at a profit in the market.
The main motive behind any investment is the return that you would get after a certain period. Time and again, mutual funds have delivered superior returns compared to other traditional investment options. Debt funds have consistently performed better than Fixed Deposit (FD) returns and are a good choice of investment for people who want to play safe. For the more adventurous investors, investment in equities (shares) is an excellent way of earning higher returns but with much lesser risk due to portfolio diversification, Rupee-cost averaging, etc. Some of the main reasons why mutual finds make for a good investment are:
Security: Mutual funds are professionally managed by fund managers, whose daily job is to manage investments by identifying the winning stocks, deciding when to buy these stocks and when to sell them, thereby providing you the security of safe investment. Moreover, all mutual funds are governed by SEBI thus ensuring accountability and fairness to investors.
The flexibility of money extraction: Mutual funds give you the flexibility of redeeming your money when you need it as they come with little or no lock-in period, unlike the other traditional investment options which come with long lock-in periods.
Portfolio diversification: You also get the advantage of diversification, as your investment is made across a variety of stocks. Unexpected changes in one stock are likely to be balanced out by the performance of the other stocks in the fund.
Lower transaction costs: The transaction costs of mutual funds are lower than what is paid for other secure transactions simply because a mutual fund buys and sells large amounts of securities in a single go.
To begin with, it is essential to know that mutual funds capital gains are the profits that you earn by investing in a mutual fund. These are the profits on which you are taxed, depending upon your holding period of the fund. The tax rules are different for equity funds and debt funds, and so is the consideration of holding period as short term or long term.
Equity funds: When it comes to Equity funds, a holding period of more than 12 months is considered long-term, else it is considered short term. While long-term capital gains are not taxable, short-term capital gains observe a flat tax rate of 15%, irrespective of the investor’s tax bracket. Another thing to be noted is that dividends from equity funds are exempted from tax.
Debt funds: When we talk about debt funds, a holding period of less than 36 months qualifies for a short-term holding period while anything greater than that is a long-term holding period. Short-term capital gains face the same tax rate as the rate charged for your tax bracket. Long-term capital gains, on the other hand, face a tax rate of 20% with cost indexation benefits, i.e., while calculating your gain, the effects of inflation are also taken into account. Debt funds do face a dividend distribution tax (DDT) at the rate of 28.24% but this is automatically deducted from your NAV, and you receive the dividends net of this DDT.
These taxes on mutual fund capital gains are to be paid while filing your annual tax returns. The gains are to be shown as income and thereafter, taxes are to be calculated according to the aforementioned rates.
Before you decide on a mutual fund, you need to consider your investment objective, your period of investment as well as your willingness to take risks. Based on these factors, you can go for debt, equity or a hybrid category.
You can go for equity schemes if you have long-term goals and are not risk-averse. These funds offer you the possibility of huge returns in the future. However, they are comparatively, riskier than debt-oriented mutual funds. If you have short and medium-term targets, you are better off engaging in debt oriented mutual funds.
Apart from these personal factors, it is also essential to invest with a fund house which as a good track record, is famous in the market and has shown consistency in the past. It is better to go for funds managed by an expert team than ones which are managed by a single expert manager. Once again, it is always a wise idea to invest in a fund which diversifies your portfolio instead of focussing on just a particular stock or asset.
Anybody with a lot of money to spare or a desire to make it grow through investments but lacks the knowledge of the financial world makes for a perfect investor in mutual funds. If you possess a lot of money and want to invest it, you would require proper knowledge of the stock market and other financial items. Without that, you run the risk of facing a loss in the future. However, by investing in mutual funds, you can have a certain sense of surety that your money is being invested in the best possible avenues as it is managed by a team of professionals of the mutual fund company. You do not, in this case, need to have a very deep or detailed knowledge of how things work in the financial world. All you have to do is invest in a good mutual fund company and reap the profits in the future.
Depending on whether you hold a growth fund, a bond fund or a balanced fund, you earn either a dividend or interest. Your gains are classified as dividend or interest at the year-end while the filing of your taxes. While a growth fund doesn’t normally pay dividends, a balanced fund pays both interests and dividends.
The dividend option is offered by various mutual funds, and it depends on the investor whether he wants to buy it or not. These dividends are paid either daily, monthly, quarterly or annually depending on the scheme of investment. Under this option, your assets are not allowed to grow beyond your NAV value. The minute they do, the extra amount is paid to you as a dividend. The dividend option is recommended for those who are risk averse or need some cash flow over their course of investment.
Under Section 80C of the Income Tax Act, a deduction of Rs 1, 50,000 can be claimed from the total income you earn. This means that you can reduce up to Rs 1, 50,000 from your total taxable income through Section 80C. Mutual fund investments in Equity Linked Savings Schemes (ELSS) or tax saving mutual fund schemes qualify for a tax deduction under this Section. Since none of the Systematic Investment Plans (SIPs) are a part of the ELSSs, they are not eligible for the tax deduction available under Section 80C.