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Mutual Funds

Mutual Funds have seen a recent surge in their inflows especially from retail and domestic investors. But despite this rapid surge the penetration is way below the potential.

With the increasing participation from retail investors, each AMC is trying to extract as much business as possible and are launching NFOs almost on a weekly basis, making it further difficult for investor to choose the right fund. Presently, there are more than 1000 mutual funds available across more than 20 categories.

Despite all this there exist so many individuals who do not know anything about mutual funds. Here is the brief on what are mutual funds, how they work, what are the different categories available in mutual funds, differenty type of funds in those different categories and other basic concepts.


Concept of Mutual Fund

Mutual fund is a vehicle (in the form of a “trust”) to mobilize money from investors, to invest in different markets and securities, in line with the common investment objectives agreed upon, between the mutual fund and the investors. In other words, through investment in a mutual fund, an investor can get access to equities, bonds, money market instruments and/or other securities, that may otherwise be unavailable to them and avail of the professional fund management services offered by an asset management company.


Role of Mutual Funds

Mutual funds perform different roles for the different constituents that participate in it.

Their primary role is to assist investors in earning an income or building their wealth, by participating in the opportunities available in various securities and markets. It is possible for mutual funds to structure a scheme for different kinds of investment objectives. Thus, the mutual fund structure, through its various schemes, makes it possible to tap a large corpus of money from investors with diverse goals/objectives.

Therefore, mutual funds offer different kinds of schemes to cater to the need of diverse investors. In the industry, the words ‘fund’ and ‘scheme’ are used inter-changeably. Various categories of schemes are called “funds”. In order to ensure consistency with what is experienced in the market, this workbook goes by the industry practice. However, wherever a difference is required to be drawn, the scheme offering entity is referred to as “mutual fund” or “the fund”.

The money that is raised from investors, ultimately benefits governments, companies and other entities, directly or indirectly, to raise money for investing in various projects or paying for various expenses.

The projects that are facilitated through such financing, offer employment to people; the income they earn helps the employees buy goods and services offered by other companies, thus supporting projects of these goods and services companies. Thus, overall economic development is promoted.

As a large investor, the mutual funds can keep a check on the operations of the investee company, and their corporate governance and ethical standards.

The mutual fund industry itself, offers livelihood to a large number of employees of mutual funds, distributors, registrars and various other service providers.

Higher employment, income and output in the economy boosts the revenue collection of the government through taxes and other means. When these are spent prudently, it promotes further economic development and nation building.

Mutual funds can also act as a market stabilizer, in countering large inflows or outflows from foreign investors. Mutual funds are therefore viewed as a key participant in the capital market of any economy.


Why are there different kinds of Mutual Fund Schemes?

Mutual funds seek to mobilize money from all possible investors. Various investors have different investment preferences and needs. In order to accommodate these preferences, mutual funds mobilize different pools of money. Each such pool of money is called a mutual fund scheme.

Every scheme has a pre-announced investment objective. Investors invest in a mutual fund scheme whose investment objective reflects their own needs and preference.


How do Mutual Fund Schemes Operate?

Mutual fund schemes announce their investment objective and seek investments from the investor. Depending on how the scheme is structured, it may be open to accept money from investors, either during a limited period only, or at any time.

The investment that an investor makes in a scheme is translated into a certain number of ‘Units’ in the scheme. Thus, an investor in a scheme is issued units of the scheme.

Typically, every unit has a face value of Rs. 10. (However, older schemes in the market may have a different face value). The face value is relevant from an accounting perspective. The number of units issued by a scheme multiplied by its face value (Rs. 10) is the capital of the scheme – its Unit Capital.

The scheme earns interest income or dividend income on the investments it holds. Further, when it purchases and sells investments, it earns capital gains or incurs capital losses. These are called realized capital gains or realized capital losses as the case may be.

Investments owned by the scheme may be quoted in the market at higher than the cost paid. Such gains in values on securities held are called valuation gains. Similarly, there can be valuation losses when securities are quoted in the market at a price below the cost at which the scheme acquired them.

For running the scheme of mutual funds, operating expenses are incurred.
Investments can be said to have been handled profitably, if the following metric is positive: (A) +Interest income
(B) + Dividend income
(C) + Realized capital gains
(D) + Valuation gains
(E) – Realized capital losses
(F) – Valuation losses
(G) – Scheme expenses

When the investment activity is profitable, the true worth of a unit increases. When there are losses, the true worth of a unit decreases. The true worth of a unit of the scheme is otherwise called Net Asset Value (NAV) of the scheme.

When a scheme is first made available for investment, it is called a ‘New Fund Offer’ (NFO). During the NFO, investors get the chance of buying the units at their face value. Post-NFO, when they buy into a scheme, they need to pay a price that is linked to its NAV.

The money mobilized from investors is invested by the scheme in a portfolio of securities as per the stated investment objective. Profits or losses, as the case might be, belong to the investors or unitholders. No other entity involved in the mutual fund in any capacity participates in the scheme’s profits or losses. They are all paid a fee or commission for the contributions they make to launching and operating the schemes. The investor does not however bear a loss higher than the amount invested by him.

Various investors subscribing to an investment objective might have different expectations on how the profits are to be handled. Some may like it to be paid off regularly as dividends. Others might like the money to grow in the scheme. Mutual funds address such differential expectations between investors within a scheme, by offering various options, such as dividend payout option, dividend re- investment option and growth option. An investor buying into a scheme gets to select the preferred option.

The relative size of mutual fund companies is assessed by their assets under management (AUM). When a scheme is first launched, assets under management is the amount mobilized from investors. Thereafter, if the scheme has a positive profitability metric, its AUM goes up; a negative profitability metric will pull it down.

Further, if the scheme is open to receiving money from investors even post-NFO, then such contributions from investors boost the AUM. Conversely, if the scheme pays any money to the investors, either as dividend or as consideration for buying back the units of investors, the AUM falls.

The AUM thus captures the impact of the profitability metric and the flow of unit-holder money to or from the scheme.


Advantages of Mutual Funds for Investors Professional Management

Mutual funds offer investors the opportunity to earn an income or build their wealth through professional management of their investible funds. There are several aspects to such professional management viz. investing in line with the investment objective, investing based on adequate research, and ensuring that prudent investment processes are followed.

Investing in the securities markets will require the investor to open and manage multiple accounts and relationships such as broking account, demat account and others. Mutual fund investment simplifies the process of investing and holding securities.

Affordable Portfolio Diversification

Investing in the units of a scheme provide investors the exposure to a range of securities held in the investment portfolio of the scheme in proportion to their holding in the scheme. Thus, even a small investment of Rs. 500 in a mutual fund scheme can give investors proportionate ownership in a diversified investment portfolio.

As will be seen later, with diversification, an investor ensures that “all the eggs are not in the same basket”. Consequently, the investor is less likely to lose money on all the investments at the same time. Thus, diversification helps reduce the risk in investment. In order to achieve the same level of diversification as a mutual fund scheme, investors will need to set apart several lakhs of rupees. Instead, they can achieve the diversification through an investment of less than thousand rupees in a mutual fund scheme.

Economies of Scale

Pooling of large sum of money from many investors makes it possible for the mutual fund to engage professional managers for managing investments. Individual investors with small amounts to invest cannot, by themselves, afford to engage such professional management.

Large investment corpus leads to various other economies of scale. For instance, costs related to investment research and office space gets spread across investors. Further, the higher transaction volume makes it possible to negotiate better terms with brokers, bankers and other service providers.

Mutual funds give the flexibility to an investor to organize their investments according to their convenience. Direct investments may require a much higher investment amount than what many investors may be able to invest. For example, investment in gold and real estate require a large outlay. Similarly, an effectively diversified equity portfolio may require a large outlay. Mutual funds offer the same benefits at a much lower investment value since it pools small investments by multiple investors to create a large fund. Similarly, the dividend and growth options of mutual funds allow investors to structure the returns from the fund in the way that suits their requirements.

Thus, investing through a mutual fund offers a distinct economic advantage to an investor as compared to direct investing in terms of cost saving.


At times, investors in financial markets are stuck with a security for which they can’t find a buyer – worse, at times they can’t find the company they invested in. Such investments, whose value the investor cannot easily realize in the market, are technically called illiquid investments and may result in losses for the investor.

Investors in a mutual fund scheme can recover the market value of their investments, from the mutual fund itself. Depending on the structure of the mutual fund scheme, this would be possible, either at any time, or during specific intervals, or only on closure of the scheme. Schemes, where the money can be recovered from the mutual fund only on closure of the scheme, are compulsorily listed on a stock exchange. In such schemes, the investor can sell the units through the stock exchange platform to recover the prevailing value of the investment.

Tax Deferral

Mutual funds are not liable to pay tax on the income they earn. If the same income were to be earned by the investor directly, then tax may have to be paid in the same financial year.

Mutual funds offer options, whereby the investor can let the money grow in the scheme for several years. By selecting such options, it is possible for the investor to defer the tax liability. This helps investors to legally build their wealth faster than would have been the case, if they were to pay tax on the income each year.

Tax benefits

Specific schemes of mutual funds (Equity Linked Savings Schemes) give investors the benefit of deduction of the amount subscribed (upto Rs. 150,000 in a financial year), from their income that is liable to tax. This reduces their taxable income, and therefore the tax liability.

Convenient Options

The options offered under a scheme allow investors to structure their investments in line with their liquidity preference and tax position.

There is also great transaction conveniences like the ability to withdraw only part of the money from the investment account, ability to invest additional amount to the account, setting up systematic transactions, etc.

Investment Comfort

Once an investment is made with a mutual fund, they make it convenient for the investor to make further purchases with very little documentation. This simplifies subsequent investment activity.

Regulatory Comfort

The regulator, Securities and Exchange Board of India (SEBI), has mandated strict checks and balances in the structure of mutual funds and their activities. Mutual fund investors benefit from such protection.

Systematic Approach to Investments

Mutual funds also offer facilities that help investor invest amounts regularly through a Systematic Investment Plan (SIP); or withdraw amounts regularly through a Systematic Withdrawal Plan (SWP); or move money between different kinds of schemes through a Systematic Transfer Plan (STP). Such systematic approaches promote investment discipline, which is useful in long-term wealth creation and protection. SWPs allow the investor to structure a regular cash flow from the investment account.

Limitations of a Mutual Fund

Lack of portfolio customization

Some brokerages offer Portfolio Management Schemes (PMS) to large investors. In a PMS, the investor has better control over what securities are bought and sold on his behalf. The investor can get a customized portfolio in case of PMS.

On the other hand, a unit-holder in a mutual fund is just one of several thousand investors in a scheme. Once a unit-holder has bought into the scheme, investment management is left to the fund manager (within the broad parameters of the investment objective). Thus, the unit-holder cannot influence what securities or investments the scheme would invest into.

Choice overload

There are multiple mutual fund schemes offered by 42 mutual funds – and multiple options within those schemes which makes it difficult for investors to choose between them. Greater dissemination of industry information through various media and availability of professional advisors in the market helps investors handle this overload.

In order to overcome this choice overload, SEBI has introduced the categorisation of mutual funds to ensure uniformity in characteristics of similar type of schemes launched by different mutual funds. This will help investors to evaluate the different options available before making informed decision to invest.

No control over costs

All the investor's money is pooled together in a scheme. Costs incurred for managing the scheme are shared by all the Unit-holders in proportion to their holding of Units in the scheme. Therefore, an individual investor has no control over the costs in a scheme.

SEBI has however imposed certain limits on the expenses that can be charged to any scheme. These limits, which vary with the size of assets and the nature of the scheme, are discussed later.