How Mutual Funds Work in India with Example?

In India, mutual funds have become one of the ideal investment choices for individuals aiming to grow their wealth over time, as they have proved their worth in the last two decades. A mutual fund collects money from investors to invest in stocks, bonds, gold, money market instruments, etc. This approach allows small investors to start their investment journey with a small sum of money.

What Are Mutual Funds?

Mutual funds are an investment vehicle that collects and pools money from numerous investors and invests it in different assets such as debt securities, stocks, gold, commodities, and others. The main objective behind this is to generate returns through a diversified investment, which is distributed among investors in proportion to their initial investment.

Fund managers, recognised as highly qualified professionals, are in charge of managing mutual funds. They make decisions to buy and sell securities on behalf of investors to fulfil the scheme’s objectives. Investors can choose from a wide variety of mutual funds, considering their investment objectives, potential return, and risk profile. 

Working Mechanism of Mutual Funds

When you invest in a mutual fund, you contribute money to a scheme that belongs to an AMC (Asset Management Company). Fund managers of the AMC who operate the mutual fund scheme will use your money and the money of numerous other investors to invest in various assets. 

As these assets generate profits, they will be distributed among investors based on their initial investment. The AMC charges a small fee to manage your investment; it is called the Expense Ratio.

The following steps show how mutual funds work in detail:

Pooling of Money: People willing to invest buy mutual fund units at their Current Net Asset Value (NAV). NAV indicates the per-unit value of a fund's net assets.

Creation of the Fund: To create a mutual fund, an asset management company designs the fund entirely, emphasising the investment objectives, risk profile, and strategy.

Regular Reporting: The fund managers employed by an AMC are responsible for managing mutual fund schemes. They also provide regular updates about a mutual fund scheme's performance, any changes in strategy, and more. These details are usually available on the Mutual Fund websites, and investors can also check the Fact Sheet for a detailed analysis.   

Portfolio Management: Skilled fund managers conduct research and choose the desired assets to build a diversified portfolio aligned with the fund's objectives. The fund house charges a minimal fee for managing funds, termed the expense ratio. 

Redemption and Exit: Investors sell back the units to the AMC at the prevailing NAV when they want to take their profits. An exit load fee can be charged to investors for withdrawing funds prematurely.

How do mutual funds work in India with an example?

Let us now understand the working mechanism of a mutual fund with an example. First, it is essential to understand the meaning of Net Asset Value (NAV). NAV is the price at which investors purchase or redeem their mutual fund investment. Units allotted for investment in mutual funds are based on NAV. 

For instance, you have invested Rs. 400 in a mutual fund with an NAV of Rs. 10. You will then be allotted (400/10) 40 units of the mutual fund. Now, if the price of the assets held by a fund fluctuates, the NAV of the mutual fund will also change. 

So, as per the above example, if NAV increases to Rs. 30, the earlier 40 units will now have a value of Rs. 1,200 (40 units * Rs. 30). When you redeem your mutual fund investment, you will get Rs. 1200 against Rs. 400, invested originally. These returns from a mutual fund are termed capital gains.

Structure of Mutual Funds in India

Mutual funds in India follow a three-tier structure with different players involved. The country's leading body overseeing all mutual funds is the Securities and Exchange Board of India (SEBI). The five main participants of a mutual fund scheme are a sponsor, an Asset Management Company, a mutual fund trustee, a custodian and a registrar and transfer agent.  

Sponsor

A sponsor is a person or entity responsible for setting up a mutual fund scheme to generate income. However, SEBI approval is needed to create a new mutual fund scheme. The sponsor is the first and foremost layer of the three-tier structure of mutual funds in India. To operate efficiently, a sponsor must create a Public Trust under the Indian Trust Act of 1882. 

After a trust is created, the trustee is registered with SEBI and safeguards the interests of unit holders under SEBI Mutual Fund regulations. Under the Companies Act, 1956, the sponsor creates an Asset Management Company to manage funds. 

To be a sponsor, one must meet the following eligibility criteria: 

• The sponsor must be employed in any financial services with at least 5 years of experience.
• The sponsor must have incurred profit in at least three of the previous five years, including the immediately preceding year.
• For the last five years, the net worth of the sponsor should be positive.
• The sponsor should hold 40% of the AMC's net worth. 

Trust and Trustees

Trust and Trustees are in the second layer of the mutual fund structure. They are the primary guardians of the assets held by a mutual fund, appointed by the fund’s sponsors. As the name suggests, they play an important role in maintaining investors' trust. 

A fund sponsor creates a trust, a legal entity responsible for holding money for its beneficiaries, in favour of the trustees. With a trustee company and its Board of Trustees, the formation of a trustee takes place. The trustees are responsible for monitoring the overall procedure and functioning of the asset management company. It is the company's responsibility to ensure that the funds are being managed in the interests of shareholders.  

Trustees do not interfere in the day-to-day business of AMC, but before introducing any mutual fund scheme in the market, the sponsor needs the trustees' approval. Being the watchdog, SEBI has introduced several rules to prevent any conflict of interest between the sponsor and the Trustees. Thus, it is the responsibility of the trustees to behave independently and take crucial measures to keep investors’ hard-earned money safe and secure. 

Asset Management Company

Asset Management Companies form the third layer in mutual funds. An AMC is responsible for all fund-related activities and has the prime responsibility of launching any mutual fund scheme that meets investors' requirements. It employs and supervises fund managers who operate different mutual fund schemes.

An AMC charges a small fee called the expense ratio to manage funds.

Types of Mutual Funds

In India, there are different types of mutual funds categorised based on structure, investment goals, and asset class. Furthermore, mutual funds can be divided based on risk. 

Based on investment goals, mutual funds can be classified as follows:

Close-ended Funds: For close-ended funds, there is a specific period during which investors can enter and exit their investments. These mutual fund schemes must be listed on stock exchanges to facilitate liquidity. Investment is locked for a specific period in closed-end funds. You can invest during the New Funds offer period (NFO) and withdraw after the lock-in period. 

Open-ended Funds: These funds do not restrict when and how many units can be bought and sold. As an investor, if you are seeking liquidity, this scheme is for you.

Interval Funds: Interval mutual funds allow transactions at a particular period. Investors can sell and purchase the units only during that period. When the trading window opens, investors can buy or redeem the units.

Based on the assets invested in, mutual funds are classified as:

Debt Funds: These funds are invested in securities like treasury bills, bonds, commercial papers, and other debt options. These funds are considered less risky than equity funds. Furthermore, debt Fund schemes can be classified as liquid funds, low-duration funds, credit risk funds, gilt funds, overnight funds, and others.

Equity Funds invest in shares of a company, and their returns are solely dependent on the stock market's performance. Moreover, expect high returns from these funds with risk. If you have a high-risk appetite and are looking for a long-term investment plan, invest in equity funds. Equity Funds can be categorised as Large-cap, Mid-cap, Small-cap, Multi-cap, Value Funds, etc.  

Hybrid Funds: By balancing debt and equity investment, hybrid funds prioritise good returns and safety. Depending on the fund house, the investment ratio may be set or flexible. Balanced, Aggressive and Conservative are the main categories of Hybrid Funds. 

Solution-Oriented Funds: These mutual fund plans help achieve specific objectives, such as saving money for retirement, your children's college or marriage. They have a minimum five-year lock-in duration.

Looking at the financial objectives, mutual funds can be subdivided into:

Tax Savings Funds (ELSS): These funds primarily invest in equities, provide tax benefits, and are known as equity-linked savings schemes. Nonetheless, under Sectio80c0C, they are eligible for tax deductions. Three years is the minimum investment period.

Growth Funds: Growth funds focus on buying high-performing equities to increase their capital. For investors looking for large returns over an extended period of time, these funds may be a compelling choice.

Liquidity-Based Funds: Certain funds can be grouped according to the degree of liquidity in the investments. Ultra-short-term and liquid funds best serve short-term objectives.

Fixed Maturity Funds: The debt instruments these funds invest in either have the same maturity length as the fund or are comparable. An example of a three-year FMF invests in assets with a minimum maturity of three years.

Capital Protection Funds: These funds allocate a portion of their investments to stocks and a portion to fixed-income instruments. This provides some capital protection along with decent returns.

Pension Funds: Pension funds' investments aim to yield consistent returns over an extended period. These are often hybrid funds with modest yields but have the potential to provide consistent returns down the road.

Role of Asset Management Company

An Asset Management Company (AMC) is a financial institution responsible for managing the operations of mutual funds and other investment schemes. This company plays a vital role in creating products that meet investors' financial goals. 

Here is a detailed overview of the role of the Asset Management Company and the functions it performs:

Investment Management: An AMC's primary responsibility is managing a range of investments. They focus on analysing market trends, Macro and microeconomic activities, and Political events to assess risks and make investment decisions to achieve the desired objectives.

Diversification: Based on their analysis, AMC diversifies investment portfolios across various assets such as equities, debt, real estate, and gold. This helps lower portfolio risk.

Risk Management: AMC actively monitors the risks of investment portfolios. The risks include liquidity, operational, credit, and other market risks.

Investment Approach: Before launching any mutual fund scheme, the AMC evaluates it to ensure it serves investors' interests and exposes them to as little risk as possible. This process plays a vital role in deciding the investment approach of a particular mutual fund scheme. 

Performance Review: AMCS are responsible for the investment decisions it makes on behalf of its investors and trustees. Regular assessments of fund performance are conducted to ensure that they meet their obligations, considering factors such as fund returns, NAV value, and asset allocation. This review sheet is accessible to all AMC investors and trustees.

How to Invest in Mutual Funds?

Before you invest in a mutual fund, whether offline or online, you must complete the KYC verification process by filling out the KYC form. 

Here are the different ways you can invest in mutual funds:

AMC Website: You can invest in mutual funds online through the respective mutual fund website.

Offline: Complete an application form with a cheque or bank draft from the respective branch of the mutual fund or the Registrar and Transfer Agent (RTA).

Distributor: You can also approach a mutual fund distributor to invest in a fund scheme. The distributor must register with AMFI. Otherwise, you can also choose to invest directly without consulting any distributor.

 Stock Exchange: You can purchase mutual fund schemes through MFSS and BSE, similar to purchasing company stock. However, investors must complete a one-time registration online with BSE or NSE to make this possible.

MF Utility: You can also invest in a mutual fund scheme online through MF Utilities Private Limited, a technology-oriented platform for mutual fund transactions.

Documents Required to Invest in Mutual Funds

While investing in mutual funds, providing the correct documents is essential. It will protect you from fraudulent activities and tax irregularities. Here are the documents you need to invest in mutual funds:

• Application form
• KYC-related documents that include your PAN card, passport-size photograph 
• Proof of Identity such as a driving licence, a passport, an Aadhaar card, a voter ID card, a PAN with photograph, an identity card
• Proof of Address: Passport/Aadhaar/Passport/Ration card/Insurance bills/Bank account statement or passbook
• A blank cheque for SIP
• Third-party declaration for minors

Tax Implications of Mutual Funds

Mutual funds are financial products subject to taxation when their gains are incurred. However, the taxes on mutual funds depend on the asset type and the investment holding period. Equity-linked savings scheme (ELSS) is an exceptional type of mutual fund that helps to save taxes. 

Mutual funds are taxed based on their investment duration and asset categorisation.

Categorisation of Assets

There are two systems of taxation based on asset categorisation – equity taxation and non-equity taxation. Equity and non-equity mutual funds are taxed at different rates based on their holding period. For hybrid funds, the taxes depend on whether they are treated as equity or non-equity funds. 

A hybrid fund investing more than 65 percent of the allocated amount in shares of domestic companies is considered an equity-oriented fund. Otherwise, it is taxed as a non-equity or debt-oriented fund. 

Holding Period

The period you remain invested in a mutual fund is its holding period. Short-term investments charge different tax rates from long-term investments.

Short-Term Capital Gains Tax

Investing in a mutual fund for less than 12 months results in short-term capital gains tax (STCG). Equity funds are charged STCG at a flat 15 per cent rate, whereas debt funds are charged at the investor's tax slab rate. 

Long-Term Capital Gains Taxation

Investing in a mutual fund with a period of more than 12 months results in long-term capital gains taxation. 10% tax is applicable on capital gains exceeding Rs. 1 lakh in a year from equity and equity-oriented funds. If the return is less than this amount, it is entirely tax-free. 

Tax Saving Mutual Funds

You qualify for tax deductions once you invest in an ELSS fund. You can save Rs. 1,50,000 under Section 80c of the Income Tax Act, 1961. You can expect a high return with a lock-in period of 3 years if you invest in this mutual fund. Because of its distinguishing features, investors consider ELSS an ideal tax-saving option. 

Securities Transaction Tax

A securities transaction tax of 0.001 per cent applies to all equity funds during redemption. Investors receive their profits after this tax is deducted, so there is no need to pay the amount separately.

Risks of Investing in Mutual Funds

Each investment carries risk with it. Thus, before you start to invest, individual investors should look into the following risk factors:

Market Risk: All securities carry some market risk. Similarly, a mutual fund is also prone to market risk because of changes in interest rates, external shocks, changes in government policies, national or regional economic development, etc.

Non-Guaranteed Returns: Every investor should be aware that the profits from investment in mutual fund schemes are not guaranteed.

Liquidity Risk: Liquidity risk is the risk of being unable to sell a security at its near value, depending on the volume of securities traded in the market.

Inflation Risk: This risk relates to a fall in the purchasing power of investment because of a rise in consumer prices.

Non-Compliance Risk: Mutual fund investors face this risk due to the fund manager's failure to follow internal policies and procedures and laws, rules, and regulations.

Advantages and Disadvantages of Mutual Funds

Before investing in a mutual fund scheme, you should consider its advantages and disadvantages to make an informed decision. 

Advantages

Here are some advantages of mutual funds:

Diversification: Investments in mutual funds are diversified across sectors. This reduces the risks associated with investments.

Minimum Investment: Mutual funds require a low minimum investment. Thus, a wide range of investors can consider investing in different mutual fund schemes.

Liquidity: Open-ended mutual funds are a flexible investment option because investors can easily buy and sell. This implies that you can access the money whenever you need it.

Transparency: Mutual funds disclose their performance and portfolio of assets regularly. Thus, investors can easily track their investment returns.

Tax Benefits: Equity-linked savings Scheme mutual funds offer tax deductions under Section 80c of the Income Tax Act.

Convenience: You can opt for an investment plan such as a Systematic Investment Plan (SIP) where you can deposit in small amounts and promote savings.

Disadvantages

Apart from the advantages, there are also certain disadvantages of investing in mutual funds. These are:

Additional Fees and Expenses: When investing in mutual funds, you must pay different fees, such as transaction and management fees. These fees affect your return on a mutual fund scheme.

Market Risk: A mutual fund's value fluctuates in the market, similar to that of stocks. This implies the chance of losses when investing in a mutual fund scheme.

Underperformance: The returns from a mutual fund scheme might not meet your desired expectations.

Complexity: At times, mutual fund schemes, along with the risks and fees associated with them, can become difficult to understand. Thus, investors face a problem in making informed decisions.

Conclusion

Before investing in a mutual fund, make sure you understand how mutual funds work and the basics of the financial markets. Then, conduct a thorough analysis of the fund, considering factors such as performance history and objectives. Thus, you can build your wealth in the long term through proper monitoring and careful planning.