In India, mutual funds have become one of the ideal investment choices for individuals aiming to grow their wealth over time, as it proved its worth in the last two decades. A mutual fund collects money from investors for investing in stocks, bonds, gold and money market instruments, and  etc. This approach allows small investors to start their investment journey with a small sum of money. Continue reading this blog to gain detailed insights into how mutual funds work, different types of mutual funds, their structure, the risks involved, and more. 

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 other assets. The main objective behind this is to generate returns through a diversified investment, which is then 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 the behalf of investors in order to fulfil the scheme’s objectives. Investors can choose from a wide variety of mutual funds considering their objectives of investment, potential return, and risk profile. 

Working Mechanism of Mutual Funds

When you invest in a mutual fund, you essentially 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 a variety of assets. 

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

The following steps show how mutual funds work in detail:

1. Pooling of Money: People willing to invest buy units of a mutual fund at its Current Net Asset Value (NAV). NAV indicates the per unit value of the net assets of a fund.
2. Creation of the Fund: For creating a mutual fund, an asset management company designs the fund entirely emphasising the objectives of investment, risk profile, and strategy.
3. Regular Reporting: It is the responsibility of the fund managers employed by an AMC to manage mutual fund schemes. They also provide regular updates about a mutual fund scheme regarding its performance, any changes in strategy, and more. These details are usually available on the Mutual Funds websites and investors can also check the Fact Sheet for a deep dive in details.   
4. Portfolio Management: Skilled fund managers conduct a research process and choose the desired assets for building up a diversified portfolio aligning with the objectives of the fund. The fund house charges a minimal fee for managing funds, termed as the expense ratio. 
5. Redemption and Exit: When they want to take their profits, investors sell back the units to the AMC at the prevailing NAV. An exit load fee can be charged to investors for withdrawing funds prematurely.

How Mutual Funds Work in India with Example?

Let us now understand the working mechanism of a mutual fund with an example. At the very 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 main body overseeing all mutual funds in the country 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/entity responsible for setting up a mutual fund scheme to generate income. However, primarily, approval of SEBI is needed to create a new mutual fund scheme. Sponsor is the first and foremost layer of the three-tier structure of mutual funds in India. To operate efficiently, a sponsor needs to create a Public Trust under the Indian Trust Act 1882. 

After creation of a trust, the trustee is registered with SEBI and serves the role of safeguarding the interests of unit holders under SEBI Mutual Fund regulations. Under the Companies Act, 1956, an Asset Management Company is created by the sponsor for dealing with fund management. 

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

1. The sponsor must be employed in any financial services with a minimum of 5 years of experience.
2. The sponsor must have incurred profit in at least three of the previous five years. This also includes the immediately preceding year as well.
3. For the last five years, the net worth of the sponsor should be positive.
4. Out of the net worth of the AMC, 40% of its stake should be held by the sponsor. 

• Trust and Trustees

Trust and Trustees are there in the second layer of the mutual fund structure. These 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 the trust of investors. 

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. Their responsibility is to make sure 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 approval of the trustees. SEBI, being the watchdog, has introduced several rules to prevent any conflict of interest between the sponsor and 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 Company forms the third layer in mutual funds. An AMC holds the prime responsibility of launching any mutual fund scheme meeting the requirements of investors. It employs and supervises fund managers who operate different mutual fund schemes. AMC is responsible for all fund-related activities.

For management of funds, an AMC charges a small fee called expense ratio.

Types of Mutual Funds

There are different types of mutual funds in India 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 certain period during which investors can enter and exit their investments. To facilitate liquidity, these mutual fund schemes are required to be listed on stock exchanges. Investment is locked for a certain period of time in close ended funds. You can invest during the New Funds offer period (NFO) and withdraw after the lock-in period. 
• Open-ended Funds: For these funds, there is no restriction on 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 for transactions at a particular period. investors can sell and purchase the units in a particular period only. When the trading window opens, investors can purchase or redeem the units.

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

• Debt Funds: These funds invest in securities like treasury bills, bonds, commercial papers and other debt options. These funds are considered less risky than equity funds. Furthermore, Debt Funds schemes can be classified as liquid funds, low-duration funds, credit risk funds, gilt funds, overnight funds, and others.
• Equity Funds: They invest in shares of a company and their returns are solely dependent on the performance of the stock market. 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 in Large-cap, Mid-cap, Small-cap, Multi-cap, Value Funds, and etc.  
• Hybrid Funds: By maintaining a balance between debt and equity investment, hybrid funds prioritise both good returns and safety. The investment ratio may be set or flexible, dependent on the fund house. Balanced, Aggressive and Conservative are the main categories of Hybrid Funds. 
• Solution-Oriented Funds: These mutual fund plans help to achieve certain objectives, such as saving money for your retirement or 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, which primarily invest in equities and provide tax benefits, are known as equity-linked savings schemes. Nonetheless, under Section 80C, they are eligible for tax deductions. Three years is the minimum investment period.
• Growth Funds: Growth funds are those that focus on buying high-performing equities to increase their capital. For investors looking for large returns over an extended length 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. Short-term objectives are best served by ultra-short-term and liquid funds.
• Fixed Maturity Funds: The debt instruments that these funds invest in either have the same maturity length as the fund or one that is comparable. An example of a three-year FMF is one that 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: The goal of pension funds' investments is 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 that holds responsibility for managing the operations of mutual funds and other investment schemes. This company plays a vital role in creating products that meet the financial goals of investors. 

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

• Investment Management: The primary responsibility of an AMC is managing a range of investments. They focus on analysing market trends, Macro & Micro Economic activities and the Political stir to assess risks, and making investment decisions to achieve the desired objectives.
• Diversification: On the basis of their analysis, AMC diversifies the investment portfolios across various assets such as equities, debt, real estate and gold. This helps to lower the risk of an investment portfolio.
• Risk Management: AMC actively monitors the risks of investment portfolios. The risks include liquidity risks, operational risks, credit risks, and other market risks.
• Investment Approach: Before launching any mutual fund scheme, the AMC evaluates it to ensure that 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 they make on behalf of their investors and trustees. Regular assessments of fund performance are conducted to ensure that they are meeting their obligations, taking into account 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, it is mandatory to complete the KYC verification process by filling up 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: Fill out an application form with a cheque or bank draft of the respective branch of the mutual fund or Registrar and Transfer Agent (RTA).
• Distributor: You can also approach a mutual fund distributor to invest in a mutual 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, which are similar to purchasing company stock. However, to avail this, investors must complete a one-time registration online with BSE or NSE.
• MF Utility: You can also invest in a mutual fund scheme online through MF Utilities Private Limited. This is a technology-oriented platform for carrying out 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 driving licence, passport, Aadhaar card, voter ID card, PAN with photograph, 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 that are subjected to taxation when gains are incurred from it. However, the taxes on mutual funds depend on the asset type and the holding period of investment. Equity 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 are considered equity-oriented funds. Or else, they are taxed as non-equity or debt oriented funds. 

• 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 with a time frame of less than 12 months results in short-term capital gains tax. Equity funds are charged STCG at a flat 15 percent 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 amount exceeding more than Rs. 1 lakh in a year from equity and equity-oriented funds. If the return is less than this amount, it is completely 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 investing 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 percent is applicable for all equity funds during redemption. Investors receive their profits after this tax is deducted. Hence, 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 there is no guarantee of profits from investment in mutual fund schemes.
• 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: This is the risk faced by mutual fund investors due to the fund manager's failure to follow internal policies and procedures, laws, rules, and regulations.

Advantages and Disadvantages of Mutual Funds

Before investing in a mutual fund scheme, you  should look at its advantages and disadvantages to reach 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 need a low minimum investment. Thus, a wide range of investors can look into investing in different mutual fund schemes.
• Liquidity: Open-ended mutual funds are a flexible option for investment because investors can buy and sell with ease. 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 certain 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: While investing in mutual funds, you need to pay different fees such as transaction fees and management fees. This affects your return with a mutual fund scheme.
• Market Risk: A mutual fund's value fluctuates in the market in a way 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 funds schemes become difficult to understand along with the risks and fees associated with it. Thus, it poses a problem in making informed decisions for investors.

Conclusion

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