What are Mutual Funds?
A mutual fund is an investment that pools money from several investors to invest in a mix of assets like stocks, bonds, government securities, and even gold. Mutual funds allow investors to achieve portfolio diversification and professional management, with returns and risks based on the performance of the fund’s investments.
The funds are managed by financial experts called fund managers. These professionals have the skills to analyze and make investment decisions. To manage the fund, the AMC charges a fee, known as the expense ratio. The gains generated from this fund investment are distributed proportionately amongst the investors after deducting applicable expenses, by calculating the Net Asset Value.
Some of the objectives for the same are:
1. Pooling of Funds
A mutual fund collects money from many investors, which can include individuals, institutions, or even pension funds. The pooled money is used to invest in a variety of assets, such as:
By pooling their resources, investors can participate in investments they may not have been able to afford individually.
2. Portfolio Diversification
Mutual funds provide investors with an easy way to diversify their investments. Diversification is crucial because it spreads risk across different types of assets. For example, if a mutual fund holds both stocks and bonds, a decline in stock prices might be balanced by stability or growth in bond prices. This reduces the risk of losing money compared to investing in just one asset class.
3. Professional Management
Mutual funds are managed by experienced professionals known as fund managers. These managers work for Asset Management Companies (AMCs) and have deep knowledge of financial markets, economic trends, and specific industries. Their primary role is to make decisions on which assets to buy, hold, or sell, ensuring the fund aligns with its investment objectives.
Fund managers rely on thorough research, data analysis, and market trends to select a mix of investments that can help achieve the best possible returns while managing risk. They continuously monitor the portfolio and adjust it as necessary.
4. Expense Ratio
Managing a mutual fund incurs costs. These expenses cover:
The expense ratio represents the percentage of the fund’s total assets that go towards covering these costs. The expense ratio can vary based on the complexity of managing the fund. For example, equity funds might have a higher expense ratio than bond funds due to the additional research and active management required.
5. Net Asset Value (NAV)
The performance of a mutual fund is reflected in its Net Asset Value (NAV), which is the price per unit of the fund. NAV is calculated daily based on the market value of the fund’s underlying assets.
Investors can buy or sell mutual fund units at the prevailing NAV, which fluctuates based on the performance of the fund’s investments. Gains, dividends, or interest earned by the fund will increase the NAV, while losses or expenses will decrease it.
6. Distribution of Gains
Mutual funds generate returns for investors through:
Capital Gains: When the fund sells an asset at a profit.
Dividends: If the stocks or bonds in the portfolio pay dividends or interest.
These gains are distributed to investors proportionately based on the number of units they hold, after deducting the fund’s expenses. Investors can either receive these gains as payouts or reinvest them back into the fund, depending on the plan they choose.
7. Liquidity
Mutual funds typically offer high liquidity. Investors can redeem (sell) their units at any time based on the current NAV, making mutual funds a flexible investment option. However, certain types of funds like ELSS (Equity Linked Savings Scheme) might have a lock-in period for tax-saving purposes.
8. Types of Mutual Funds
Large-cap, mid-cap and small-cap mutual funds are types of mutual funds based on market capatilisation of the companies they invest in.
The choice between large, mid, and small-cap funds hinges on your risk appetite. Large-cap funds prioritise stability with lower risk, ideal for conservative investors. Mid-cap funds offer a balance, providing growth potential with moderate risk. Small-cap funds hold the allure of potentially high returns, but come with the most significant risk. Ultimately, the best allocation depends on your risk tolerance, investment goals, and investment timeframe.
What are large-cap funds?
Large-cap funds are those companies that have a market capitalisation of more than Rs. 20,000 Crore. In other words, Large-cap funds invest in well-established companies with market capitalisations ranking from 1 to 100. These companies, such as Reliance, SBI, and ITC, are typically well-established and have a proven track record of success. They are often leaders in their respective industries and have a strong market presence.
What are mid-cap funds?
Mid-cap funds are those companies that have a market capitalisation between Rs. 5,000 crores and Rs. 20,000 crores. Mid-cap funds allocate investments to medium-sized companies positioned between the ranks of 101 to 250 in terms of market capitalisation. These companies are typically smaller than large-cap companies but larger than small-cap companies. Companies such as Godrej Industries and Voltas fall into the mid-cap category. Mid-cap firms hold promise for delivering favourable returns over extended periods. However, mid-cap funds generally entail higher risk compared to large-cap funds.
What are small-cap funds?
Small-cap funds are those companies that have a market capitalisation of less than Rs. 5,000 crores. Small-cap funds allocate investments to companies ranked 251st and beyond in terms of total market capitalisation. Typically smaller in size compared to large and mid-cap counterparts. Due to their size, they have the agility to swiftly implement ideas and capitalise on market opportunities, a trait often more challenging for larger organisations. Hence, small-cap funds tend to provide higher returns when compared to large and mid-cap funds but possess a higher risk.
Flexi cap mutual fund
Flexi cap Mutual Funds are an open-ended equity fund that allows fund managers to invest in a mix of large-cap, mid-cap, and small-cap stocks without restrictions. This flexibility enables them to adjust allocations based on market conditions, optimizing returns while providing diversification across different sectors. Suitable for investors with moderate to high risk tolerance, these funds aim for long-term growth, making them ideal for those willing to stay invested for at least five years. The performance relies on the fund manager’s expertise, and while there can be fluctuations in value, the potential for capital appreciation makes Flexi cap funds an attractive investment option.
Equity Linked Savings Scheme (ELSS)
ELSS is a mutual fund that primarily invests in equities and offers tax benefits under Section 80C, allowing deductions up to ₹1.5 lakh per year. It has a mandatory lock-in period of three years, promoting long-term investment. Gains from ELSS are taxed as Long-Term Capital Gains (LTCG) at 10% for amounts over ₹1 lakh. These funds aim for capital appreciation and typically offer higher returns compared to traditional tax-saving options. They are suitable for risk-tolerant investors due to their equity exposure. Investors can invest through lump-sum payments or Systematic Investment Plans (SIPs). Overall, ELSS funds provide a tax-efficient way to grow wealth over time.
Taxability Of Mutual funds
By familiarizing yourself with the taxation rules of mutual funds, you can strategically plan your investments to take advantage of any available tax deductions.
The taxation rules for mutual funds can be understood more clearly by breaking them down into key variables that determine your tax liability. Here are the four main factors influencing taxation on mutual funds:
1. Types of Funds
Mutual funds are categorized into different types for tax purposes. The main categories include:
Equity-Oriented Mutual Funds: These funds invest primarily in equities and are subject to different tax rules compared to debt funds. Long-term capital gains (LTCG) from these funds are taxed at 10% for gains exceeding ₹1 lakh.
Debt-Oriented Mutual Funds: These funds invest in fixed income securities and are taxed differently. Long-term capital gains are taxed at 20% with indexation benefits, while short-term capital gains are taxed at the investor’s income tax slab.
Hybrid Funds: These funds invest in a mix of equity and debt, and their tax treatment depends on the allocation—more than 65% in equities will treat them as equity funds for tax purposes.
2. Capital Gains
Capital gains refer to the profits made when you sell a mutual fund investment for more than its purchase price. Capital gains can be classified into:
Short-Term Capital Gains (STCG): Profits from mutual fund units sold within a specific period (1 year for equity funds and 3 years for debt funds). STCG is taxed at 15% for equity funds and as per the individual’s income tax slab for debt funds.
Long-Term Capital Gains (LTCG): Profits from units held for longer than the specified period. LTCG from equity funds is taxed at 10% for gains exceeding ₹1 lakh, while gains from debt funds are taxed at 20% with indexation.
3. Dividends
Dividends are a portion of the mutual fund’s profits distributed to investors, and they can be a significant source of income without needing to sell the investment. However, dividends are now taxed in the hands of the investor as per their income tax slab since the Dividend Distribution Tax (DDT) was abolished in April 2020. Understanding how dividends are taxed can influence your decision on whether to reinvest or take the payout.
4. Holding Period
The holding period refers to the length of time you keep your mutual fund investments before selling them. This period significantly impacts your tax liability:
Longer Holding Periods: The longer you hold an investment, the lower your tax burden, as gains may qualify for lower long-term capital gains tax rates. The Indian income tax laws encourage longer holding periods by offering favorable tax treatment for investments held over the long term.
Shorter Holding Periods: Selling investments before the defined holding period results in higher taxes due to STCG rates.
Conclusion
In summary, mutual funds are a popular investment option that pools money from multiple investors for diversified portfolios managed by professionals. They offer benefits like portfolio diversification and liquidity. Understanding taxation, including capital gains and holding periods, is crucial for optimizing returns. With various types of funds available, investors can choose according to their risk tolerance and financial goals. Overall, mutual funds provide a flexible way to grow wealth while potentially benefiting from tax deductions.
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