The Complete Guide to Mutual Funds

Intimidated by the complicated world of investing? Mutual funds provide newbies with an easy way to get started. If you want to understand mutual funds better to make informed decisions, this comprehensive guide is for you! Let’s get cracking.

What are Mutual Funds?

A mutual fund is a managed investment scheme that pools money from thousands of investors to invest in a variety of market instruments like shares, bonds, etc., based on the fund’s stated objective.

Each investor in the mutual funds holds units of the fund depending on how much they invested. The number of units changes with new inflows and redemptions from the fund. A professional fund manager handles all the investments in various assets on behalf of the investors.

Types of Mutual Fund Schemes

Based on portfolio structure and investment objective, mutual funds offer many types of schemes. Here are some key categories:

1. Equity Funds 

These funds invest a minimum 65% of their total assets in shares of various companies. They aim for high capital growth over the long term instead of regular returns. Popular sub-types are:

• Large Cap Funds: Invest predominantly in shares of large blue-chip companies with a steady track record. Lower risk than small caps.
• Mid/Small Cap Funds: Invest majorly in medium/emerging companies to tap their higher growth potential. Hence, they carry higher risk. 
• Sectoral/Thematic: Invest across companies engaged in specific sectors like IT, Pharma, Commodities, etc. thus concentrating risk to the sectors.

2. Hybrid Funds

Also called balanced funds, they invest in an optimal mix of both equities and fixed-income instruments. This balances pursuing the growth potential of shares while also having the stability of debt and G-sec instruments in the same fund. Based on their equity: debt allocation, main types are:

• Conservative Hybrid Funds: Invest 75-90% in fixed-income securities 10-25% in equities. For investors with lower risk appetite focused on stable capital protection than maximising returns.
• Aggressive Hybrid Funds: Invest 65-80% in equities 20-35% in debt. For investors willing to accept higher volatility in pursuit of greater capital appreciation.
• Dynamic Asset Allocation Funds: Vary the equity: debt allocation dynamically based on pre-defined triggers for market volatility or momentum to optimize returns post-tax. Useful for passive investors. 

3. Debt/Income Funds  

Invest a minimum 65% assets in fixed-income-producing securities like corporate bonds, government securities, money market instruments etc. Provide regular income payouts for investors with low proportion of capital growth over the medium-long term. Have various sub-categories based on the maturity duration of debt securities invested in. Lower risk than equity exposure in aggressive hybrid and equity funds.  

Analyzing Historical Performance  

When researching mutual funds to shortlist options to invest, analyze past returns over longer periods against appropriate benchmark index and peer funds in the category. Some key metrics include: 

1/3/5 year CAGR: Compound annual growth rate indicates what annual returns the fund generated on average over the evaluation timeframe.

Standard deviation: Fluctuation in the fund’s periodic returns over a period. Lower values indicate a more stable performance trajectory.  

Sharpe ratio: Fund’s returns adjusted for the degree of risk fund has undertaken.

Your fund selections would vary based on your specific age, financial responsibilities, income stability, risk tolerance and investment goals. For example, higher age, lower or unpredictable income and lower risk appetite warrant investing a larger share in funds consistently delivering moderate but less volatile returns.   

Managing Mutual Fund Costs

Two primary types of expenses charged to investors in a mutual fund scheme: 

• Expense Ratio: Annual percentage fee charged from fund assets towards managing the fund operations, admin, marketing etc. Generally ranges from 1-2.5%. A lower expense ratio means less eating your returns, so analyze this before investing. 

• Entry/Exit Loads: One-time percentage fee charged during investment in or redemption from the mutual fund. SEBI has banned mutual funds from levying entry load in recent years. Exit load applied if units are redeemed before a minimum period to discourage short-term trades. Check the prevailing exit load structure before investing in any scheme.  

Taxation of Mutual Fund Returns 

Capital gains from redeeming equity funds before 12 months attract short-term capital gains tax of 15%. For redemptions over 12 month or more tenure only 10% tax on long-term capital gains beyond Rs 1 lakh per financial year applicable. 

Debt fund returns for units held over 36 months are taxed at 20% post indexation benefit to offset inflation. For less than 36 months holding period, normal income tax slab rates apply to debt fund earnings.

Dividend payouts from mutual funds are exempted from tax in hands of recipient investors under current laws.

How to Invest in Mutual Funds 

You can invest lumpsum purchase or via SIP instalment route in mutual funds directly without intermediary or through a registered mutual fund distributor. Here is the typical purchase process flow: 

Lumpsum Investment Route 

1. Verify your KYC documentation is updated in the last 12 months

2. Research & select appropriate mutual fund schemes using ratings, metrics 

3. Choose between direct vs regular plan  

4. Create your mutual fund account (also called own folio) on fund house website   

5. Initiate purchase request form by selecting fund & payment mode and making payment

SIP Route  

1. Complete necessary KRA-KYC documentation  

2. Analyze various mutual fund schemes’ metrics to find an optimal match  

3. Opt for direct plan rather than a regular plan to save on costs

4. Open a designated mutual fund demat account & register bank account for auto-debits

5. Initiate SIP registration form providing bank details & auto debit mandate  

Conclusion

Mutual funds offer new investors an accessible route to participate across diverse market instruments in a managed basket format. Evaluate all available schemes based your specific life stage priorities to create an optimized investment portfolio. Invest regularly to leverage benefits of rupee cost averaging and compounding towards achieving long term financial goals. Redeem partially to fund specific needs or rebalance across funds.