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Some basic facts about mutual funds

May 14, 2009 12:07 IST

To invest in mutual funds, you need to first understand what they are, and how they work.

Even more basic is your grasp of stocks and bonds. Very quickly, stocks stand for shares of ownership in a public company, and bonds are money lent to the government or company, on which you receive interest. These are the two most common forms of investment, owned and loaned (real estate and precious metals being examples of others), but we are presently concerned with these instruments, since most mutual funds invest in stocks and/or bonds.

Simply, mutual funds act as intermediaries and facilitate investments in various securities (stocks and bonds). The logical question here would be: why do I need a mutual fund? Why can't I just invest directly?

The mutual fund advantage

Investing in a mutual fund allows you to minimise risk and maximise returns, because it acts as a middle man for a group of investors with a shared and predefined investment objective. If your main objective is security in investment but you don't know how to begin, a mutual fund is one way to go.

Typically, a fund manager will maintain the fund, and since you are one shareholder in the fund, you have the added advantage of easy investment, and lower trading costs.

Who are these fund managers?

Asset management companies (AMCs) approved by the Securities and Exchange Board of India (Sebi) manage the funds by making investments in various types of securities. This means that all recognised AMCs are monitored by higher authorities and stringent regulations, and funds are managed by professionals who have the necessary expertise.

How is your risk minimised?

Typically, investing in a mutual fund means investing in more than one stock. Some fund managers will diversify and spread your investment further by buying a mosaic of stocks and bonds. Investing in a large number of assets, or diversification, means that a loss incurred on one investment is minimised by gains in others.

How are trading costs reduced?

Since the AMC buys and sells large amounts of securities at a time, transaction costs are reduced, and the benefit is extended to the investor, because the average cost of the unit is lowered.

There are three ways in which you will see returns on your investment in a mutual fund:

  • Through dividends on stocks and interest on bonds;
  • Through capital gains, if the fund sells securities that have increased in price and the fund distributes these gains; and
  • By selling your shares when the holdings increase in price.

Mutual funds can either be open-ended or close-ended in nature. With open-ended funds, you can either enter or exit the fund any time during the scheme period, by buying/ selling fund units -- this means a high degree of liquidity. Close-ended funds, as the term implies, means that an exit is possible only when the scheme period is over.

Mutual fund schemes in India are varied and cater to a wide range of requirements and profiles, based on financial position, tolerance to risk, and expectations of returns. Each mutual fund has a specific stated objective.

The fund's objective is laid out in the fund's prospectus, which is the legal document that contains information about the fund, its history, its officers and its performance.

High on risk and high on return are Equity funds. Also known as Growth Schemes, the aim of these schemes is to provide capital appreciation over medium to long term. These schemes normally invest a major part of their fund in equities and are willing to bear short-term decline in value for possible future appreciation.

They may be further classified into Diversified Equity Funds, Mid-Cap Funds, Sector Specific Funds and Tax Savings Funds (ELSS).

Debt funds, or Income Schemes, invest in debt instruments, typically issued by the government, private companies, banks and other financial institutions, and promise low risk and a stable income.

These schemes generally invest in fixed income securities such as bonds and corporate debentures. Capital appreciation in such schemes may be limited. Further classification includes Gilt Funds, Income Funds, MIPs, Short Term Plans and Liquid Funds.

Balanced funds are a mix of both equity and debt funds. They invest in both equities and fixed income securities, providing both growth and stability.

Money Market Schemes promise high liquidity, preservation of capital and a moderate income. These schemes generally invest in safer, short-term instruments, such as treasury bills, certificates of deposit, commercial paper and inter-bank call money.

Tax-saving schemes offer tax rebates to the investors under tax laws. For example, under Sec.88 of the Income Tax Act, contributions made to any Equity Linked Savings Scheme (ELSS) are eligible for rebate.

Index schemes track and emulate the performance of a particular index such as the BSE Sensex. The stocks in these portfolios will mirror those in the Index, as will the percentage of each stock retained. Returns will therefore mirror the movement of the Index.

Finally, a further benefit from investing mutual funds is the 100 per cent income tax exemption on all mutual fund dividends. For Equity Funds, short-term capital gains are taxed at 15 per cent. Long-term capital gains are not applicable.

For Debt Funds, short-term capital gains are taxed as per the slab rates applicable to you. Open-ended funds with equity exposure of more than 65 per cent are exempt from the payment of dividend tax for a period of three years from 1999-2000.

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