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What Are Mutual Funds - Basics, Types, Benefits, & More!

We’re going to tell you the truth about mutual funds in simple words. Come check it out!
May 3, 2022

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Picking stocks is an uphill task even for the most skilled retail investors. There are too many companies, too many stocks, and too much noise in the market. That’s why barely 1% of India invests in direct stocks. 

But there’s a solution to the noise - mutual funds. You may have heard of it through friends, family, or numerous TV ads. Significantly more Indians invest in mutual funds than stocks.   

We’re going to help you understand why starting with what is a mutual fund, the various types of mutual funds you can invest in, and the pros & cons of India’s increasingly popular asset class. 

What Are Mutual Funds?

A mutual fund is an asset that uses a pool of money from investors to buy stocks, bonds, and other securities. Every mutual fund is managed by a fund manager and a team of analysts. 

Fund managers are experts who have years if not decades of experience in finance. They take the pain of research away from investors who don’t have the time or resources to pore over charts.  

The mutual fund industry hit a milestone in March 2022. 12.95 crore portfolios were actively investing in mutual funds in India. You may have guessed why. 

Mutual funds uncomplicate the confusing world of stocks and bonds. Moreover, when you buy a mutual fund, you get to own many stocks and bonds in one asset. 

This not only saves time but also helps you diversify your portfolio. The world of mutual funds is interesting because there are types across and within categories. We’ve broken them down for your convenience. 

Types Of Mutual Funds (Categories)

Mutual funds are classified into three categories:

  • Equity funds
  • Debt funds
  • Hybrid funds

These categories can tell you what a mutual fund invests in. The categories are also an indicator of the risk that each mutual fund carries and factors like expense ratio, entry load, exit load, and others.

Let’s explore each of these mutual fund categories.   

Equity Mutual Funds

Equity funds invest a large part of their pooled money in stocks. In fact, at least 65% of a mutual fund’s portfolio must include equities and equity-related instruments to be classified as equity funds. 

There are categories within equity funds that we’ll touch upon later. For now, all you need to know is that equity funds are suitable for the long term because of their above-average risk profile. 

It’s no secret that stocks are prone to volatility. By association, the volatility is transferred to equity funds albeit in a much less intense manner. But equity fund returns are known to be lucrative. 

The best equity funds on Cube have generated up to 18% returns over a 5-year period. The returns are subject to tax. Short Term Capital Gains (STCG) are taxed at 15% if the equity fund is sold after less than a year. 

Long Term Capital Gains (LTCG) are taxed at 10% if the equity fund is sold after more than 3 years and if the gains exceed ₹1 lakh (in the financial year).  

Debt Mutual Funds

If you invest in a debt fund, you can be certain of two things. One, most of the pooled money will be used to buy debt securities like bonds, commercial paper, treasury bills, and others. 

Two, the returns will be predictable in the range of 6-8%. That’s because debt funds invest in securities that have fixed returns. Take for example bonds. Most debt funds invest in them. 

A bond is a loan that a company takes out through investors instead of a bank. In return, they payout a fixed interest in intervals and return the principal amount at the end of the loan’s tenure.  

The debt fund will pay out the fixed interest it receives as returns to investors. Thus, debt funds are relatively less risky than equity funds but they won’t make you filthy rich.   

Just like equity funds, however, debt funds are also divided into several categories. The most popular ones include:

  • Corporate bond funds: Invest in bonds issued by corporations like Reliance.
  • Dynamic bond funds: Invest in bonds with dynamic interest rates.
  • Liquid funds: Invest in debt securities that mature in 91 days or less. 
  • Money market funds: Invest in low-risk, short-term loan instruments.
  • Overnight funds: Invest in debt securities that mature overnight (24 hours).

All debt funds are taxed the same way. Gains on debt funds sold in less than 3 years are liable for STCG according to your tax bracket. LTCG on debt funds sold after 3 years are taxed at 20% with indexation benefit.   

Hybrid Funds

Equity funds invest in stocks. Debt funds invest in bonds. Hybrid funds invest in both. That’s why they’re often referred to as balanced funds. But this is a broad categorization. Here’s a breakdown of hybrid funds.

Hybrid Fund Type

Equity Allocation

Debt Allocation

Aggressive Hybrid Fund

65% to 80%

20% to 35%

Arbitrage Funds

Minimum 65%

35% or less

Conservative Hybrid Fund

10% to 25%

75% to 90%

Dynamic Asset Allocation Fund

Subject to market conditions

Subject to market conditions

There are other hybrid funds as well that invest in three asset classes. Multi-Asset Allocation Funds hold equity, debt, and gold while Equity Savings Funds incorporate equity, debt, and arbitrage opportunities.

Hybrid funds look to bring the best of equity and debt to mitigate risk. Because of this, they can generate potentially better returns than debt funds while being less risky than equity funds. 

Returns on hybrid funds are taxed based on the equity allocation. If the fund invests primarily in equity and equity-related securities, it’ll be subject to the same tax rules as equity funds. 

  • STCG: hybrid equity funds held for less than a year taxed at 15% 
  • LTCG: hybrid equity funds held for more than a year taxed at 10%

Otherwise, hybrid funds are treated as non-equity funds during taxation. 

  • STCG: hybrid non-equity funds held for less than three years taxed as per the investor’s I-T slab 
  • LTCG: hybrid equity funds held for more than three years taxed at 20% with indexation benefit

This breakdown should simplify the tax rules on hybrid funds:

Tax Type

Hybrid Fund Type

Tax Rate

STCG

Equity

20% to 35%

Non-equity

35% or less

LTCG

Equity

10%

 

Non-equity

20% with indexation

ELSS Funds/Tax Saving Mutual Funds

Although Equity Linked Savings Scheme (ELSS) funds are equity funds, their purpose is different and so are their inner workings. Equity funds can’t help you save tax while ELSS funds can. 

Under Section 80c, ELSS funds allow investors to save up to ₹46,800 in tax on investments of ₹1,50,000 during a financial year. This benefit comes at a cost. 

ELSS funds carry a mandatory lock-in of 3 years, unlike other equity funds. In fact, you won’t have the option of premature withdrawal in ELSS funds. 

This is where the differences end and similarities begin with equity funds. Because of their stock-heavy nature, ELSS funds are known to generate lucrative returns in the range of 12-16%. 

The mandatory lock-in period means that ELSS funds are suitable for long term goals along with the fact that stocks can be volatile in the short term. 

Different Caps Of Mutual Funds

If you see “cap” in any mutual fund’s name, it means two things. Firstly, it’s an equity fund, of that you can be sure. Secondly, it denotes the market cap that the equity fund is skewed towards.

Market capitalization denotes the total value of all the shares of a company on the stock market. Bigger the market cap, the bigger the company. This leads to three tiers:

  1. Large-cap
  2. Mid-cap
  3. Small-cap

Equity funds are also broken down into the tiers mentioned above by association with the stocks they invest in. Let’s explore this in further detail and understand how this classification works. 

Small-Cap Funds 

A company with a market cap that’s less than ₹5,000 crores falls under the category of “small-cap”. Equity funds that invest in such companies are known as small-cap mutual funds. 

Small-cap stocks are generally volatile, well above the levels of mid-cap and large-cap stocks. It’s no surprise that’s the case. Small-cap companies are in their developmental stage in the world of business. 

There’s another side to this, that of growth. Small-cap stocks have the potential to enter mid-cap and large-cap zones in the long run. Thus, the returns can be lucrative. The trade-off is higher risk. 

Mid-Cap Funds

Mid-cap companies have a market cap of more than ₹5,000 crores but less than ₹20,000 crores. These companies are no longer emerging but rather established businesses vying to explode into the large-cap zone.

Equity funds that invest in such companies are known as mid-cap funds. Stocks of mid-cap companies are generally less volatile than their small-cap counterparts but don’t generate similar returns. 

On the flipside, mid-cap stocks are relatively more volatile than large-cap stocks but can generate better returns. These two qualities are transferred to mid-cap mutual funds by association.   

Large-Cap Funds

Large-cap companies have a market cap of more than ₹20,000 crores. These companies are the Tatas and HDFCs of the world - iconic businesses that have been around for many decades.  

Equity funds that invest in these large companies are known as large-cap mutual funds. Stocks of large-cap companies are not as volatile as mid-cap or small-cap companies.

At the same time, large-cap stocks generate predictable returns. Large-cap funds possess similar qualities and can be a suitable investment for conservative investors new to mutual funds.   

Flexi-Cap Funds

Once known as multi-cap funds, flexi-cap funds have the freedom to invest in stocks across market caps. Think of it like going to a dessert shop and ordering one of everything. 

This leads to diversification across and within categories but the returns vary. A fund manager of a flexi-cap fund can choose to be 100% invested in a single cap of stocks if they choose to.  

Types Of Mutual Funds (Nature)

We’ve discussed how mutual funds are divided within and across categories based on what they invest in. Now we move on to a classification of mutual funds based on their investment structure.

Open-Ended Mutual Funds

A majority of mutual funds in India are open to investments and redemptions throughout the year. These are known as open-ended mutual funds. The hallmark of open-ended funds is high liquidity. 

They don’t carry a lock-in and can be redeemed at any time. Nor do open-ended funds have any limit on the AUM they can accumulate. Furthermore, open-ended funds must reveal their NAV daily. 

Closed-Ended Mutual Funds

If all this while you’ve been thinking that you can invest in mutual funds at any time, you might not be the only one. But, there are mutual funds that absorb investments only during a New Fund Offer (NFO).  

These are known as closed-ended mutual funds. They carry a mandatory lock-in and offer no liquidity during that time. Unlike open-ended funds, closed-ended funds are traded on stock exchanges. 

Benefits Of Mutual Funds

1. Convenience

Mutual funds ensure that investors don’t have to bear the burden of building a portfolio of individual stocks. A team of experts does that for them. Professional management also has other advantages. 

Most retail investors are known to struggle with asset allocation and aren’t always aware of the economics of the market. Fund managers and their teams solve both problems. 

2. Diversification

A single mutual fund includes multiple stocks, bonds, or both. This means that an investor can get a lot for the price of one to mitigate risk and maximize returns at the same time.

Furthermore, diversification within mutual funds ensures that even if there’s a dip in a sector or two, other assets can pull their weight to deliver returns.  

3. Solid Returns

The mutual fund industry in India is rapidly growing because of the returns that various schemes have generated. Most mutual funds have outperformed India’s favourite assets like fixed deposits.  

At the same time, mutual funds have proven that they’re a sustainable way to create wealth for goals across multiple terms. Want to save up for emergencies? Liquid funds. Have short term goals? Debt funds.

Have medium to long term goals? Equity funds. But should you only stick to mutual funds for all terms? Read this blog to know more: How to Build the Perfect Investment Portfolio 

Drawbacks Of Mutual Funds

1. Cost

Professional management does solve a lot of problems. But as they say, quality comes at a cost known as an “expense ratio”. Active funds have a higher expense ratio while passive funds charge the bare minimum.

That said, the expense ratio will eat into your investment in both scenarios. So, it is best to evaluate the expense ratio and other costs like entry and exit load before you invest in mutual funds. 

2. Over-Diversification

Buying too many mutual funds is a problem. But not for the reasons you think. A lot of mutual funds hold similar stocks and bonds in their portfolios. Investors may miss this factor due to oversight. 

The net result of this could be a scenario where you’ve diversified your portfolio across multiple mutual funds but all of them have more or less similar holdings. 

The question then becomes - how many mutual funds do I actually need to hit my goals? Consulting a trained financial professional can help solve this problem. 

3. Risk 

At the end of the day, mutual funds are market-linked assets. They are hampered by the volatility of the stock market and bond market. This means every mutual fund carries a degree of risk.

You can counter this risk by investing wisely based on your risk tolerance and financial goals. But this is easier said than done. Only professionals can help you achieve this optimally. 

Note: Facts & figures are true as of 02-05-2022. None of the information shared here is to be construed as investment advice. Exercise caution when investing in assets like stocks, mutual funds, alternative investments, and others.

Shriram Shekhar
Shriram is a Content Marketer at Cube Wealth, the Financial Freedom App with a smart Perfect Portfolio Planner. He has developed cutting edge IT products for over 2 years before turning to his passion for the written word. Shriram’s love for philosophy, product development, and empowering people through quality content is what got him to Cube Wealth.

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