Mutual Funds Explained | Types of Mutual Funds

If an individual has Rs.5000 as savings, he may invest in few stocks and create a portfolio of his own, but his returns would be limited to changes in the market value of the share and dividends from the stocks. He would be exposed to the risk of those stocks not performing well. Whereas in case of mutual funds, with little investment, you get a share of larger portfolio and the risk is diversified to lot many stocks in the portfolio. So by investing in mutual funds you are not only putting your eggs in different baskets. (Mutual Funds Explained)

A Mutual Fund offers an opportunity to invest in a diversified, professionally managed basket of securities at a relatively low cost. The small investors who generally lack expertise to invest on their own in the securities market prefer some kind of collective investment vehicle like mutual fund, which pool their managerial resources, invest in securities, and distribute the returns there from among them on cooperative principles.

Watch this article as video

What is Mutual Fund? Mutual Funds Explained

A Mutual Fund is a trust that pools the savings of a number of investors, who share a common financial goal. Mutual funds make investments in the stock and debt markets on behalf of investors joining the scheme and thus offers two special services namely expertise in investments and diversification. The income earned through these investments and the capital appreciation realized is shared by its unit holders in proportion to the number of units owned by them.

As per section 2(q) of Securities and Exchange Board of India (SEBI) (Mutual Funds) Regulations, 1996, “Mutual Fund” means a fund established in the form of a trust to raise monies through the sale of units to the public or a section of the public under one or more schemes for investing in securities, including money market instruments or gold or gold related instruments or real estate assets

Advantages of Mutual Funds

• Professional Management: The funds are managed by the skilled and professionally experienced managers with back up of a research team.
• Diversification: MF offers diversification to reduce risk.
• Convenient Administration: Services are offered in de-mat form and hence time and delays are taken care of.
• Return Potential
• Low Cost: The costs cannot exceed the prescribed limits of SEBI
• Liquidity: In case of open ended schemes, liquidity is provided by direct sale/repurchase by MF and in case of closed ended schemes it is provided by listing the same on a stock exchange
• Transparency: NAVs are calculated on daily basis. Performance reports are provided half yearly and hence they are transparent
• Flexibility: There are a lot of features in a regular mutual fund scheme, which imparts flexibility to the scheme. An investor can opt for a Systematic Investment Plan (SIP), Systematic Withdrawal Plan (SWP), Systematic Transfer Plan (STP)etc. to plan his cash flow requirements as per his convenience.
• Choice of schemes
• Tax benefits
• Well-regulated: All the schemes come under the strict purview of SEBI Regulations thus protecting investor interests
• Capital appreciation
• Low Minimum Investment. You can get started with investing in most Mutual Funds with as little as Rs 100

History of Mutual Funds in India

• The Indian mutual fund industry began with the formation of Unit Trust of India (UTI) in 1963 with the introduction of its first biggest scheme Unit Scheme ’64. UTI set up by the Reserve Bank of India and functioned under the Regulatory and administrative control of the Reserve Bank of India. UTI was de-linked from the RBI and the Industrial Development Bank of India (IDBI) took over the regulatory and administrative control in place of RBI. At the end of 1988UTI had Rs. 6,700 crores of assets under management.
• In early 1990s, Government allowed public sector banks and institutions to set up mutual funds. SBI Mutual Fund was the first non-UTI Mutual Fund established in June 1987followed by Can bank Mutual Fund (Dec 87), Punjab National Bank Mutual Fund (Aug 89),Indian Bank Mutual Fund (Nov 89), Bank of India (Jun 90), Bank of Baroda Mutual Fund(Oct 92). LIC established its mutual fund in June 1989 while GIC had set up its mutual fund in December 1990. At the end of 1993, the mutual fund industry had assets undermanagement of Rs. 47,004 crores.
• In the year 1992, Securities and exchange Board of India (SEBI) Act was passed. The objectives of SEBI are to protect the interest of investors in securities and to promote the development of and to regulate the securities market. SEBI notified regulations for the mutual funds in 1993. The private sector funds entered in Indian Mutual Fund Industry in 1993. The erstwhile Kothari Pioneer (now merged with Franklin Templeton) was the first private sector mutual fund registered in July 1993. In 1993, the first Mutual Fund Regulations came into being with which were later substituted by SEBI (Mutual Funds) Regulations, 1996. As at the end of January 2003, there were 33 mutual funds with total assets of Rs. 1,21,805 crores.
• In February 2003, Unit Trust of India Act 1963 was repealed and bifurcated UTI into two separate entities. One is the Specified Undertaking of the Unit Trust of India functioning under an administrator and under the rules framed by Government of India and does not come under the purview of the Mutual Fund Regulations., it broadly managed the assets of US 64 scheme. The second is the UTI Mutual Fund, sponsored by SBI, PNB, BOB and LIC. It is registered with SEBI and functions under the Mutual Fund Regulations.
• SEBI introduced several progressive measures in September 2012 to “re-energize” the Indian Mutual Fund industry and increase MFs’ penetration. The Industry’s AUM had crossed the milestone of ₹10 Trillion (₹10 Lakh Crore) for the first time in May 2014. Average Assets Under Management (AAUM) of Indian Mutual Fund Industry as on April 2024 stood at ₹ 57,01,359 crore.

Structure of Mutual Fund

A mutual fund is set up in the form of a trust, which has sponsor, trustees, asset management company (AMC) and custodian.

• Trust: The trust is established by a sponsor or more than one sponsor who is like a promoter of a company and registered with Securities and Exchange Board of India (SEBI).
• Sponsor: A sponsor is any person who, acting alone or in combination with another body corporate, establishes a mutual fund. The trust is established by a sponsor or more than one sponsor who is like promoter of a company. The sponsor forms the Trust and appoints the board of trustees, appoints the AMC as the fund managers and may also appoint custodian to hold the fund assets. The sponsor contributes at least 40% of the net worth of the asset management company
• Trustees: The trustees of the mutual fund hold its property for the benefit of the unitholders. Trustees hold unit holder money in authentic manner. The trustees are vested with the general power of superintendence and direction over AMC. They monitor the performance and compliance of SEBI Regulations by the mutual fund. SEBI Regulations require that at least two thirds of the directors of trustee company or board of trustees must be independent i.e. they should not be associated with the sponsors. The trustees ensure that Asset Management Company is managed independently and interest is not compromised
• Asset Management Company (AMC): Asset Management Company (AMC) approved by SEBI manages the funds by making investments in various types of securities. 50% of the directors of AMC must be independent. The AMC hires a professional money manager, who buys and sells securities in line with the fund’s stated objective. The investment experts who invest the pooled money on behalf of investors of the scheme are known as ‘Fund Managers’. Under SEBI Regulations, every mutual fund is required to have an Asset Management Company (AMC) incorporated in accordance with the Companies Act, 2013 to manage the funds of the mutual fund.
• Custodian: The Custodian is registered with SEBI, holds the securities of various schemes of the fund in its custody
• Depository: A depository is an organisation where the securities of an investor are held in the electronic form at his request through the medium of a Depository Participant (DP).
• Distributors: The mutual fund distributor’s job is to assess the needs, limitations, resources and financial goals of the investor. This analysis would help the mutual fund distributor arrive at a suitable asset allocation plan for the investor.The distributor then goes on to identify mutual fund schemes, which are appropriate for the investor in the given situation

What is an Asset Management Company (AMC)?

• Investment manager of the mutual fund
• Appointed by the trustees, with SEBI approval
• Trustees and AMC enter into an investment management agreement
• Required to invest seed capital of 1% of amount raised subject to a maximum of Rs.50 lakh in all open-ended schemes.
• Should have a net worth of at least Rs.50 crore at all times.
• At least 50% of members of the board of an AMC have to be independent
• AMC of one mutual fund cannot be an AMC or trustee of another fund
• AMCs cannot engage in any business other than that of financial advisory and investment management

How does a Mutual Fund Work?

Mutual funds pool the funds from small investors and invest in shares and bonds of companies. The income earned through these investments and the capital appreciation realized are shared by its unit holders in proportion to the number of units owned by them.

Types of Mutual Funds

Based on maturity period, mutual funds could be classified as:

• Open – Ended Funds: An open-end fund is one that is available for subscription and repurchase all through the year. These do not have a fixed maturity. Investors can conveniently buy and sell units at Net Asset Value (“NAV”) related prices which are declared on a daily basis. The key feature of open-end schemes is liquidity.
• Close – Ended Funds: These schemes have a pre-specified maturity period. One can invest directly in the scheme at the time of the initial issue. Depending on the structure of the scheme there are two exit options available to an investor after the initial offer period closes. Investors can transact (buy or sell) the units of the scheme on the stock exchanges where they are listed. Alternatively, some close-ended schemes provide an additional option of selling the units directly to the Mutual Fund through periodic repurchase at the schemes NAV. SEBI Regulations ensure that at least one of the two exit routes is provided to the investor
• Interval Funds: These funds are a hybrid of open and close ended funds. While they operate mainly as close ended funds, these funds may trade on stock exchanges and are open for sale or redemption at predetermined intervals at the prevailing NAV

Based on the investment objective, a mutual fund can also be classified as:

• Growth Funds: Growth Schemes are also known as equity schemes. The aim of growth funds is to provide capital appreciation over the medium to long- term. Such schemes normally invest a major part of their corpus in equities. Such funds have comparatively high risks. These schemes provide different options to the investors like dividend option, capital appreciation, etc. and the investors may choose an option depending on their preferences. Growth schemes are good for investors having a long-term outlook seeking appreciation over a period of time. The Equity Funds are sub-classified depending upon their investment objective, as follows:
  • Large Cap Fund: Investing in large cap stocks.
  • Mid-Cap Funds: Investing in mid cap stocks.
  • Multi Cap Fund: Investing in Large Cap, Mid Cap and Small cap stocks.
  • Diversified Equity Fund
  • Sector Specific Funds: The fund’s portfolio consists of investment in only one industry or sector of the market such as pharmaceuticals, telecommunication, Financial Services and Banking, Information Technology etc.
  • Tax Savings Funds (ELSS)
• Income Funds: Income Schemes are also known as debt schemes. The aim of these schemes is to provide regular and steady income to investors. These schemes generally invest in fixed income securities such as bonds and corporate debentures. Capital appreciation in such schemes may be limited.
• Balanced Schemes: Balanced Schemes aim to provide both growth and income by periodically distributing a part of the income and capital gains they earn. These schemes invest in both shares and fixed income securities, in the proportion indicated in their offer documents (normally 50:50).
• Money Market Schemes: These funds are also income funds and their aim is to provide easy liquidity, preservation of capital and moderate income. These schemes invest exclusively in safer short-term instruments such as treasury bills, certificates of deposit, commercial paper and inter-bank call money, government securities, etc.
• Gilt Funds: Gilt mutual funds invest exclusively in government securities. The Gilt funds do not carry a credit risk – where the issuer of the security can default. However, it comes with an interest rate risk i.e. risk due to the rise or fall in interest rates
• Other Special Schemes:
  • Tax saving funds: The Income Tax Act offers tax deduction under specific provisions of the Income Tax Act, 1961. Designed to generate capital growth, ELSS mutual funds invest primarily in equities and largely suit investors with a higher risk appetite for capital appreciation. Spread over medium to long-term, tax saving funds comes with a lock-in period of 3 years
  • Index Funds: Index funds are attached to a particular index such as the BSE SENSEX or the S&P CNX NIFTY. Their performance is linked to the results of that index. Here, the portfolio comprises stocks that represent an index and the weightage assigned to each stock is in line with the identified index. Hence, the returns will be more or less similar to those generated by the Index.
  • Sector-specific Funds: Sector-specific funds invest in the securities of a specific sector or industry such as FMCG, Pharmaceuticals, IT, etc. The returns on these funds are directed by the performance of the respective sector/industries. Sector funds allow an investor to diversify funds across multiple companies within an industry. These funds tend to be riskier as the performance is directly linked to that of the overall sector

Based on the investment objective, a mutual fund can also be classified as:

• Passive Funds:
  • Replicate a market index.
  • Invest in same securities and in same proportion as that of index.
  • No active selection of any stock / sector.
  • Expenses are lower.
  • Portfolio is modified every time index composition changes
• Active Funds
  • Invests in securities and sectors that may offer a better return than the index.
  • Actively manage the allocation to market securities and cash.
  • May perform better or worse than the market index.
  • Incur a higher cost than passive funds

How to invest in Mutual Funds?

There are four ways to invest in Mutual Funds in India:

1. Physical Mutual Fund Application Form
2. Online Mode: Through the website of mutual fund
3. Mobile App of Mutual Fund
4. AMFI Registered Mutual Fund Distributor

Investment modes in Mutual Funds

There are two modes to invest in Mutual Funds:

1. Lump-Sum Investment:
   • One time investment.
   • Usually, large sum of money is invested in one go.
   • Investor faces risk of volatility in markets
2. Systematic Investment Plan (SIP):
   • Staggered Investment.
   • Period of commitment – 6 months, 1 / 3 / 5 years.
   • Specific intervals – monthly, quarterly, half-yearly.
   • Made on specific dates e.g. 1st, 5th, 10th, 15th of every month

Regular vs Direct Plan

• Direct Plan: Under direct plan investors can invest directly with a fund house where in no agent or distributor is involved and thus, they can save on costs. The direct plan has a separate NAV, which is generally higher than normal or regular plan as direct plan charges lower expenses because it does not entail paying any commission to agent/distributor and thus gets reflected in the form of higher NAV.
• Regular or Normal Plan: Under regular or normal plan investors can invest through an agent or distributor in order to avail their investment advice/services. The regular plan too has a separate NAV, which is generally lower than direct plan as former charges higher expenses in order to pay commission to an intermediary involved.

Growth vs Dividend Options

• Growth Option: Under growth option, dividends are not paid out to the unit holders. Income attributable to the unit holders continues to remain invested in the scheme and is reflected in the NAV of units under this option. Investors can realize capital appreciation if any, by way of an increase in NAV of their units by redeeming them.
• Dividend Payout Option: Dividends are paid out to the unit holders under this option. However, the NAV of the units falls to the extent of the dividend paid out and applicable statutory levies.
• Dividend Re-investment Option: The dividend that accrues on units under option is re-invested back into the scheme at ex-dividend NAV. Hence investors receive additional units on their investments in lieu of dividends.

Mutual Fund Offer Document

There are important documents issued by each Mutual Fund:

1. Scheme information document (SID): The SID chalks out important information about the mutual fund like:
   • Scheme type (open or closed end).
   • Investment objective.
   • Asset allocation.
   • Investment strategies.
   • Terms with regard to liquidity.
   • Fees and expenses.
   • Other information relating to the scheme
2. Statement of additional information (SAI): It is a supplementary document added to a mutual fund’s prospectus that contains additional information about the fund and includes further disclosure regarding its operations.
   • Contains generic and statutory information of mutual fund.
   • Contains financial information of mutual fund.
   • Lays down rights of investor.
   • Other additional information.

Regulator of Mutual Funds in India

In India, the Mutual Funds are regulated by SEBI (Mutual Funds) Regulations, 1996. A Mutual Fund should be registered with SEBI. SEBI formulates policies and regulates the mutual funds to protect the interest of the investors

What is Net Asset Value (NAV)

The net asset value of a mutual fund scheme is basically the per unit market value of all the assets of the scheme. Net Asset Value is the market value of the securities held by the scheme. Since market value of securities changes every day, NAV of a scheme also  varies on day to day basis.

For example, if the market value of securities of a mutual fund scheme is Rs. 200 lakhs and the mutual fund has issued 10 lakhs units of Rs. 10 each to the investors, then the NAV per unit of the fund is Rs.20.

What is Expense Ratio?

The expense ratio is the percentage that denotes the amount of money you are paying to the Asset Management Company as a fee to manage your investments. In other words, it is the per-unit cost for running and managing the mutual fund. The expense ratio differs from one mutual fund to another. A mutual fund scheme with a lower expense ratio is more beneficial to you because it takes away a lesser portion of money from your returns.

What is Exit Load?

It includes the load imposed when the units are sold back to the mutual fund. Its aim is to deter investors from withdrawing. It varies from 0 to 3 percent.

The Association of Mutual Funds in India (AMFI)

AMFI was incorporated on August 22, 1995, as a non-profit organization. The Association of Mutual Funds in India (AMFI) is dedicated to developing the Indian Mutual Fund Industry on professional, healthy and ethical lines and to enhance and maintain standards in all areas with a view to protecting and promoting the interests of mutual funds and their unit holders.

The objectives of AMFI are:

• To define and maintain high professional and ethical standards in all areas of operation of mutual fund industry
• To recommend and promote best business practices and code of conduct to be followed by members and others engaged in the activities of mutual fund and asset management including agencies connected or involved in the field of capital markets and financial services.
• To interact with SEBI and to represent to SEBI on all matters concerning the mutual fund industry.
• To represent to the Government, Reserve Bank of India and other bodies on all matters relating to the mutual fund Industry
• To undertake nationwide investor awareness programme to promote proper understanding of the concept and working of mutual funds.
• To disseminate information on mutual fund industry and to undertake studies and research directly and/or in association with other bodies.
• To regulate conduct of distributors including disciplinary actions (cancellation of ARN) for violations of Code of Conduct.
• To protect the interest of investors/unit holders

Download as PDF

Watch this article as video

Check out Financial Markets Institutions and Services Course