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This is one of my favourite financial instrument as it is one of the best friend of small & retail investor giving them the power to achieve optimum diversification, access to professional fund management and research. If you look closely into the word “Mutual Fund”, the literal meaning would very well explains what it is for. It is fund which is mutually owned by investors for a common objective. This objective is mostly investing the funds in line with the objectives agreed mutually by the fund owner. To put it even simpler, thousands of investors come together to pool their small savings into a pot. This pot is called a Mutual Fund. There is a team which is made incharge to manage the funds in the pot and invest these funds in line with the predetermined objective.

 

Mutual Fund Infrastructure

Before we go into the details of a mutual fund, it may be a good idea to explain the key organisational components of a mutual fund and how things knit together within this organisation. Knowing these details helps in gaining more trust in the Mutual Fund entity and how it operates. In order to make it easier to understand, we shall take an example of HDFC Mutual Fund’s organisation structure :

  1. Sponsor is an entity which sets up the Mutual Fund’s organisational structure. If we take an example of HDFC Mutual Fund, HDFC Limited & Standard Life Investments Limited are its sponsors. Sponsors contribute a limited amount of capital to setup this Trust (usually Rs. 1 lac only).
  2. A Mutual Fund is established as a ‘Trust’ by the Sponsor. Continuing with our example, HDFC Mutual Fund has been created as a Trust.
  3. A Trustee is appointed to ensure that the Trust carries out its operations under the regulatory requirements and also has an oversight into the activities of the AMC. HDFC Trustee Company  Limited is the Trustee of HDFC Mutual Fund.
  4. Asset Management Company – is generally a public limited company which is appointed by the Trustee to manage the funds of the Mutual Funds. HDFC Asset Management Company is an AMC appointed by HDFC Trustee Company Limited to manage the funds of HDFC Mutual Fund. The AMC is generally owned by the Sponsor. It is the AMC which takes care of day to day fund management of a Mutual Fund.
  5. Custodian – All securities held by a mutual fund are kept with the Custodian. HDFC Bank Limited & Citibank NA are the custodians for HDFC Mutual Fund. Physical Gold for HDFC Gold ETF is held by The Bank of Nova Scotia.
  6. Registrar & Transfer Agent – Are responsible for the administrative aspects associated with the mutual funds such as processing applications, issuing statements etc. CAMS are the R&T agent for HDFC Mutual Fund.
  7. Auditors – One of the most important part of a mutual fund organisation structure are its Auditors who should be reputed enough to safeguard the interest of mutual fund holders. Deloitte Haskins & Sells (one of the largest auditing firm in the world) are HDFC Mutual Fund’s auditor. It is important to note that the auditors of a Mutual Fund must be different from the auditors of the AMC (as required by SEBI). Auditors of HDFC AMC are HariBhakti & Co. This ensures that auditors of the mutual funds and AMC are independent and are not influenced in any manner.

 

Types of Mutual Funds

Classification of mutual funds depends upon the asset type in which a mutual fund is investing into. A broad classification has been summarised into the following table :

A quick summary of each of these categories are :

  • Equity Funds– invest only into Equity shares of Companies. Depending upon the type of Equity Shares an equity fund is investing, they are classified into the following types :
    • By Market Capitalisation
      • Large Cap – Investing primarily into blue chip companies.
      • Mid Cap – Investing into companies of medium size;
      • Small Cap – Investing into small companies.
      • Diversified – Investing into companies of all types of Market capitalisation across different industry sectors.
    • Sector Funds – invest into Equity shares of companies belonging to a particular sector only such as Banking Companies or Power sector companies, etc.
    • Index Funds – these are primarily passively managed Funds. They invest into bunch of stocks which represent an index such as NIFTY, BANK NIFTY, etc.
  • Debt Funds – invest only in fixed income securities of different maturity tenures. Depending upon the maturity of the underlying debt securities, they are classified into Long Term, Medium Term, Short Term & Liquid Funds.
  • Hybrid Funds– the funds belonging to this category is a mix of any of the above categories. Most common hybrid categories are :
    • Balanced Funds – These funds invest not less than 65% into Equity shares and the remaining is invested into debt. It provides a ready made diversified asset mix for the investors and are also tax efficient (no tax on Long Term Capital Gains on these funds).
    • Monthly Income Schemes – These are debt heavy funds with any where from 70-100% of their corpus invested into debt securities and remaining invested into Equity. These funds provide investors stability along with growth opportunity.
  • Gold Funds – Invest into Gold ETFs. You may want to read more upon ETFs by visiting A peek into Exchange Traded Funds.
  • Fund of Funds – these funds are similar to Gold Funds, except that they invest in funds of any types and not just restricted to Gold. For example, a fund may invest into other funds of different geographies.

 

Active vs Passive Funds

Actively managed funds differ from the Passively managed funds based upon the day to day involvement of the fund manager in managing the investments of the fund. In case of actively managed fund, the fund manager may regularly churn the stocks held by the fund and try to beat the underlying comparitive index to justify the extra costs associated with managing the funds. On the other hand, passively managed funds are not managed on a day to day basis and hence their cost ratios are lower than actively managed funds. However, their returns are very close to the index which they are tracking.

 

Open Vs Close Ended Funds

Open ended fund continue to accept fresh investments from the investors after the NFO (New Fund Offer). The investors can also sell their investments held in an open ended fund to the mutual fund company and get their money back. Hence the value of assets managed by the mutual funds can keep on changing depending upon if the investors are buying more of its units or selling its units. On the other hand, a close ended mutual fund accepts fresh investments only during the NFO period which is generally between 15-30 days. After the NFO period ends, the investors can not purchase fresh units or sell their existing units of the Mutual Funds by approaching the AMC. Some close ended mutual funds are listed on stock markets providing the required liquidity to the unit holders. It is only at maturity that the unit holders get the value of their investment back from the AMC. Maturity period of close ended funds is generally 3 years.

Terms Associated with Mutual Funds

While investing into Mutual Funds, you would often come across some financial terms which are very specific to the mutual fund industry. The most frequently used terms are detailed below :

  • Units – is equivalent to the term ‘shares’ which is used in the context of Comapanies. A Mutual Fund ‘Unit’ represents a part ownership of the funds of the Mutual Fund investments. The value of a mutual fund ‘Unit’ is represented as a ‘NAV’. When an investor invests in a Mutual Fund’s scheme, he is alloted units reflecting the value of the his investments.
  • NAV – represents the value of one unit of a mutual fund. NAV is computed on a daily basis by dividing the total value of investments held by a mutual fund by total number of units of the mutual funds. Returns in a mutual fund scheme is reflected by increase in the NAV price over a period of time.
  • Loads – Loads are the terminology used in the mutual fund industry for charges levied either at the time of purchasing a mutual fund or at the time of selling.
  • Entry Load – is a charge levied at the time of purchase of a mutual fund. Since 2010, these charges have been abolished. Hence no charges are now deducted by a fund house at the time of purchase.
  • Exit Load – is a charge levied at the time of selling a mutual fund. Generally these charges are in the range of 0.5% to 3%. Equity funds generally levy 1% exit load on the total value of the investment being redeemed, if a person sells their units within 1 year of purchase.
  • NFO – stands for ‘New Fund Offer’. A new mutual fund is offered to the public via a New Fund Offer. It is similar to the term IPO used for shares.
  • Folio – reflects an account number with the mutual fund house. You can get your mutual fund details from a fund house by quoting your folio number. The same needs to be quoted while redeeming the fund.

 

How are Mutual Fund Units Held

There are two options available to hold the units of a mutual fund. The more popular method is holding them in Paper Form. When an investor invests into a mutual fund house, the fund house allots a folio number to the investor. An account statement issued by the mutual fund house reflects this folio number. You can use this folio number for any future purchases, sell orders or account statement requests. If an investor looses this paper certificate, it does not mean that his investments are lost. Another paper certificate / statement can be issued from the respective Mutual Fund house by quoting the folio number.

Another option is holding the units in Demat form.  Investors can quote their existing Demat account number while filling their mutual fund forms and their units shall be transferred to their demat account. If the respective mutual fund is listed on a stock exchange, the investor can sell the units by placing an order with their stock broker. Holding mutual funds in Demat form is not popular as it entails added costs such as demat charges, stock broker’s brokerage without providing any additional advantage.

 

How Mutual Funds Grow Money

This is the main point which all investor want to understand before investing into mutual fund. Investors provides cash to a mutual fund house and in return they are provide units in that fund. Now what ? What does the respective fund do with that money ?
 
The fund manager who is managing the funds of the respective mutual fund shall invest the accumulated cash from all unit holders in line with the objectives of the fund. For example, if the scheme’s objective was to invest into Gold, the fund manager shall invest the funds into Gold. If the objective was to achieve growth by investing into shares of Banking companies, the fund manager shall invest the funds in shares of Banking Companies. This selection is based upon the research and the outlook of the fund manager.
 
To understand how the unit holders will gain from investing in a mutual fund, lets take an example. For example, if 100,000 people invest into a fund house by contributing Rs. 10 each, giving the fund house Rs. 10,00,000. The number of units in this case is 100,000. The fund house   invests these into shares of two companies in line with the fund’s objectives. Let say the fund manager invested the funds as follows :
  1. Share A – 7,000 shares of 100 Rs each – Rs. 700,000
  2. Share B – 6,000 shares of 50 Rs. each –  Rs. 300,000

Total amount invested in above two shares : Rs. 10,00,000.

If after 1 year, the prices of the shares are as follows :

  1. Share A – 7,000 shares of 120 Rs each – Rs. 840,000
  2. Share B – 6,000 shares of 70 Rs. each –  Rs. 420,000

The total value of the fund’s investment would be R.s 12,60,000. Since the fund is divided into 100,000 units, the value per unit would be 12,60,000 / 100,000 = Rs. 12.6. This means that the people who had invested in these units can encash their units at Rs. 12.6, which they had purchased for Rs. 10. Hence there is a growth of Rs. 2.6 per unit or 26% return in one year.

 

Taxability of Mutual Funds

If you earn income, you would have to pay tax – Not really true when it comes to investing via mutual funds. Long Term Capital Gain on Equity Mutual funds is tax free. You may want to refer to our detailed article on Tax Implications of Mutual Funds on NRIs and Residents for further information on tax associated with each of the different categories of mutual funds.

 

Conclusion

Hope you would realise the hidden benefits associated with a mutual fund and how you can use this as an effective tool to grow your funds. It is not necessary for a person to be a star stock trader or research analyst to get an exposure of stocks. Mutual funds help people with inadequate resources and skills to invest and grow their funds. You may also want to read our article on How SIPs Work which is one of the best available tool to invest into Mutual Funds.


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7 Responses to What is a Mutual Fund ?

  1. Jatin Kacha says:

    Excellent..!

    Very comprehensive detail on MF.
    This kind of effort really help early stage people in investment sector.

    Thanks again for gr8 effort.

  2. Thanks Jatin. Glad to see that the motive of the article is coming out clearly.

    Regards
    BanyanFA

  3. […] used for investing towards investing into Mutual Funds. You may want to refer to our article What is a Mutual Fund to get more understanding on this financial instrument. SIP requires a person to invest on a […]

  4. […] A detailed article on Mutual Funds can be found at What is a Mutual Fund. A debt fund primarily invests into Bonds and Fixed deposits. The returns of a debt funds is hence […]

  5. […] to make the best out of them to further your investment goal. You may want to refer to our article What is a Mutual Fund which is a precurser to the decisions involved in selecting the right Payout […]

  6. DD says:

    nice…..Info

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