What is a mutual fund ? and the basics of mutual funds

A vehicle for investing in stocks and bonds

A mutual fund is not an alternative investment option to stocks and bonds, rather it pools the money of several investors and invests this in stocks, bonds, money market instruments and other types of securities.

Buying a mutual fund is like buying a small slice of a big pizza. The owner of a mutual fund unit gets a proportional share of the fund’s gains, losses, income and expenses.

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.
Some popular objectives of a mutual fund are –

Managed by an Asset Management Company (AMC)

         The company that puts together a mutual fund is called an AMC. An AMC may have several mutual fund schemes with similar or varied investment objectives.
         The AMC hires a professional money manager, who buys and sells securities in line with the fund's stated objective.

All AMCs Regulated by SEBI, Funds governed by Board of Directors

         The Securities and Exchange Board of India (SEBI) mutual fund regulations require that the fund’s objectives are clearly spelt out in the prospectus.
         In addition, every mutual fund has a board of directors that is supposed to represent the shareholders' interests, rather than the AMC’s.

The Basics of Mutual Funds

Net Asset Value or NAV
NAV is the total asset value (net of expenses) per unit of the fund and is calculated by the AMC at the end of every business day.

How is NAV calculated?
The value of all the securities in the portfolio in calculated daily. From this, all expenses are deducted and the resultant value divided by the number of units in the fund is the fund’s NAV.

Expense Ratio
AMCs charge an annual fee, or expense ratio that covers administrative expenses, salaries, advertising expenses, brokerage fee, etc. A 1.5% expense ratio means the AMC charges Rs1.50 for every Rs100 in assets under management.
A fund's expense ratio is typically to the size of the funds under management and not to the returns earned. Normally, the costs of running a fund grow slower than the growth in the fund size - so, the more assets in the fund, the lower should be its expense ratio.

Load
Some AMCs have sales charges, or loads, on their funds (entry load and/or exit load) to compensate for distribution costs. Funds that can be purchased without a sales charge are called no-load funds.

Open- and Close-Ended Funds

1) Open-ended Funds
At any time during the scheme period, investors can enter and exit the fund scheme (by buying/ selling fund units) at its NAV (net of any load charge). Increasingly, AMCs are issuing mostly open-ended funds.

2) Close-Ended Funds
Redemption can take place only after the period of the scheme is over. However, close-ended funds are listed on the stock exchanges and investors can buy/ sell units in the secondary market (there is no load).

Important documents
Two key documents that highlight the fund's strategy and performance are 1) the prospectus (legal document) and the shareholder reports (normally quarterly).

Benefits of Investing Through Mutual Funds

Professional Money Management
Fund managers are responsible for implementing a consistent investment strategy that reflects the goals of the fund. Fund managers monitor market and economic trends and analyze securities in order to make informed investment decisions.

Diversification 
Diversification is one of the best ways to reduce risk. Mutual funds offer investors an opportunity to diversify across assets depending on their investment needs.

Liquidity
Investors can sell their mutual fund units on any business day and receive the current market value on their investments within a short time period (normally three- to five-days).

Affordability
The minimum initial investment for a mutual fund is fairly low for most funds (as low as Rs500 for some schemes).

Convenience
Most private sector funds provide you the convenience of periodic purchase plans, automatic withdrawal plans and the automatic reinvestment of interest and dividends.
Mutual funds also provide you with detailed reports and statements that make record-keeping simple.

Flexibility and Variety
You can pick from conservative, blue-chip stock funds, sectoral funds, funds that aim to provide income with modest growth or those that take big risks in the search for returns. You can even buy balanced funds, or those that combine stocks and bonds in the samefund.

Tax Benefits on Investment in Mutual Funds
1) 100% Income Tax exemption on all Mutual Fund dividends

2) Equity Funds - Short term capital gains is taxed at 15%. Long term capital gains is not applicable.
Debt Funds - Short term capital gains is taxed as per the slab rates applicable to you. Long term capital gains tax to be lower of -
10% on the capital gains without factoring indexation benefit and 
20% on the capital gains after factoring indexation benefit.

3) Open-end funds with equity exposure of more than 65% (Revised from 50% to 65% in Budget 2006) are exempt from the payment of dividend tax for a period of 3 years from 1999-2000.

Note: Equity Funds are those where the investible funds are invested in equity shares in domestic companies to the extent of more than 65% of the total proceeds of such funds.