What is a Mutual Fund ?

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 Funds organisation structure :

1. Sponsor is an entity which sets up the Mutual Funds 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 Funds 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 Funds 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.

STT is levied on every purchase or sale of securities that are listed on the Indian stock exchanges. This
would include shares, derivatives or equity-oriented mutual funds units.

CHIT FUNDS:

nsaction whether called chit, chit fund, chitty, kuree or by any other name by or under which a
person enters into an agreement with a specified number of persons that every one of them shall
subscribe a certain sum of money (or a certain quantity of grain instead) by way of periodical
installments over a definite period and that each such subscriber shall, in his turn, as determined by
lot or by auction or by tender or in such other manner as may be specified in the chit agreement, be
entitled to the prize amount".[1]

When you sell an asset and make a profit on it, it is known as capital gains. This is
applicable to any asset - property, stocks, bonds, mutual funds, art, gold, and so
on and so forth. In other words, when you sell your mutual fund units, you incur a
capital gains tax.

Capital gains is further split into long term and short term. And the tax implication
differs for equity and debt funds.

Equity funds

An equity oriented mutual fund is one where a minimum 65% of the investible
corpus is invested in domestic equity.

So gold exchange traded funds, or Gold ETFs, are not treated as equity funds for
taxation.

Even international funds are not considered as equity funds in the case of
taxation even though they invest in equity. The criteria to qualify for an equity
funds is not just investments in stocks but stocks listed in India.

In the case of hybrid or balanced funds, if at least 65% of the assets are invested
in domestic equity, they qualify as equity-oriented funds.
If you sell an equity mutual fund after holding it for a period of 12 months, then it
qualifies for long-term capital gains. As of now, long-term capital gains on equity
funds is nil. So you pay no tax.

If you sell your equity mutual fund before this period, then it qualifies for short-
term capital gains, which is 15%.

Another feature of an equity fund is that dividends are not taxed. The dividend is
tax free in the hands of the unit holder. Neither does the fund house have to pay
any dividend distribution tax.

Debt funds

The non-equity funds qualify as debt funds for the purpose of taxation. So this
would include all types of debt funds, international funds, monthly income plans,
or MIPs, and Gold ETFs.

Short-term capital gains would be levied if the holding period is less than 3 years.
Short-term capital gains are added to the income and taxed as per the individual's
income tax slab. From a tax perspective, it is obvious that debt funds no longer
offer tax advantages over fixed deposits if the holding period is less than three
years.

If you sell the asset after holding it for a period of 36 months, or 3 years, it
qualifies as long-term capital gains. This is 20% with indexation.

Indexation is the process that takes into account inflation from the time you
bought the asset to the time you sell it. The way it works is that it allows you to
inflate the purchase price of the asset (in this case the mutual fund units) to take
into account the impact of inflation. The end result is that you get the benefit of
lowering your tax liability.

Dividends received in the case of a debt fund unit holder are exempt from tax.
However, the fund house has to pay a dividend distribution tax, or DDT, before
distributing this income to its investors. The DDT is deducted by the asset
management company prior to the disbursal of dividends. So, no tax on dividends
is payable in the hands of the investor.