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A beginner’s guide to investing in mutual funds

Financial experts (and Google) list "mutual funds” as the best investment option. But you'd like to know more? Here’s a one-stop read to get all your questions about mutual funds answered!

Introduction

Financial experts (and Google) list "mutual funds” as one of the best investment options. But what are mutual funds? How do they work? How can one invest in them? What are the things to keep in mind as an investor? For beginners, investing in mutual funds can be very confusing. Here’s a beginners guide to mutual funds that answers all the questions about mutual funds.

Mutual funds 101

In this section, we have covered what mutual funds are, how to invest in them and what are things one has to know before investing in them. In other words, this section acts like a guide to mutual fund investing for beginners.

Definition of mutual fund

A mutual fund is an investment vehicle that pools money from multiple investors having a common objective and invests in shares, bonds and other assets.

How do mutual funds work?

Mutual funds are one of the easiest ways to enter and participate in the financial market. There are many tailor made mutual funds available in the market for specific investment goals and purposes. However, investors can create their own mutual fund portfolio based on the goal and its tenure. It is important to understand how a mutual fund works right from the time it is rolled on in the market.

An asset management company or the fund house forms a mutual fund with an objective in place. Investors with similar objectives invest their money into the fund. The fund manager of the fund house then invests the money collected in equities and/or fixed income securities after thoroughly doing market research. He charges a certain fee for the same. It's called an expense ratio. Once the funds are invested in the market, the portfolio manager discloses the mutual fund portfolio.

Mutual funds can be actively managed funds or passively managed funds. In actively managed funds, the portfolio manager uses multiple strategies for selecting the stocks in a portfolio. However, in passively managed funds (index funds), the fund's portfolio is a replica of the benchmark index.

While a unit of a stock is called share and its value is called price, in mutual funds, the value of the unit is called NAV or net asset value. NAV of a mutual fund is the value of its assets left after the liabilities are taken care of. It is obtained by dividing the total Assets Under Management (AUM) (after subtracting the liabilities) by the number of shares outstanding. Returns of a mutual fund are calculated based on the increase or decrease in the NAV.

Since SEBI regulates mutual funds, regular disclosures of NAV, expense ratio, assets under management (AUM) and returns is mandatory.

Types of Mutual Funds in India

Mutual funds in India are categorised based on their structure, asset class and investment objective. Therefore, beginners need to understand these types before investing in mutual funds.

Based on Structure

Mutual Funds are categorised as open-ended funds and closed-ended funds.

Open-ended funds can be bought or sold on a daily basis at their Net Asset Value (NAV). The NAV changes daily, and there is no restriction on the number of units the fund has. Open-ended funds are highly liquid as they can be redeemed anytime. Investing in these funds is highly convenient as one can enter and exit from it anytime.

Closed-ended funds have a fixed asset base and a fixed number of units. Units of these funds are traded on a stock exchange. Unlike open-ended funds, the NAV of the closed-ended funds doesn't change on a daily basis. Investors cannot buy the units of a closed-ended fund after the NFO closes. Closed-ended funds do not allow the investors to exit from the fund until maturity. However, to ensure liquidity, the fund is traded on a stock exchange. Therefore, investors can buy or sell units on the exchange. Also, closed-ended funds have a fixed maturity period.

Based on Asset Class

Mutual funds are broadly categorised as Equity Mutual Funds, Debt Mutual Funds and Hybrid Mutual Funds.

Equity Mutual Funds

Equity mutual funds are a type of mutual funds that invest at least 65% of their corpus in stocks. They have a significant amount of risk associated with them. Hence the returns are higher in comparison to other types of mutual funds.

Following are the types of equity mutual funds:

Large Cap Funds Minimum investment of 80% of the total assets in equity & equity related instruments of large cap companies.
Mid Cap Funds Minimum investment of 65% of the total assets in equity & equity related instruments of mid cap companies.
Large and Mid Cap Funds Invests in large and mid cap stocks. Minimum investment of 35% of the total assets in each category.
Small Cap Funds Minimum investment of 65% of the total assets in equity & equity related instruments of small cap companies.
Multi Cap Funds Invests across small, mid and large cap stock. Minimum investment of 65% of the total assets in equity & equity related instruments.
Value Funds Follows value investment strategy. Minimum investment of 65% of the total assets in equity & equity related instruments.
Thematic/Sector Funds Minimum investment of 80% of the total assets in equity & equity related instruments of a particular theme or sector.
Equity Linked Savings Scheme Minimum investment of 80% of the total assets in equity & equity related instruments. ELSS (tax saver funds) comes with a three-year lock in period. Qualifies for tax deduction under Section 80 C of the Income Tax Act.
Focused Funds Focuses on the number of stocks (maximum up to 30 stocks). Minimum investment of 65% of the total assets in equity & equity related instruments.
Dividend Yield Funds Invests in dividend yielding stocks. Minimum investment of 65% of the total assets in equity.

Debt Mutual Funds

Debt mutual funds are schemes that invest a major portion of the corpus in fixed-income or debt instruments. For example, they invest in instruments such as government securities debentures, corporate bonds, and money market instruments like certificates of deposits, commercial papers, and treasury bills. Compared to equity mutual funds debt funds are low-risk investments. These funds invest in high-quality instruments.

Following are the types of debt mutual funds:

Overnight Funds Invests in overnight securities with 1 day maturity.
Liquid Funds Invests in money market and debt securities with up to 91 days maturity.
Ultra Short Duration Funds Macaulay Duration of the portfolio is between 3-6 months and invests across debt and money market securities.
Low Duration Funds Macaulay Duration of the portfolio is between 6-12 months and invests across debt and money market securities.
Money Market Funds Invests in money market instruments with maturity up to 1 year.
Short Duration Funds Macaulay Duration of the portfolio is between 1-3 years and invests across debt and money market securities.
Medium Duration Funds Macaulay Duration of the portfolio is between 3-4 years and invests across debt and money market securities.
Medium to Long Duration Funds Invests in money market and debt securities, The Macaulay duration of the portfolio is between 4-7 years.
Long Duration Funds Invests in money market and debt securities, The Macaulay duration of the portfolio is greater than 7 years.
Dynamic Bond Funds Investments made across multiple durations.
Corporate Bond Funds Minimum investment of 80% of the total assets in the highest rated corporate bonds.
Credit Risk Funds Minimum investment of 65% of the total assets in below highest rated corporate bonds.
Banking and PSU Funds Invests a minimum of 80% of the total assets in Public Sector Undertakings, Debt Instruments of Banks and Public Financial Institutions.
Gilt Funds Minimum of 80% of the total assets in Gsecs (across maturity)
Gilt Funds with 10 year constant duration Macaulay Duration of the portfolio is equal to 10 years and invests 80% of the total assets in G-secs.
Floater Funds Minimum of 65% of the total assets in floating rate instruments.

Hybrid Mutual Funds

Hybrid Mutual funds invest in both equity and debt instruments. Previously a hybrid mutual fund was known as a balanced fund. Some hybrid funds also invest in other assets like real estate and gold. These are suitable for investors seeking good returns with moderate risk tolerance. Hybrid funds can be used both for monthly income and capital appreciation.

Following are the types of hybrid mutual funds:

Conservative Hybrid Funds Invests between 10% and 25% of total assets in Equity and equity related instruments.Between 75% and 90% of total assets in debt instruments.
Balanced Hybrid Funds or Aggressive Hybrid Funds Invests between 40% and 60% of total assets Equity and equity related instruments.Between 40% and 60% of total assets Debt instruments.
Dynamic Asset Allocation or Balanced Advantage Funds Dynamic Asset Allocation funds invest in equity and debt instruments and manage them dynamically.
Multi Asset Allocation Funds Invests across at least three asset classes with a minimum allocation of 10%.
Arbitrage Funds Follows the arbitrage strategy. Minimum of 65% of the total assets in equity and equity related instruments.
Equity Savings Funds Equity and equity related instruments: a minimum of 75% of total assets.Debt instruments: minimum 10% of total assets

Based on Investment Objective

Growth Option

Under the growth option, the dividends from the mutual fund investments are directly reinvested into the fund.

Dividend Option

Under the dividend option, the profits made by the mutual fund are regularly distributed among the unitholders.

How to invest in mutual funds?

Investors can invest in mutual funds either through online or offline modes. Investors can choose to invest in either direct or regular plans based on their understanding. Also, beginners or investing veterans can choose either the Systematic Investment Plan (SIP) or lump sum route for investing in mutual funds.

Direct vs Regular

All mutual funds come in two variants – Direct Plan and Regular Plan. Direct Funds are sold directly by the fund house. The expense ratio for direct plans is lower as there is no commission paid to an intermediary (distributor). On the other hand, regular plans are sold by intermediaries. Hence these plans have a higher expense ratio. However, regular plans are helpful for investors who do not have any knowledge about the financial markets. The advisor will help in selecting a suitable mutual fund on the basis of the investor’s profile. Therefore, beginners or investors who do not understand mutual funds can take the help of an advisor for investing in mutual funds (regular plan).

Online vs Offline

Investing in a mutual fund (direct or regular plan) can be done through either online and offline mode. Offline mode involves submitting the documents at the fund house directly or by handing it over to an agent or distributor. In contrast, online investing is done at the investor's convenience from their home. In other words, investors can invest by directly visiting the asset management company's website. Alternatively, one can also invest through online platforms such as Scripbox that enable mutual fund investments. Investing through Scripbox is easy, hassle-free and the entire process is paperless.

SIP vs Lump sum

Investors can invest in mutual funds either through SIP or lump sum route. SIP is Systematic Investment Plan. It enables investors to invest a fixed amount regularly in a mutual fund. SIP is good for investors who wish to save small amounts regularly. It generally reduces the average cost of investment. It also inculcates discipline in an investor. Also, with Systematic Investment Plans, one doesn't have to worry about timing the market.

Lump sum investments, on the other hand, are one time investments made into a mutual fund.

Therefore, beginners willing to invest in mutual funds for the first time can try investing through the SIP route with small amounts.

Things to consider as an investor

Expenses

Mutual funds charge a fee for their service. The fee includes expense ratio, entry load and exit load. It is important to invest in the funds with a low expense ratio.

Past Performance

Past performance doesn’t guarantee future returns. However, studying the past performance of a mutual fund will help in understanding the behaviour across different market cycles. Therefore, it is a good indicator to understand whether the scheme has given stable and consistent returns to its investors.

Lock-in

Mutual funds do not have a long lock in periods. Mutual funds are volatile investment options. However, investments withdrawn within one year of investment attract an exit load of 1%. Also, Equity Linked Savings Scheme (ELSS) is the only type of mutual fund that has a lock-in period of three years. Additionally, closed-ended funds require investors to hold the investment until maturity.

Taxation

Equity and Debt mutual funds have different taxation. Also, tax depends on the holding period of the investment.

For equity mutual funds, the returns are subject to short term capital gains tax (STCG) when held for less than one year. The returns are taxed at 15% (plus 4% cess). While for investments held for more than one year, they are subject to long term capital gains tax (LTCG). For LTCG, gains beyond INR 1 lakh are taxed at 10% (plus 4% cess) without indexation benefit.

For debt mutual funds, returns from investments held for less than three years attract short term capital gains tax (STCG). The returns are taxed as per the investor’s applicable income tax slab rate. For investments held beyond three years, they are subject to long term capital gains tax (LTCG) of 20% with indexation benefit.

Additionally, investments in Equity Linked Savings Scheme (tax saver funds) help in saving tax and qualify for tax exemption. Investments up to INR 1.5 lakh can be claimed for tax exemption as per the Section 80 C of the Income Tax Act.

Fund manager and Fund house

As an investor, it is essential to know about the fund manager who will be managing your fund. At the same time, the fund house's reputation too has some weightage while shortlisting funds. Understanding the fund manager's investment style and experience is good. The entire performance of the mutual fund's portfolio depends on the decisions taken by the fund manager. Therefore, studying the fund house as well as the fund manager is important while investing in a mutual fund.

Financial advisor

Many beginners tend to have a doubt, whether they can afford a financial advisor? Well, financial advisors come with certain costs. However, the investment plan designed by them has a good probability of earning higher returns. Therefore, though one has to pay an extra for investing in regular mutual funds, it is worth it. Solution providers  like Scripbox will help investors invest towards a life goal. Scripbox constantly monitors the investor's mutual fund portfolio and suggests rebalancing when required.

Documents required to invest in mutual funds

To invest in mutual funds, one would need the following documents:

  • Pan Card
  • Photograph
  • Address proof (Aadhaar Card (Both Front & Back)/Driving License/Passport/Voter ID Card)
  • Savings bank account details

Investing in mutual funds

Now that the knowledge on mutual funds, its types and the things to consider as an investor is clear. The next is to know how to invest in mutual funds. In this section, we have covered the "where" and "how to" start investing in mutual funds for beginners.

There are multiple options available for investing in mutual funds. Investors can choose to invest online or offline. Or they can choose to invest directly or through an intermediary. However, for beginners, it is always advised to go through an intermediary and take help of a financial advisor while investing in mutual funds.

In this era of the digital world, investing has been digitalized too. SEBI has taken measures to make online investing safe and secure. Beginners can choose the online mode to invest in mutual funds. However, many online portals are providing this service. Investors can get confused about which platform to choose.

Investors have to choose a platform that not only facilitates the purchase and sale of mutual funds but also advises them as per their goals. One such platform is Scripbox.

Scripbox is a one-stop solution to all financial goals of investors. It is a platform that provides multiple services like advisory, monitoring and portfolio reviewing.

Below are the reasons why beginners should consider Scripbox while investing in mutual funds.

  • Financial goals: Scripbox has financial goals based on different stages of life. Investors can choose the goal closet to their financial goal and invest according. The funds in each of these goals have been selected after thorough research.
  • SIP/Lumpsum: Investing in mutual funds can be through a lump sum route or SIP route. Scripbox allows investors to choose any of the routes to invest in mutual funds based on their cash flows.
  • Online: Scripbox is completely online. Right from the process of registering to KYC and investing to redemption, everything can be done at the click of a mouse. Investors can submit their PAN card, Adhaar card, bank account details and their cancelled cheque online at the time of registration.
  • Regular monitoring and portfolio review: Scripbox does regular monitoring of its clients’ portfolios. It even suggests any changes to be done based on the current market conditions.
  • Ease of transacting: Pausing SIPs, cancelling them and redeeming the investments can be easily done on the Scripbox’s website. There is no paperwork needed for the same.
  • Proofs for income tax: If investors are investing in ELSS funds, Scripbox provides proofs for the same so that investors can file their taxes.
  • Proprietary Algorithm: Scripbox has a proprietary algorithm that screens all mutual funds in the market and ranks the best funds.
  • Value-added services: Scripbox provides different calculators that are completely free to use. Investors can use these calculators and estimate the potential returns from their investments. SIP calculator, ELSS calculator, Income Tax calculator, FD calculator, Power of Compounding calculator, loan  EMI calculator, Retirement calculator, Recurring Deposit Calculator are just some of the many calculators it offers.

Scripbox is just a platform that facilitates mutual fund transactions and guides based on market conditions.

It doesn't guarantee any returns from any mutual fund, nor does it assure safety from risk and market volatility. However, it can help investors choose the best funds to invest based on their financial goals and understanding of risk.

Few important things to know about mutual fund investing.

For beginners, it is important to understand that mutual fund investing is not a 'one rule that applies to all' concept. Each investor is unique. Hence investors need to know which fund suits them best. The fund choice is based on the following factors:

  • Investor's income: The income of the investor is very important as it determines whether the investor can invest through a lump sum or SIP route. A regular income person can opt for SIP.
  • Age of the investor: The age of the investor is very important while investing. Young people with no family commitments may be willing to take more risk and can invest for longer horizons than older ones.
  • Investor's expectations and goals: Investors goals and expectations determine the tenure of the investments. If an investor is saving up for retirement, then equity funds are more preferable as it's a long term goal. However, for a short term goal like a vacation in the next year, debt funds are suitable.
  • Their understanding of risk: Will investors panic for small stock market movements? Will they be patient enough to let the investment grow through the stock market ups and downs? These are few questions that define how investors perceive risk. A financial advisor might give out a risk profiling questionnaire to understand their risk tolerance of an investor. Based on the risk-taking capacity, financial advisors can suggest mutual funds for beginners.

Age-based investing

Investing has no age. Mutual fund investors can be of any age. It is always advised to invest in the early stages of life as they can benefit from compounding. However, one need not worry if they haven't invested in their early stages. They can start investing now. The phrase "better late than never" applies to invest as well. Here's a beginners guide to mutual funds for people of different age groups that they can refer to for saving and investing.

In the age of 20s

This age group is more inclined towards spending that saving. However, saving a little now takes one a long way ahead. One should start investing and saving at least 5-10% of their salary. The main aim should be retirement planning. The first objective should be an emergency fund which has at least 4 months of their income equivalent saved in a liquid fund. After this is done, close to 90% of the investments can be equity. This is because this goal is 30 years away and investing a small amount now will help in accumulating a huge corpus by the age of 60 through compounding. The magic not only lies in investing early but also sticking to it till the age of retirement.

In the age of 30s

If one is starting their investing journey in their 30's, they can aim at investing and saving at least 20-25% of their salary. In this age group, there will be financial commitments like EMIs, loan repayments, kids, etc. Equities can still be a major part of the portfolio, and retirement planning should be one of the main goals.

In the age of 40s

This age might feel a little late to start investing. However, they still have time until retirement and the earnings to stop. One should aim at saving and investing 25-30% of their salary. Equity funds can be at least 60-70% of the portfolio, while debt funds can take up 30-40% of the portfolio.

IN the age of 50s

Investing in the 50s can still be beneficial. By this age, kids' education would've been done, and major financial commitments would have almost been over. However, retirement should be the main goal as the number of years left to earn are very few now. One should aim at saving and investing close to 40-45% of their salary. One can still invest 50% of their investments in equity funds, and the rest in debt funds.

In the age of 60s

The earning capacity now for most of the investors is close to zero. However, one can still invest during this age. There are multiple fixed income and monthly income plans for earning a regular income. Now is the time to relax and enjoy the retirement life. Investors can aim at investing close to 70% in fixed income funds and the rest in other assets.

Conclusion

Mutual fund investing for beginners can be quite confusing. However, through proper guidance, it becomes easier. Scripbox is an online platform that helps in mutual fund investing through its recommendations, reviewing and monitoring. For beginners, it is important to understand that mutual fund investing is not a 'one rule that applies to all' concept. All investors are unique and have to invest in the funds that best suit their financial goals and requirements.

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