UNDERSTANDING THE DYNAMICS OF MUTUAL FUNDS

 “Successful investing is about managing risk, not avoiding it”- By Benjamin Graham.

The biggest risk is not taking any risk. Due to plethora of investment options ranging from debt funds to equity funds, mutual funds have been successful in diversifying the risk based on one’s risk appetite. Mutual Funds generate income from its investment portfolio and is distributed proportionately amongst the investors after deducting applicable expenses.  Every individual by ITSELF or with the help of mutual fund advisor/distributor can invest in mutual funds even if he does not have requisite knowledge.  This investment can be for short term to long term based on one’s investment horizon. Even you can invest for few days. These mutual funds are associated with various benefits, lets have a glance to it:

Higher Returns- Mutual Funds has ability to provide returns greater than fixed deposits. It can provide returns ranging from 7%-30% based on ones risk appetite.

Liquidity- Except for ELSS funds, one can easily sell their mutual fund units at any point of time to meet their financial needs. Their money gets deposited in the bank account within 1-3 days of redemption based on the scheme.

Investment in small denominations- One has the advantage of investing in mutual fund with a minimum amount of Rs.500/- per month.

Diversification- Our Investment gets diversified over multiple asset classes according to ones risk appettite. Thus diversification helps us to reduce risk to a greater extent

Professional Management- A lot of investors does not have time to research, thus fund managers takes care of this and makes best decision. He continuously monitors the investment and adjusts the portfolio accordingly to meet the objectives.

Tax Benefits- To attract investment in mutual funds, GOI has given tax benefit upto 1.5 lakhs u/s 80C of Income Tax Act, 1961 by investing in ELSS schemes.

Transparency- There is a myth that mutual funds are not safe as bank products. Mutual funds are regulated by statutory bodies like SEBI and AMFI which brings transparency in its operations.        

Points to be taken into consideration before investing in mutual funds are:

High Expense Ratio- Operating expense, fund managers salary/commission is included in this expense ratio. This amount gets automatically adjusted in the NAV. An expense ratio greater than 1.5% is generally considered high. So one should also look at expense ratio of the scheme before making any investment decision.  

Tax on sale of mutual fund- Mutual funds are subject to capital gain tax on its redemption.  

Lock in period- If one has invested in ELSS funds than their funds get blocked for a period of 3 years. This can be a disadvantage during liquidity crises.

While investing in mutual funds, the fund house allocates units based on the NAV of scheme on that particular day to the investors. A mutual funds NAV represents market value of underlying instrument.

Lets understand the working of mutual fund and allocation of units to investors with a small example:

Lets assume HDFC Income Saving Fund has allocated 11,000 units to its investors and has its portfolio asset under management (‘AUM’) of Rs. 10,00,000/- and having NAV of 90.91/- per unit on 01/11/2020. Now on this same day if  Ramesh wants to invest Rs .10,000/- for an NAV of 90.91 per unit in this scheme then he would be allocated 110 units. This Rs.10.000/- received from Ramesh is invested by fund manager in purchasing 100 shares of ONGC on the same day.

Now on 15/01/2021, if Ramesh wants to sell all his units then he will receive Rs. 11,062/- (110 units *100.56 per unit). Thus Ramesh earned a profit of Rs. 1,062/- on investment of Rs. 10,000/-. Thus it can be observed that investors can generate good returns due to professional management of funds by fund manager and can indirectly participate in equity and debt market with the help of mutual fund.

Methods of investment in mutual funds would be explained in the next blog. Keep sharing, Keep gaining.

-          -By CA Dhruval Shah

        You may reach out to me at dhruvalcshah@gmail.com.

Disclaimer: The above blog is for knowledge purpose only. The author will not be responsible for any investment gains or loss, do consult your investment advisor before taking any investment decisions.