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What are Mutual Funds?

A mutual fund is a trust that pools the savings of a number of investors who share a common investment objective. The money thus collected is invested in capital market instruments such as shares, debentures, and other securities. The combined holdings the mutual fund owns are known as its portfolio. Each unit represents an investor’s proportionate ownership of the fund’s holdings and the income those holdings generate.

The income earned through these investments is shared by its unit holders in proportion to the number of units owned by them. Thus a Mutual Fund is the most suitable investment for the common man as it offers an opportunity to invest in a diversified, professionally managed basket of securities at a relatively low cost.

Investments in securities are spread across a wide cross section of industries and sectors and thereby reduce the risk. Asset Management Companies (AMCs) normally come out with a number of schemes with different investment objectives from time to time. A mutual fund is required to be registered with the Securities and Exchange Board of India (SEBI), which regulates securities markets before it can collect funds from the public.

Structure of Mutual Funds in India:

In India, mutual funds function as trust created under the Indian Trust Act, 1882. There are three layers of mutual fund in India as follows:

1. Sponsor: The sponsor is a person who establishes a mutual fund and gets it registered with Sebi. The sponsor forms the Trust, appoints the Board of Trustees, and has the right to appoint the Asset Management Company (AMC) or the fund manager.

2. Trustees: The mutual fund is managed by a Board of Trustees. The trustees act as a protector of unit holders' interests. They do not directly manage the portfolio of securities and appoint an AMC (with approval of Sebi) for fund management. If an AMC wishes to float additional or different schemes, it will need to be approved by the trustees. Trustees play a critical role in ensuring full compliance with Sebi's requirements.

3. Asset Management Company: The AMC is appointed by trustees for managing fund schemes and corpus. An AMC functions under the supervision of its own board of directors and also under the directions of trustees and Sebi. The market regulator has mandated the limit of independent directors to ensure independence in AMC workings.

The other constituents are:

1.Custodian and depositories: The fund management includes buying and selling of securities in large volumes. Therefore, keeping a track of such transactions is a specialist function. The custodian is appointed by trustees for safekeeping of physical securities while dematerialised securities holdings are held in a depository through a depository participant. The custodian and depositories work under the instructions of the AMC, although under the overall direction of trustees.

2.Registrar and transfer agents: These are responsible for issuing and redeeming units of the mutual fund as well as providing other related services, such as preparation of transfer documents and updating investor records. A fund can carry out these activities in-house or can outsource them. If it is done internally, the fund may charge the scheme for the service at a competitive market rate.

History of Mutual Funds in India:

The mutual fund industry in India started in 1963 with the formation of Unit Trust of India (UTI) at the initiative of the RBI & Government of India. The objective then was to attract small investors and introduce them to market investments. Since then, the history of mutual funds in India can be broadly divided into six distinct phases.

Phase I (1964-87): Growth Of UTI:
In 1963, UTI was established by an Act of Parliament and was the only entity offering mutual funds in India. The first scheme was Unit Scheme 1964 followed by many others. The first Indian offshore fund, India Fund was launched in August 1986.

Phase II (1987-93): Entry of Public Sector Funds:
The year 1987 marked the entry of other public sector mutual funds. With the opening up of the economy, many public sector banks and institutions were allowed to establish mutual funds. The State Bank of India established the first non-UTI Mutual Fund, SBI Mutual Fund in November 1987.

Phase III (1993-96): Emergence of Private Funds:
A new era in the mutual fund industry began in 1993 with the permission granted for the entry of private sector funds. This gave the Indian investors a broader choice of 'fund families' and increasing competition to the existing public sector funds. Quite significantly foreign fund management companies were also allowed to operate mutual funds, most of them coming into India through their joint ventures with Indian promoters. The private funds have brought in with them latest product innovations, investment management techniques and investor-servicing technologies. During the year 1993-94, five private sector fund houses launched their schemes followed by six others in 1994-95.

Phase IV (1996-99): Growth And SEBI Regulation:
Since 1996, the industry scaled newer heights in terms of mobilization of funds and number of players. Deregulation and liberalization of the Indian economy had introduced competition and provided impetus to the growth of the industry. A comprehensive set of regulations for all mutual funds operating in India was introduced with SEBI (Mutual Fund) Regulations, 1996. These regulations set uniform standards for all funds.

Phase V (1999-2004): Emergence of a Large and Uniform Industry:
The year 1999 marked the beginning of a new phase in the history of the mutual fund industry in India, a phase of significant growth in terms of both amount mobilized from investors and assets under management. In February 2003, the UTI Act was repealed and it adopted the same structure as any other fund in India. The emergence of a uniform industry with the same structure, operations and regulations make it easier for distributors and investors to deal with any fund house. Between 1999 and 2005 the size of the industry has doubled in terms of AUM which have gone from above Rs 68,000 crores to over Rs 1,50,000 crores.

Phase VI (From 2004 Onwards): Consolidation and Growth:
The industry has lately witnessed many of mergers and acquisitions. At the same time, more international players continue to enter India while new domestic players have also entered the market. Sebi has in recent times introduced many significant regulations in the industry for monitoring the same and protecting investor interests.

Advantages of Mutual Funds:

Professional Management:
Mutual funds hire full-time, high-level investment professionals. Funds can afford to do so as they manage large pools of money. Mutual funds are managed by fund managers generally with knowledge and experience whose time is solely devoted to tracking and updating the portfolio. They have real-time access to crucial market information and are able to execute trades on the largest and most cost-effective scale. Thus investment in a mutual fund not only saves time and effort for the investor but is also likely to produce better results.

Portfolio Diversification:
Diversified investment improves the risk return profile of the portfolio. Optimal diversification has limitations due to low liquidity among small investors. The large corpus of a mutual fund as compared to individual investments makes optimal diversification possible. Due to the pooling of capital, individual investors can derive benefits of diversification.

Low Transaction Costs:
Mutual fund transactions are generally very large. These large volumes attract lower brokerage commissions and other costs as compared to smaller volumes of the transactions that individual investors enter into.

Choice of products & assets:
There are four basic types of mutual funds based on the asset class they invest in: equity, bond, hybrid and money market. Further, within each asset class there are further choices of products. For any investment objective of any investor, the choice of the products available are many.

Liquidating a portfolio is not often easy and you have to rely on the market liquidity for the security. A mutual fund house stands ready to buy and sell its units at any point of time. Thus it is easier to liquidate holdings in a Mutual Fund as compared to direct investment in securities. There are however also products like close-ended funds or intervals funds which have restrictions on the buy and sell transactions.

Tax benefits:
In India dividend received by investors is tax-free. This enhances the yield on mutual funds marginally as compared to income from other investment options. Also in case of long-term capital gains, the investor benefits from indexation and lower capital gain tax. Investments in the ELSS schemes qualifies under the section 80 C.

There are many flexibilities available in terms of payment and credit modes, investing, swtiching and withdrawing from the portfolio like SIP, SWP, STP and Switch with different frequency options. The schemes also offer flexibilities in the nature of plan – with dividend payout, reinvestment and growth options. There are virtually no restictions on the amount, period, product type, plan choices you can make.

Well Regulated & Transparent:
All mutual funds are registered with SEBI and they function within the provisions of strict regulations designed to protect the interest of investors. The SEBI regularly monitors the operations of an AMC. There is high degree of disclosures and transparency also. You get regular information on the value of your investment in addition to disclosure on the specific investments made by the mutual fund scheme. You can also track your investments on a daily basis.

Operationally, there is a lot of convenience and ease in transacting with mutual funds. All your holdings and fund accounting is managed by high quality custodians and registrars. You may make use of auto-debit mandates, ECS, etc. to make & schedule investments. The redemption proceeds, dividends can be automatically credited into your accounts within few days of the transaction. Mutual funds are also available on the stock exchange and you can do transactions through online and other modes in a paper-less manner.

Open to everyone:
Any rich or poor person can invest in mutual funds. Often you can even start a SIP with amount as low as Rs.500/-. There is no upper limit on the amoun of investment you can make. Most other government backed investment products in the market have these restrictions. Any person – be it individual, trusts, firms or companies can invest in mutual funds.

Different Types of Funds:

Schemes according to Maturity Period:

  1. Open-ended Fund/ Scheme: An open-ended fund or scheme is one that is available for subscription and repurchase on a continuous basis. These schemes do not have a fixed maturity period. Investors can conveniently buy and sell units at Net Asset Value (NAV) related prices which are declared on a daily basis. The key feature of open-end schemes is liquidity.

  2. Close-ended Fund/ Scheme: A close-ended fund or scheme has a stipulated maturity period e.g. 5-7 years. The fund is open for subscription only during a specified period at the time of launch of the scheme. Investors can invest in the scheme at the time of the initial public issue and thereafter they can buy or sell the units of the scheme on the stock exchanges where the units are listed. In order to provide an exit route to the investors, some close-ended funds give an option of selling back the units to the mutual fund through periodic repurchase at NAV related prices. SEBI Regulations stipulate that at least one of the two exit routes is provided to the investor i.e. either repurchase facility or through listing on stock exchanges. These mutual funds schemes disclose NAV generally on weekly basis.

  3. Interval - Operating as a combination of open and closed ended schemes, it allows investors to trade units at pre-defined intervals.

Schemes according to Investment Objective:

  1. Growth / Equity Oriented Scheme: The aim is to provide capital appreciation over the medium to long- term. Such schemes normally invest a major part of their corpus in equities and have comparatively high risks. These schemes provide different options to the investors like dividend option, capital appreciation, etc. and the investors may choose an option depending on their preferences. These schemes are good for investors having a long-term outlook seeking appreciation over a period of time.

  2. Income / Debt Oriented Scheme: The aim of income funds is to provide regular and steady income to investors. Such schemes generally invest in fixed income securities such as bonds, corporate debentures, government securities and money market instruments. Such funds are less risky compared to equity schemes and are not affected because of fluctuations in equity markets. However, opportunities of capital appreciation are also limited in such funds. The NAVs of such funds are affected because of change in interest rates in the country. If the interest rates fall, NAVs of such funds are likely to increase in the short run and vice versa. However, long term investors may not bother about these fluctuations.

  3. Money Market or Liquid Fund: These funds are also income funds and their aim is to provide easy liquidity, preservation of capital and moderate income. These schemes invest exclusively in safer short-term instruments such as treasury bills, certificates of deposit, commercial paper and inter-bank call money, government securities, etc. Returns on these schemes fluctuate much less compared to other funds. These funds are appropriate for corporate and individual investors as a means to park their surplus funds for short periods.

  4. Hybrid / Balanced Funds: The aim of balanced funds is to provide both growth and regular income as such schemes invest both in equities and fixed income securities in the proportion indicated in their offer documents. These are appropriate for investors looking for moderate growth. They generally invest 40-60% in equity and debt instruments. These funds are also affected because of fluctuations in share prices in the stock markets. However, NAVs of such funds are likely to be less volatile compared to pure equity funds. There are also MIP products which invest anywhere between 5% to 20% of the portfolio into equities.

Some specific type of funds based on underlying asset class /security choices:

  1. Gilt Fund: These funds invest exclusively in government securities. Government securities have no default risk. NAVs of these schemes also fluctuate due to change in interest rates and other economic factors as is the case with income or debt oriented schemes.

  2. Index Funds: Index Funds replicate the portfolio of a particular index such as the BSE Sensitive index, S&P NSE 50 index (Nifty), etc. These schemes invest in the securities in the same weightage comprising of an index. NAVs of such schemes would rise or fall in accordance with the rise or fall in the index, though not exactly by the same percentage due to some factors known as "tracking error" in technical terms. There are also exchange traded index funds launched by the mutual funds which are traded on the stock exchanges.

  3. Sector specific funds/schemes: These are the funds/schemes which invest in the securities of only those sectors or industries as specified in the offer documents. e.g. Pharmaceuticals, Software, Fast Moving Consumer Goods (FMCG), Petroleum stocks, etc. While these funds may give higher returns, they are more risky compared to diversified funds. Investors need to keep a watch on the performance of those sectors/industries and must exit at an appropriate time. They may also seek advice of an expert.

  4. Fund of Funds (FoF) scheme: A scheme that invests primarily in other schemes of the same mutual fund or other mutual funds is known as a FoF scheme. An FoF scheme enables the investors to achieve greater diversification through one scheme. It spreads risks across a greater universe.

Other types of funds:

  1. Capital Protection: The primary objective of this scheme is to safeguard the principal amount while trying to deliver reasonable returns. These invest in high-quality fixed income securities with marginal exposure to equities and mature along with the maturity period of the scheme.

  2. Fixed Maturity Plans (FMPs): FMPs, as the name suggests, are mutual fund schemes with a defined maturity period. These schemes normally comprise of debt instruments which mature in line with the maturity of the scheme, thereby earning through the interest component (also called coupons) of the securities in the portfolio. FMPs are normally passively managed, i.e. there is no active trading of debt instruments in the portfolio. The expenses which are charged to the scheme, are hence, generally lower than actively managed schemes.

  3. Tax Saving - As the name suggests, this scheme offers tax benefits to its investors. The funds are invested in equities thereby offering long-term growth opportunities. Tax saving mutual funds, called Equity Linked Savings Schemes - ELSS has a 3-year lock-in period.

What is the taxation applicable on Mutual Funds?

The rates are applicable for the financial year 2015-16.

Tax Implication on Dividend received by Unit holders:

  Individual/ HUF Domestic Company NRI
Equity Oriented Schemes Nil Nil Nil
Debt oriented schemes Nil Nil Nil

Tax on distributed income (payable by the scheme) rates **

  Individual/ HUF Domestic Company NRI
Equity Oriented Schemes* Nil Nil Nil
Money Market & Liquid Schemes 25% + 12% Surcharge + 3% Cess = = 28.84% 30% + 12% Surcharge + 3% Cess = 34.608% 25% + 12% Surcharge + 3% Cess = 28.84%
Debt schemes (other than infrastructure debt fund) 25% + 12% Surcharge + 3% Cess = = 28.84% 30% + 12% Surcharge + 3% Cess = 34.608% 25% + 12% Surcharge + 3% Cess = 28.84%
Infrastructure Debt Fund 25% + 12% Surcharge + 3% Cess = = 28.84% 30% + 12% Surcharge + 3% Cess = 34.608% 5% + 12% Surcharge + 3% Cess = 5.768%

* Securities transaction tax (STT) will be deducted on equity funds at the time of redemption/ switch to the other schemes/ sale of units.

** With effect from 1 October 2014, for the purpose of determining the tax payable, the amount of distributed income has to be increased to such amount as would, after reduction of tax from such increased amount, be equal to the income distributed by the Mutual Fund.

Capital Gains Taxation

  Individual/ HUF$ Domestic Company@ NRI$/#
Equity Oriented Schemes
• Long Term Capital Gains (units held for more than 12 months) • Short Term Capital Gains (units held for 12 months or less)
Long term capital gains Nil Nil Nil
Short term capital gains 15% 15% 15%
Other Than Equity Oriented Schemes
• Long Term Capital Gains (units held for more than 36 months) • Short Term Capital Gains (units held for 36 months or less)
Long term capital gains 20%& 20%& Listed - 20%& Unlisted - 10%*
Short term capital gains 30%^ 30% 30%^

Tax Deducted at Source (Applicable only to NRI Investors)

  Short Term Capital Gain Long Term Capital Gain
Equity Oriented Schemes 15% Nil
Other than Equity Oriented schemes 30%^ 10%* (for unlisted) & 20%& (for listed)

$ Surcharge at 12% to be levied in case of individual/ HUF unit holders where their income exceeds Rs 1 crore.
@ Surcharge at 7 to be levied for domestic corporate unit holders where income exceeds Rs 1 crore but less than Rs. 10 crores and at 12%, where income exceeds Rs. 10 crores.
# Short term/ long term capital gain tax will be deducted at the time of redemption of units in case of NRI investors only.
& After providing indexation.
* Without indexation
^ Assuming the investor falls into highest tax bracket.
Education Cess at 3% will continue to apply on tax plus surcharge.
The Finance Bill, 2015 proposes to provide tax exemption to unit holders upon consolidation or merger of mutual fund schemes, provided consolidation is of two or more schemes of equity oriented fund or two or more schemes of a fund other than equity oriented fund.

Dividend Stripping: The loss due to sale of units in the schemes (where dividend is tax free) will not be available for set off to the extent of tax free dividend declared; if units are:(A) bought within three months prior to the record date fixed for dividend declaration; and (B) sold within nine months after the record date fixed for dividend declaration.

Bonus Stripping: The loss due to sale of original units in the schemes, where bonus units are issued, will not be available for set off; if original units are: (A) bought within three months prior to the record date fixed for allotment of bonus units; and (B) sold within nine months after the record date fixed for allotment of bonus units. However, the amount of loss so ignored shall be deemed to be the cost of purchase or acquisition of such unsold bonus units.

1. Income Tax Rates

For Individuals, Hindu Undivided Family, Association of Persons, Body of Individuals and Artificial juridical persons Total Income Tax Rates

Total Income Tax Rates
Up to Rs. 250,000(a)(b)(d) Nil
Rs. 250,001 to Rs. 500,000(d) 10%
Rs. 500,001 to Rs. 1,000,000(d) 20%
Rs. 1,000,001 and above(c)(d) 30%

  • In the case of a resident individual of the age of 60 years or above but below 80 years, the basic exemption limit is Rs 300,000.
  • In case of a resident individual of age of 80 years or above, the basic exemption limit is Rs 500,000.
  • Surcharge @ 12% is applicable on income exceeding Rs 1 crore; Marginal relief for such person is available
  • Education cess is applicable @ 3% on income tax plus surcharge

2. Securities Transaction Tax (STT)

STT is levied on the value of taxable securities transactions as under.

Transaction Rates Payable By
Purchase/ Sale of equity shares 0.1% Purchaser/Seller
Purchase of units of equity oriented mutual fund Nil Purchaser
Sale of units of equity oriented mutual fund 0.001% Seller
Sale of equity shares, units of equity oriented mutual fund (non-delivery based) 0.025% Seller
Sale of an option in securities 0.017% Seller
Sale of an option in securities, where option is exercised 0.125% Purchaser
Sale of a futures in securities 0.010% Seller
Sale of units of an equity oriented fund to the Mutual Fund 0.001% Seller

3. Special rates for non-residents

  • The following incomes in the case of non-resident are taxed at special rates on gross basis:
    Transaction Rates(a)
    Dividend(b) 20%
    Interest received on loans given in foreign currency to Indian concern or Government of India. 20%
    Income received in respect of units purchased in foreign currency of specifies Mutual Funds / UTI 20%
    Royalty or fees for technical services 10%
    Interest income from a notified infrastructure debt fund 5%
    Interest on FCCB, FCEB / Dividend on GDRs(b) 10%
    Rs. 1,000,001 and above(c)(d) 30%

    These rates will further increase by applicable surcharge and education cess.

    Other than dividends on which DDT has been paid.
    In case the non-resident has a Permanent Establishment (PE) in India and the royalty/ fees for technical services paid is effectively connected with such PE, the same could be taxed at 40% (plus applicable surcharge and education cess) on net basis.

  • Tax on non-resident sportsmen or sports association on specified income @ 10% plus applicable surcharge and education cess.

4. Capital Gains

Transaction Short-term capital gains(a) Long-term capital gains(a)(b)
Sale transactions of equity shares/ unit of an equity oriented fund which attract STT 15% Nil
Sale transaction other than mentioned above:
Individuals (resident and non-residents) Progressive slab rates 20% / 10%
Partnerships (resident and non-residents) 30%
Resident companies 30%
Overseas financial organizations specified in section115AB 40% (corporate) 30% (non corporate) 10%
FIIs 30% 10%
Other Foreign companies 40% 20% / 10%
Local authority 30% 20% / 10%
Co-operative society rates Progressive slab

  • These rates will further increase by applicable surcharge & education cess.
  • Indexation benefit, as applicable.