Benefits of Investing in Mutual Funds

What are Mutual Funds?

Mutual fund is a financial instrument which pools the money of different people and invests them in different financial securities like stocks, bonds etc. Each investor in a mutual fund scheme owns units of the fund, which represents a portion of the holdings of the scheme. The securities are selected keeping in mind the investment objective of the scheme. Mutual funds are managed by asset management companies (AMCs). AMCs appoint fund managers to manage different mutual fund schemes and ensure that the scheme investment objectives are met. For fund management and other services provided by AMCs, a fee is charged to the investors. Let us now discuss the advantages of mutual funds.

Let us now discuss mutual fund tax benefits

Benefits of mutual funds in India

  • Risk Diversification: One of the biggest benefits of mutual funds is risk diversification. Every stock is subject to three types of risk – company risk, sector risk and market risk. Company risk and sector risk are unsystematic risk, while market risk is known as systematic risk. Mutual funds help investors diversify unsystematic risks by investing in a diversified portfolio of stocks across different sectors. While individual stocks have both unsystematic and systematic risks, mutual funds are only subject to systematic risk or market risk.
  • Smaller capital outlay: Another advantage of mutual funds is that you can start investing in mutual funds with relatively small amounts. Investors will require a large capital outlay to build a diversified portfolio of stocks. On the other hand, since mutual funds work on the basis of pooling of money, mutual fund investors can have the beneficial ownership of a diversified portfolio of stocks with a much smaller capital outlay. Investors can buy units of a diversified equity mutual fund with an investment as low as Rs 5,000/- only or even lower at Rs 500 for ELSS schemes.
  • Investment expertise: Investing in stocks and bonds requires considerable expertise and experience. You need to have knowledge of financial markets, industry sectors, individual companies and research expertise. A major advantage of mutual funds is that they are managed by professional fund managers who have the desired qualification, expertise and experience in picking the right stocks or other instruments to get the best risk adjusted returns. The fund managers are supported by the research team of the AMCs.
  • Economies of scale in transaction costs: : Lower transaction cost due to economies of scale is another advantage of mutual funds. Since mutual funds buy and sell securities in large volumes transaction costs on a per unit basis is much lower than what retail investors may incur if they buy or sell shares through stock brokers.
  • Variety of products: Mutual funds offer investors a variety of products to suit their risk profiles and investment objectives. Apart from equity funds, there are hybrid funds, debt funds, liquid funds and tax savings schemes etc. to suit different investment requirements. The benefits of investing in mutual funds is that you can invest in the appropriate product suitable for your specific needs and risk appetite.
  • Variety of modes of investments: Flexibility in terms of modes of investment and withdrawal is one of the advantages of mutual funds compared to other investment options. Investors can opt for investment modes like lump sum (or one time), systematic investment plans (SIP), systematic transfer plans (STP) and systematic withdrawal plans (SWP).
  • Disciplined investing: Mutual funds encourage investors to invest over a long period of time, which is essential to wealth creation. Furthermore, the advantages of mutual fund systematic investment plans or SIPs is that they encourage investors remain disciplined to meet their various financial goals. Many investors fail to build a substantial investment corpus because they are not able to invest in a disciplined way. Mutual fund SIPs help investors to maintain a disciplined approach to investment. SIPs also helps investor take emotions out of the investment process as very often investors get very enthusiastic in bull market conditions, but get nervous in bear markets. It is an established fact that investments made in bear markets help investors get high returns in the long term. By investing through SIPs in a mechanical way, investors can stay disciplined, which is one of the biggest benefits of investing in mutual funds.
  • Variety of investment objectives: One of the advantages of mutual fund investing is that you can meet various types of investment objectives like capital appreciation and income. Equity mutual funds can help you create wealth through capital appreciation, while debt mutual funds can generate income for you. Hybrid mutual funds can help you in both capital appreciation and wealth creation.
  • Liquidity: Open ended mutual funds are one of the most liquid investments after bank deposits and far more liquid than investments like, life insurance plans, infrastructure bonds, post office schemes etc. Investors can redeem their units in open ended funds usually on a T+3 (transaction + 3 days) basis. Liquid, overnight, low duration and ultra-short funds can usually be redeemed on T+1 day. Superior liquidity is one of the major advantages of mutual funds compared to some investment options like life insurance plans (which have policy surrender charges) and Government small savings schemes (which have fixed maturity periods).
  • Transparency: Transparency is another advantage of mutual funds for retail and HNI investors. Mutual fund schemes disclose their Net Asset Values (NAVs) at the end of each business day; so investors are aware of the market value of their mutual fund units on a daily basis. On a monthly basis, mutual funds publish Monthly Fund Factsheets where the portfolio holdings (securities in a scheme’s portfolio along with weights) are disclosed for each and every mutual fund scheme. Investors have the information where the fund managers have invested on a monthly basis. In addition to portfolio holdings, monthly fund factsheets have useful information like returns compared to the scheme benchmark, risk ratios etc.
  • Tax advantage: Tax advantages of mutual funds is one of biggest benefits of investing in mutual funds compared to many traditional fixed income investments. In equity funds, short term capital gains (held for less than 12 months) are taxed at 15% and long term capital gains (held for more than 12 months) are tax exempt up to Rs 1 lakh in a FY and taxed at 10% thereafter (excess of Rs 1 lakh of capital gains). In non-equity funds, short term capital gains (held for less than 36 months) are taxed at as per your income tax rate and long term capital gains (held for more than 36 months) are taxed at 20% after allowing indexation benefits. Interest income from most traditional fixed income investment is taxed as per the income tax rate of the investors. For investors in the higher tax brackets, tax advantages of mutual funds is significant compared to traditional fixed income investments.

Advantages of mutual fund lump sum investments

Lump sum is the traditional way of investing. In lump sum investing, you invest your entire amount in one go. The entire lump sum amount earns returns from the day the amount is invested till it is redeemed. Tactical lump sum investments also enable to take advantage deep market corrections. Over long investment tenures, the power of compounding is the maximum in lump sum. Lump sum investments are also preferred for short term investments, so that you can maximize your returns. This is one of the biggest benefits of mutual funds in India. Investments in Overnight, Liquid, Ultra-short Duration, Low Duration and Money Market funds are usually in lump sum.

Advantages of mutual fund SIPs

In SIP, you invest your savings in mutual funds at regular intervals e.g. monthly, fortnightly etc. When registering your SIP, you need to give a bank ECS mandate whereby a fixed amount will be auto-debited from your bank account at regular frequency (e.g. weekly, fortnightly, monthly etc.) specified by you and get invested in the scheme of your choice at prevailing NAVs. One of the advantages of mutual funds SIPs is that you can start early with small amounts from your regular savings and invest over long horizons; thereby benefitting from power of compounding. Another advantages of mutual funds SIPs is that you can take advantage of market volatility through Rupee Cost Averaging. Disciplined investing is also one of the benefits of mutual fund SIPs.

Advantages of mutual fund STPs

Another biggest advantages of mutual funds is Systematic Transfer Plan (STP). It is a mechanism by which an investor is able to transfer a fixed or variable amount from one mutual fund scheme to another mutual fund scheme. If you are investing for your long term financial goals and at the same time, are concerned about short term volatility in the market, you can invest your capital in a low risk debt or money market (e.g. liquid) mutual fund and use STP to withdraw fixed amounts from your debt / money market mutual fund and transfer to equity funds on a regular basis over several months. The benefit of mutual fund STP is that it lowers the impact of volatility. Benefit of mutual funds STP is that it enables to take advantage of market volatility through Rupee Cost Averaging.

Advantages of mutual fund SWPs

Systematic Withdrawal Plan (SWP) is a mutual funds facility using which you can draw fixed amounts from your mutual fund investment at regular intervals (e.g. monthly, any other interval as specified by the AMC). SWP works by redeeming the required number of units at prevailing NAVs to meet your SWP cash-flows. The SWP will continue as long you have sufficient unit balance to meet your cash-flows. One of the advantages of mutual funds SWP is that you get fixed cash-flows according to your needs from your mutual fund investment. The other benefits of investing in mutual funds SWP is that it is more tax efficient than other income options like dividends or interest.

What is the advantage of mutual fund growth option?

In growth option, profits made by the scheme are re-invested in the scheme instead of being paid out to investors. Since profits are re-invested in the scheme, you will earn profit of profit, thereby benefiting from the power of compounding. Thus, power of compounding is one the biggest advantages of mutual funds. If you investment objective is capital appreciation or wealth creation, you should invest in growth option.

What is the advantage of mutual fund IDCW option?

In dividend option, profits made by the mutual fund scheme are paid out investors at certain intervals. The most common dividend pay-out interval is annual. However, some schemes also offer other pay-out intervals e.g. daily, monthly, quarterly etc. If you want cash-flows from your mutual fund investment you can invest in IDCW option. However, you should know that mutual fund dividends or IDCW payments are not assured and are paid at the discretion of the fund manager or fund house.

Conclusion

Mutual funds have come a long way in India over the last 2 – 3 decades. Mutual funds are now among the most popular investment options for retail investors. In this article we discussed the benefits of investing in mutual funds. Mutual funds offer a wide spectrum of investment solutions for a most types of investment needs and risk profiles. Contact your financial advisor if you want to know more about benefits of mutual funds in India.

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