How Mutual Funds Work in India (in 3 Easy Steps)

Mutual funds have delivered better returns than all popular investments among Indians like Term deposit or fixed deposit, savings account, according to the Association of Mutual Funds in India (screenshot below).

mutual funds vs other investments

Mutual funds offer 1.4x average annual returns on 5-year investment and 2.2x average annual returns on 10-year investment as shown in the screenshot.

If you are also interested in mutual funds investment to grow your money but don’t know much about them, you have landed at the right place.

In this article, you would learn about –

  • What is a mutual fund
  • How mutual funds work
  • Types of mutual funds
  • How to invest in mutual funds
  • Important terminologies to understand

How Mutual Funds Work in India

#1. What is a Mutual Fund

The mutual fund is an investment class where you get a professional called a Fund Manager who helps you invest in the stock market through several plans if you don’t want to invest directly in stocks or if you don’t possess enough knowledge.

The fund manager works under an Asset Management Company (AMC) or a Mutual Fund House.  You have to pay some fee to the AMC for its professional services called the Expense Ratio.

Let’s take an example of an Uber car ride to understand mutual funds.

uber taxi

Suppose you have to travel from Delhi to Agra but you don’t know how to drive the car or you don’t want to drive yourself for some reason, you will book an Uber.

Uber will provide you a rental car with a driver (obviously) to reach Agra and charge you for the services.

Now if you correlate it with mutual funds, 

  • Uber is an AMC or Mutual Fund House, 
  • Car-driver is the fund manager who helps you reach your destination, 
  • The car model you selected (hatchback or sedan), is the type of mutual fund you want to invest in (equity, or debt funds), and
  • Destination Agra represents your investment goal.

You enjoy the car ride without any hassle of driving yourself and pay Uber for its services. Similarly, you invest in mutual funds to avoid the hassle of picking the right stock and pay some fee in return to the AMC.

#2. How a Mutual Fund Works

mutual fund

A Mutual Fund is a professionally managed investment type, where the savings from many investors are collectively invested as one. The collected money is called pooled money.  

The fund manager invests the pooled money by diversifying them into various instruments such as stocks, bonds, and government securities like treasury bills. 

Because your money is well-diversified among different instruments, that reduces the risk of money loss during market volatility.

All the Investors investing in a mutual fund have a common financial goal that decides the theme or objective of that mutual fund. 

For example, in an equity-based mutual fund, all the investor money will be invested primarily in stocks and a small portion will be invested in fixed return assets. 

The fund manager actively switches the pooled money between different stocks, asset classes for optimum returns on the investments.

You have to pay an annual fee (expense ratio) to AMC for the active participation of the fund manager throughout the year to manage your funds. 

#3. How to Invest in Mutual Funds

You have to buy units called NAV (Net Asset Value) while investing in mutual funds. Similar to stock price, NAV is the price of a particular mutual fund unit.

A. Two ways to invest in mutual funds

You can invest in mutual funds in two ways – Lump Sum and through SIP (Systematic Investment Plan).

In lumpsum investment, you invest a total amount in one go in your selected mutual fund and just wait-n-watch how the fund performs till maturity or till you withdraw the money.

While in SIP (Systematic Investment Plan), you invest a fixed amount of money in the selected mutual fund every month. 

Lumpsum investment offers higher annual returns if the market remains stable. But SIP offers rupee cost averaging and reduces risks during market volatility.

Because when the market falls, the average cost of a mutual fund NAV also reduces. This helps you to acquire more units of mutual funds through SIP than investing which is not possible in lumpsum investment.

B. Returns, dividends, and exit load

Investors either receive the whole amount (invested money plus profits earned) at the maturity of the mutual funds that could be 1 year, 3 years, or whatever is decided at the time of inception.

Or investors keep on receiving bonuses as dividends on the mutual funds and get invested money plus profits earned at the maturity depending on the fund. 

You have the option to choose whether you want to receive dividends periodically or get them reinvested to earn more profit and you will settle when the tenure ends.

If you terminate your mutual fund scheme in between you have to pay the exit load, which is a penalty fee that an investor pays if he quits the mutual fund before the maturity date.

C. Tax on mutual funds

Mutual fund investments attract 2 types of capital gains taxes –

  • Long-term capital gains (LTCG) – You have to pay 10% tax if you make capital gains (profits) above Rs. 1 lakh on a holding period as shown in the table below.
  • Short-term capital gains (STCG) –  You have to pay 15% STCG if the holding period is less than the prescribed tenue as mentioned in the table below.
Fund TypeShort-term capital gainsLong-term capital gains

Equity funds

Shorter than 12 months

12 months and longer

Debt funds

Shorter than 36 months

36 months and longer

Also read – How to select stocks for intraday trading

5 Types of Mutual Funds

mutual funds types

#1. Equity Funds

Equity funds are “High Risk – High Return” funds where above 60% of the pooled money is invested in stocks. Equity funds are highly risky as their price is directly linked to stock market volatility.

The rest of the money is invested in debt securities like debentures and bonds to diversify the risk to some extent.

If you have a long-term investment goal, then equity funds are the best option because on average an equity fund offers 15% to 18% annual return for a period of 5 years and above.

Major equity mutual funds are –

  • Large-cap funds – invest in stocks with the largest market capitalization
  • Mid-cap funds – invest in stocks of mid-size companies
  • Small-cap funds – companies with a market cap between 10 crore and 500 crores.
  • Sector-based funds – invest in stocks of a particular sector or industry like pharma funds

Benefits of equity-based mutual funds

  • Long-term investment in equity funds leads to wealth creation because of high return
  • Lesser risk of losing money as compared to direct investment in stocks
  • Lower expense ratio in mutual funds than high brokerage in stocks 

#2. Debt Funds

Debt Funds are the “Low Risk – Low Returns” funds where a major portion (above 65%) of your money is invested in debt securities like government bonds, corporate bonds, and treasury bills.

The debt securities offer lower but fixed returns and also reduces the risk of losing money. 

Only 35% or even a lesser portion is invested in equities for seeking some returns on the invested money, the risk of losing money is also limited to that portion of the investment only.

Debt funds are beneficial for the short-term investment of 2 to 3 years. You can opt for Debt funds against fixed deposits as they give you better returns than FDs. Debt funds offer 7% to 9% annual returns.

Debt mutual funds types are –

  • Liquid funds or Ultra short term funds – easy cashable funds with a tenure of 1 to 3 years
  • Gilt Funds – invests in government securities only

Benefits of equity-based mutual funds

  • Better returns than fixed deposits
  • Lesser risk of losing money as compared to stocks or equity funds
  • Some debt funds come with no exit load making them more cashable than other safer assets like FDs which attract penalties for premature withdrawal. 

#3. Hybrid Funds or Balanced Funds

Hybrid Fund or Balanced Fund is a blend of both equity and debt funds. In Hybrid funds, the money investment ratio is around 50:50 or 60:40 in equities and debt securities. 

If you don’t want to take much risk (as happens in equity funds) without compromising on returns, then hybrid mutual funds are an ideal fit.

Benefits of hybrid mutual funds

  • Balances risks and returns
  • Ideal for a short term period of 3 to 5 years
  • Higher liquidity 
  • Low expense ratio

#4. Index Funds

Index funds imitate the portfolio of the benchmark index and perform similarly. Index funds in India follow NIFTY and Sensex.

NIFTY 50 represents the top 50 stocks that represent the entire market. Similarly, Sensex 30 represents the top 30 performers on BSE. Index fund’s performance is highly dependent on the performance of these top stocks.

Unlike mutual funds, Index funds are passively managed because the fund manager invests money in those top stocks and leaves it to perform organically.

He doesn’t have to constantly monitor the fund performance and switch money to different stocks to increase returns. So index fund’s returns rely on how the market or the index performs, not on the fund manager’s abilities.

Less active involvement leads to a lower expense ratio (typically below 0.50%).

An example of index funds is the Nifty50 index fund that invests in top 50 stocks performing under Nifty50.

Benefits of Index funds

  • Broad diversification of money reduces the risk
  • Lower fee (expense ratio) as compared to other mutual funds
  • Long term returns are good as most indices perform better in the long run

#5. Tax-Saver or ELSS Funds

ELSS (Equity-linked Savings Scheme) fund is a special mutual fund type eligible for tax deductions under section 80C of the Income Tax Act of India. 

You can claim a tax rebate of up to Rs 1,50,000 a year in taxes by investing in ELSS funds.

In ELSS funds, a major part (above 65%) of your money is invested in stocks. You can’t withdraw ELSS funds like any other mutual funds anytime because the ELSS funds come with a lock-in period of three years.

But if you compare with other section 80C investments like provident fund, tax-saver FDs, or EPF, ELSS funds have the shortest lock-in period.

Benefits of ELSS funds

  • Wealth creation with tax benefits because the only tax-saving investment with inflation-beating returns
  • Tax rebate of up to Rs 1,50,000 a year u/s 80C
  • No upper limit in ELSS funds unlike other 80C investment schemes such as EPF

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Important Terminologies Used in Mutual Funds

  • AMC – Asset Management Company that manages mutual funds also called Mutual Fund House.
  • NAV – Net Asset Value which represents the price of a single mutual fund unit.
  • Expense ratio – The fee investor pays annually to a fund house for managing their funds.
  • Exit load – The penalty fee that you pay to AMC if you withdraw the mutual fund before the maturity date.
  • Index – An index is an instrument to track the collective performance of an asset group of assets (like stock exchanges) systematically. For example, NIFTY and Sensex in India.

Frequently Asked Questions

#1. Are mutual funds stored in a demat account?

Yes. When you buy mutual funds they are transferred to your demat account.

#2. Are mutual funds better than stocks?

Mutual funds are better than stocks if you don’t know the nitty-gritty details of stock fundamental analysis and understanding market trends.

However, you might get lower returns as compared to direct stock investment but as mutual funds diversify your money, so they become a safer investment option as compared to direct stock investment.

#3. Can mutual funds be redeemed online?

Yes. You can redeem mutual funds online through the AMC website or the broker’s platform like Zerodha or Upstox from which you have purchased the mutual fund units.

Closing Thoughts

I hope you have got a clear understanding of how mutual funds work. If you still have questions, do let me know in the comments section.

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