Understanding mutual funds and Equity Linked Savings Schemes

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In the previous chapter, you saw that insurance, in its various forms, helps you enjoy a protective cover over the things that you value. Like your life, your house and your assets. But looking beyond that, at the end of the day, a major part of personal finance focuses on learning about how you can use your money to create wealth, isn’t it? And here’s where a different kind of investment comes into the picture - mutual funds.

Understanding mutual funds needs to feature quite high on your list of learning about the various lucrative investment options available in India. And in this chapter, we’ll focus on some key aspects of understanding mutual funds and answer central questions like these.

  • What are mutual funds?
  • What is the net asset value?
  • What are the different types of mutual funds?

These are only some of the things we’ll be looking at in this chapter. Come, let’s begin at the basics.

What are mutual funds?

A mutual fund is a kind of investment where the funds from many investors are pooled together to form a common pool of money. The investors, in this regard, can be individuals, companies and other entities. This collective amount of capital that they’ve contributed is then invested in a variety of assets, depending on the kind of mutual fund and its investment objective.

But what happens after your funds have been invested like this? Since the common pool of funds was invested, how much of that share is yours? Here’s where the concept of net asset value (NAV) comes in.

What is net asset value?

Getting to know what the net asset value of a fund means is one of the fundamental concepts with regard to understanding mutual funds

Just like how the capital of a company, which essentially represents the ownership of the company, is divided into shares, the ownership in a mutual fund is also divided into units. And again, just like how shares have their own value, each unit of a mutual fund also does. This is what the net asset value helps you understand and assess.

You can use the NAV of a fund to determine whether or not you’ve made good returns on your investment. But first, how is the NAV calculated? Isn’t that important if you want to go about understanding mutual funds? Well, you’re right. So, let’s see how the NAV is computed.

Mutual funds have a variety of securities in their portfolio, isn’t it? These securities are basically the assets that a fund invests in. And to manage a fund, there are many professionals and staff members needed. The salaries paid to them, together with the other operational and management expenses of the fund, make up the fund’s liabilities. These two parameters – the assets and the liabilities of a mutual fund – are key when it comes to calculating the NAV.

Here’s the formula.

Net Asset Value of the fund = Value of assets – Value of liabilities 

NAV can also be calculated on a per unit basis. In that case, the formula becomes this. 

NAV of each unit in the fund = NAV of the fund ÷ The total number of units outstanding

Let’s look at an example to understand NAV better. Say a mutual fund has the following characteristics.

  • Value of assets in the portfolio: Rs. 50 lakhs
  • Cash and cash equivalents: Rs. 15 lakhs
  • Short-term liabilities: Rs. 1 lakh
  • Long-term liabilities: Rs. 14 lakhs
  • Number of units outstanding: 5 lakh units

In this case, the net asset value of the fund would be (in rupees):

= (50,00,000 + 15,00,000) - (1,00,000 + 14,00,000)

= 65,00,000 - 15,00,000

= Rs. 50,00,000

And the net asset value of each unit would be:

= Rs. 50,00,000 ÷ 5,00,000 units

= Rs. 10 per unit

Now, if you invest in this mutual fund when the NAV is Rs. 10 per unit, you’ll be allotted units accordingly. The NAV is calculated each day, based on specific rules. 

What are the different types of mutual funds?

Now, you know the answers to two important questions:

  • What are mutual funds?
  • What is NAV?

But you’re probably wondering about the types of mutual funds, aren’t you? Well, that’s quite a broad subject, since mutual funds can be divided into different categories based on multiple parameters. You’ll see more of this below.

Based on the nature of the principal investment

As we saw a little earlier in this chapter, mutual funds invest the pool of funds in a variety of assets. Based on the nature of the primary asset that a fund invests in, it can be any one of three types.

  • Equity funds, which invest primarily in the equity markets
  • Debt funds, which invest primarily in debt and money market instruments
  • Hybrid funds, which invest in a balanced mix of equity and debt assets

Based on the maturity period

Say you’ve invested in a mutual fund. Are you free to cash in on your investment at any point? Or is there any set period that needs to lapse before you can sell your investment and take home those returns? Well, that depends on what kind of fund you’re looking at.

  • Open-ended schemes, where you can buy or sell units at any point in time, making them very liquid
  • Close-ended schemes, where there is a predetermined maturity period and where you can only invest during the initial launch period, which is called the New Fund Offer (NFO)

Can mutual funds help you save tax?

Capital appreciation and wealth creation and all are essential, no doubt. But you ask the average individual what their concern is when tax season comes around, and the unanimous answer will be - How do I reduce my tax liability? So, how do mutual funds add up on this front? Can they help you save tax?

Well, the average mutual fund cannot. But there’s a special kind of mutual fund that serves this dual purpose - saving tax and creating wealth. This is known as the Equity Linked Savings Scheme (ELSS).

What is ELSS?

So, this is probably the first question in your head now - what is ELSS? Let’s get to know these funds. ELSS funds are essentially equity funds where a major portion of the investor funds is invested in equity and equity-related instruments. Isn’t that the same as the regular equity fund? Well, not quite. The primary asset may be the same, but the similarities end there. 

ELSS goes much further than the regular equity fund and offers investors a much-needed tax break. It’s also got some very distinct features, as we’ve explained in the next segment. 

What are the features of ELSS?

  • Being primarily equity-oriented, generally, around 80% of the total corpus in an ELSS is invested in equity and equity-related instruments.
  • Within the equity segment, there’s a lot of diversification that occurs, so the asset portfolio includes equity from small-cap, mid-cap and large-cap variations as well as equity from companies belonging to different sectors. 
  • ELSS mutual funds have a lock-in period of 3 years. 
  • You can either invest a lump sum amount in ELSS, or you can invest small amounts periodically by adopting a Systematic Investment Plan (SIP).

How does ELSS help you save tax?

Under section 80C of the Income Tax Act, the amount that you invest in ELSS during a financial year can be claimed as a deduction from your annual taxable income, up to Rs. 1,50,000. So, say you invest Rs. 50,000 in ELSS this year. And say your taxable income before deductions comes up to Rs. 2,90,000. 

By employing 80C deduction for your ELSS investment, your taxable income comes down to Rs. 2,40,000 (Rs. 2,90,000 - Rs. 50,000). And at this level, you need not pay tax at all, since it’s below the basic exemption limit.

At this point, it’s important to note that at the time of maturity, any amount above Rs. 1 lakh that you earn from your ELSS investment is taxed as long-term capital gain (LTCG), at 10%.

Wrapping up

Okay then, this sort of wraps up the primer on personal finance. But before we wind up altogether, we’ll leave you with some general pointers to keep in mind when you’re planning your finances. No, no. Not right here. To get to know these pointers, head to the next chapter in Smart Money.

A quick recap

  • A mutual fund is a kind of investment where the funds from many investors are pooled together to form a common pool of money.
  • This collective amount of capital that they’ve contributed is then invested in a variety of assets.
  • Net Asset Value of a mutual fund = Value of assets – Value of liabilities 
  • NAV of each unit in the fund = NAV of the fund ÷ The total number of units outstanding
  • Based on the nature of the primary asset that a fund invests in, it can be an equity fund, a debt fund, or a hybrid fund.
  • Based on the maturity period of a fund, it can be open-ended or close-ended.
  • ELSS funds are equity funds where a major portion of the investor funds is invested in equity and equity-related instruments. Additionally, these funds help you save tax.
  • ELSS has a lock-in period of 3 years.
  • Under section 80C of the Income Tax Act, the amount that you invest in ELSS during a financial year can be claimed as a deduction from your annual taxable income, up to Rs. 1,50,000. 
  • At the time of maturity, any amount above Rs. 1 lakh that you earn from your ELSS investment is taxed as long-term capital gain (LTCG), at 10%.
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