Three common myths about mutual funds among newbies

Last Updated on September 28, 2023 at 4:48 pm

This article aimed at new mutual fund investors discusses three common myths about mutual funds. Experienced investors may find this information quite basic, but please consider sharing this post with someone who may benefit from it.

The three myths are:

1. “I want my money back!” Nope! A mutual fund is not a bank FD to give back your principal!
2. “Mutual funds earn monthly interest”. No, they don’t.
3. “I just booked profits from a mutual fund”. No, you cannot redeem profits alone from a mutual fund!

But, first, some basics.

It is all about units!

When you invest in a mutual fund, you buy units at a particular market value after all expenses (including commissions) are deducted, known as the NAV (net asset value).

For example, if the current NAV is Rs. 929.329 per unit, and you invest Rs. Fifty lakhs (why think small? We are only thinking!), you will be allotted 50,00,000/929.329 = 5380.226 units.

The age of units when you request a redemption and their current market value that determines your actual gains (or losses).

(1) You will not get your money back!

When a debt fund got into trouble for holding a worthless bond (the issuer had no money to pay interest and even the principal), one investor said: “I want my money back!”

Sorry folks, you will not get your money back in mutual funds. You had purchased units from the mutual fund company at market value (except during the NFO period). When you redeem, you would like the AMC to buy back those units at the current market value. 

For example, if the current NAV of those 5380.226 units is 557, and you wish to redeem all the units, you will get a grand sum of 29.96 Lakhs. Assuming all units were free from an exit load.

The mutual fund may have an exit load structure as below:

1% if units are less than or equal to 365 days old

0% if units are more than 365 days old.

This means if you redeemed those ~5380 units before they are 365 days old, a 1% exit load would be deducted from 29.96 lakhs, and the rest will be given to you (cheque or via NEFT if you had opted for it).

If you have invested multiple times and want to redeem a big chunk, some units will qualify for exit load, and some will be free of it, depending on their age.

My point is: Think in terms of units and their age when investing in mutual funds. Not in terms of money.

(2) Mutual funds do not offer interest!

Fixed deposits offer interest. Bonds offer interest. Mutual funds offer a market-linked value. When the fund manager declares a dividend (now known as Income Distribution cum Capital Withdrawal), she sells some stocks or bonds in the market and distributes the money to unit holders “as a dividend”. Once such money is removed from the fund, the NAV will fall to that extent.

(3) You cannot separate principal and gains!

When you invest in an FD, you can tell the bank to credit the interest each year, each quarter or each month to your SB account. This is because there is a clear distinction between the amount invested and the income generated.

This is not true in a mutual fund. When you redeem, you buy units at their current market value, which has both the principal and gains bundled in.

For example, consider 5380 units purchased at a NAV of 929.329. The current NAV is 1000, and I wish to redeem 1 L.

This means 100000/1000 = 100 units will have to be withdrawn.

Or 100 units x 1000 NAV = 1L.

We purchase those 100 units at a NAV of 929.329 or the purchase value  or the principal = 100 x 929.329 = Rs. 92,932.90

The 1 Lakh we have redeemed now has this Rs. 92,932.90. The remaining ~ 7,067 is the capital gain.

Notice that you cannot separate the principal and the capital gain (or loss) when you redeem.

As noted above, the age of those 100 units matters for exit load.

The type of fund and age of the units matter for taxation.

If the fund has held at least 65% of Indian stocks on average in the last 12 months, the taxman shall consider it an equity fund. The gains (if any) from more than 365 days old units are known as long-term capital gains. If above Rs. one lakh, these are taxed at 10% with applicable cess and surcharge. If the unit’s age is 365 days or lower, a short-term capital gains tax of 15% + applicable cess and surcharge will apply.

If the fund has held more than 35% of Indian stocks but less than 65% on average in the last 12 months:  if the unit age is more than 1095 days  (3 years), then a capital gains tax of 20% +cess will apply  (gain computed after inflating purchase price to current “value”). If units are less than or equal to 1095 days old, the capital gain will be added to income and taxed as per slab.

If the fund has held less than or equal to  35% of Indian stocks on average in the last 12 months, then the gains are taxed as per slab.

First in, First Out

Suppose you have SIP going.

In the 1st month, you purchase ten units at a NAV of 12

In the 2nd month, you purchase 12 units at a NAV of 10 (is this possible?)

and so on.

Now after 370 days from the date of 1st purchase, you wish to redeem Rs. 180. The current NAV is 15.

So 180/15 = 12 units.

Now 12 units will be redeemed. The question is, which 12? The First-in, first-out rule will apply for both exit load and taxation.

Of these 12 units, ten will be from the first purchase.

These ten units have an age of 370 days. So they will be free of exit load (if that is the rule for the fund) and taxed as long term capital gains (if it is an equity fund).

The remaining two units will be from the second purchase. These are only 340 days old. So an exit load will apply to them, and if the fund is an equity fund, it will be taxed as short-term capital gains.

In summary, never forget that mutual funds are market-linked instruments. They do not offer any interest. Always view purchases and redemptions in terms of units. Also, remember returns are not guaranteed. See: Do not expect returns from mutual fund SIPs! Do this instead!