Readers' Corner: Mutual funds

Anuradha Rao
I am new to investing in mutual funds. Can you help me understand when investors should choose dividend option instead of growth in a mutual fund?

Mutual funds provide investors with two options, dividend and growth option.  Though they have different Net Asset Values (NAV), their investment objective, portfolio and investment style remain same. The reason for having two different options is to meet various requirements of the investors based on their goals. In case of equity mutual funds, it is advisable to invest in dividend option as the dividend received are tax-free and at the same time investor does not lose growth opportunity in these funds. Whereas in case of debt funds, there is a dividend distribution tax of 28.84 per cent, inclusive of surcharge and cess, which is payable by individual investors. The dividend credited to investor account is net of this charge. Therefore, in case of debt funds, it is advisable to invest in growth option from a short-term investment perspective.

When can an investor choose arbitrage fund over a debt fund? What should be the investment horizon in an arbitrage fund?

Arbitrage and debt funds belong to a different category of funds. Arbitrage funds work on the principle of taking hedged positions in equities and capitalising on mispricing between a stock and its futures price. Debt funds, on the other hand, earn returns by buying bonds that have different maturities in line with the investment objective of the funds, thereby accruing their coupons and benefitting from any capital gains or otherwise that may accrue on these.

Arbitrage funds enjoy the treatment of equity funds for the purpose of taxation. If you invest in growth option of the arbitrage fund, then the gains are tax-free if the holding period is more than one year. Otherwise, the gains are taxed as short-term capital gains at the rate of 15.45 per cent. Dividends declared by arbitrage funds are tax exempt. Debt funds, on the other hand, are subject to different tax treatment. For investments held for more than three years, all gains are taxed at 20 per cent post indexation as long-term capital gains. Short-term capital gains are added to the income of the investor and taxed accordingly. Dividends declared by these funds are subject to dividend distribution tax of 28.84 per cent.

Is the dividend reinvested in the equity-linked saving scheme (ELSS) also eligible for tax exemption next year onwards?

The Best Practices Circular issued by Association of Mutual Funds in India (AMFI) has directed mutual funds to discontinue dividend reinvestment option in ELSS.  It has two options growth and dividend and within the dividend option, there are two facilities available - dividend pay-out and dividend transfer.

I have seen index funds giving slightly more returns than their benchmarks. When a fund is expected to mirror a particular an index, how can it deliver higher returns?

An index fund is a type of mutual fund with a portfolio constructed to match or track the components of a well-known market index. It is a passive form of fund management and the primary advantage to such a strategy is no active management risk and it is generally at a lower expense ratio. In case of index funds, the mandate is not to beat the underlying benchmark but to track it as closely as possible. An index fund may deliver slightly higher returns than the underlying benchmark because of cash in the portfolio in case of a fall in the market, due to different revenue streams or during re-balancing of the portfolio.

My sister is in the UK. She wants to invest money in India. Can you tell me if non-resident Indians (who are citizens of other countries) and overseas citizens of India can invest in mutual fund? Are they allowed to invest directly? What is the process and documents she would need?

Mutual funds are an excellent way for a non-resident Indian (NRI) or a Person of Indian Origin (PIO) to participate in the growth of the country and reap benefits. They can invest in Indian mutual funds in Indian currency only through any one of these accounts with an Indian bank: Non-Resident External Rupee (NRE) account, Non-Resident Ordinary Rupee (NRO) account or Foreign Currency Non-Resident Account (FCNR). The investment can be made either on a repatriable or non-repatriable basis. It means that such investors should choose whether they want the income from mutual funds to be remitted back to their bank account in the country they are staying in, or if the amount should be remitted to an Indian bank account. While making first-time investments, investors need to be KYC compliant. Rest of the process and documents needed for making investments or transactions in mutual funds will remain same.

If I invest in a mutual fund in my son’s name, can I buy and sell on his behalf? What happens when he becomes a major?

When you open an account on behalf of a minor, the minor shall be the first and sole holder of the folio. While investing, you will have to submit documents supporting the date of birth of minor and relationship in case of natural guardian and in such cases, investments can be made through the guardian's account or the bank account of the minor. As a guardian, you can buy or sell mutual fund units on behalf of your son who is a minor until the age he attains major status. Once the child becomes major, the guardian cannot undertake any financial transactions When the minor investor reaches the age of maturity, minor needs to submit an application form along with required documents for changing the status in the Fund’s records from ‘minor’ to ‘major’.

Is it advisable to invest in a multi-cap fund instead of separately investing in large-cap and small- and mid-cap funds?

Large-cap funds invest in stocks of large, liquid blue-chip companies with stable performance and returns. Mid-cap funds invest in mid-cap companies that lie between large-caps and small-caps in terms of company size. Small-cap funds invest in companies with small market capitalisation with the intent of benefitting from the higher gains in the price of stocks. 

Whereas, multi-cap funds are funds that invest across market cap and sectors. They have the flexibility to adapt their portfolios according to the market cycle and are not restrictive to any specific segment of the market. As equity markets are cyclical, to capture each cycle and benefit from the fund manager’s expertise, it is advisable to invest in a diversified high-quality multi-cap fund.

Each mutual fund scheme has a different investment objective, fund philosophy and risk-reward profile. An investor should look at each fund separately based on his/her risk appetite investment horizon and associated goal. It is advisable to consult your financial advisor to determine the product suitability.

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