Concept and role of a mutual fund
How pooling, units and NAV work, the scheme types and SEBI categories, growth versus IDCW, and the honest pros…
Everything a distributor sells is built on one idea: many investors pool money, a professional invests it, and each investor owns a proportionate slice measured in units. The exam tests whether you can explain that slice, the different kinds of schemes, and what the SEBI categories actually require. This chapter carries a heavy question load, including small NAV and unit calculations.
Pooling, units, NAV and AUM
A mutual fund collects money from investors with a common objective, invests it according to a stated mandate, and shares the gains and losses in proportion to each investor's holding. Each investor is a unitholder. The size of their holding is measured in units, and the value of one unit is the net asset value (NAV).
The total market value of a scheme's investments is its assets under management (AUM). AUM changes for two reasons: the prices of the holdings move, and investors buy or redeem units. NAV changes only for the first reason. New money at today's NAV creates new units; it does not change the NAV for existing holders.
| Amount invested | ₹1,00,000 |
| Stamp duty at 0.005% | ₹5 |
| Net amount for allotment | ₹99,995 |
| Applicable NAV | ₹25.00 |
| Units allotted (99,995 ÷ 25) | 3,999.80 |
Units are allotted to three decimal places, so fractional units are normal. A scheme with ₹500 crore of assets, ₹2.5 crore of liabilities and 24.875 crore units has a NAV of ₹20.00.
Open-ended, close-ended and interval schemes
An open-ended scheme sells and repurchases units at NAV on every business day after the new fund offer. Its unit capital expands and contracts with investor flows. There is no fixed maturity.
A close-ended scheme raises money once, during the NFO, for a fixed tenure. After that the fund does not sell or buy units. To give investors an exit, SEBI requires close-ended schemes to be listed on a stock exchange, where units trade at whatever price buyers and sellers agree, which may be a discount or premium to NAV. At maturity the scheme redeems at NAV.
An interval scheme is a hybrid: it is close-ended most of the time but opens for purchases and redemptions during specified transaction periods (at least 2 days, with at least 15 days between periods). Interval schemes must also be listed.
Active, passive and the SEBI categories
An actively managed scheme has a fund manager choosing securities to beat a benchmark. A passive scheme (index fund or ETF) simply copies an index and aims to match it at low cost. ETFs are listed and bought through a demat account; index funds are bought from the fund house like any open-ended scheme.
SEBI's 2017 categorisation circular limits each fund house to one scheme per category (with exceptions for index funds, ETFs, fund of funds and sectoral or thematic funds). The five groups and the rules the exam asks about:
Equity schemes (11 categories)
- Large cap: at least 80% in the top 100 companies by market capitalisation. Mid cap: at least 65% in companies ranked 101 to 250. Small cap: at least 65% in companies ranked 251 onwards. AMFI publishes the ranking every six months.
- Large and mid cap: at least 35% each in large and mid caps.
- Multi cap: at least 25% each in large, mid and small caps (75% minimum in equity). Flexi cap: at least 65% in equity, any market cap, at the manager's discretion.
- Dividend yield, value or contra (a fund house may offer only one of value and contra), focused (maximum 30 stocks), sectoral or thematic (at least 80% in the sector or theme).
- ELSS: at least 80% in equity, 3-year lock-in, tax deduction under Section 123 (old Section 80C) in the old regime.
Debt schemes (16 categories)
Mostly defined by portfolio duration or credit quality. Overnight (1-day maturity), liquid (up to 91 days), ultra short (Macaulay duration 3 to 6 months), low duration (6 to 12 months), money market (up to 1 year), short (1 to 3 years), medium (3 to 4 years), medium to long (4 to 7 years), long duration (above 7 years), dynamic bond (any duration), corporate bond (at least 80% in AA+ and above), credit risk (at least 65% in AA and below), banking and PSU (at least 80% in those issuers), gilt (at least 80% in government securities), gilt with 10-year constant duration, and floater (at least 65% in floating rate instruments).
Hybrid schemes (7 categories)
Conservative hybrid (10 to 25% equity), balanced hybrid (40 to 60% equity, no arbitrage), aggressive hybrid (65 to 80% equity), dynamic asset allocation or balanced advantage (moves freely), multi asset (at least 3 asset classes with at least 10% each), arbitrage (at least 65% equity, hedged), and equity savings (at least 65% equity and 10% debt, partly hedged).
Solution-oriented and other schemes
Retirement and children's funds carry a lock-in of 5 years or until retirement age or majority, whichever is earlier. Index funds and ETFs must hold at least 95% in the index securities; fund of funds must hold at least 95% in the underlying funds.
Growth, IDCW and plans
Within a scheme, the investor picks an option. In the growth option profits stay in the scheme and the NAV compounds. In the IDCW option (income distribution cum capital withdrawal, the regulator's name for dividend), the scheme pays out part of its distributable surplus, and the NAV falls by the amount paid. An IDCW of ₹2 on a NAV of ₹15 leaves an ex-IDCW NAV of ₹13. IDCW can be paid out or reinvested as fresh units. The investor's wealth is the same immediately before and after; IDCW is not extra return, it is the investor's own money handed back, and it is taxed at slab rates.
Separately, every scheme offers two plans: the regular plan, whose expense ratio includes distributor commission, and the direct plan, which excludes it and so has a lower expense ratio and a higher NAV. Same portfolio, same manager, different cost.
What mutual funds do well, and what they do not
The advantages the exam expects: professional management, diversification even for small amounts, liquidity at NAV for open-ended schemes, low transaction costs through scale, tax efficiency compared with holding bonds directly, transparency (daily NAV, monthly portfolios), tight regulation by SEBI, and convenience through SIP, STP and SWP. Systematic investing also brings rupee cost averaging.
The limitations: the investor has no say in individual stock choices, the portfolio is not customised to one person, costs are charged whether the scheme performs or not, and too many schemes in one portfolio dilutes the benefit of diversification. For an investor who wants a bespoke portfolio there is PMS, with its ₹50 lakh minimum; mutual funds are the mass-market product.
Remember
- NAV = (assets − liabilities) ÷ units; fresh inflows create units and change AUM but not NAV.
- Open-ended schemes transact at NAV daily; close-ended units trade on the exchange at market price and redeem at NAV only on maturity.
- Large cap = top 100 companies, mid cap = 101 to 250, small cap = 251 onwards; multi cap needs 25% each, flexi cap needs 65% equity anywhere.
- Equity-oriented hybrids: aggressive 65 to 80% equity, conservative 10 to 25%, arbitrage and equity savings at least 65%.
- IDCW reduces NAV by the amount paid; it is the investor's own money, taxed at slab, not an extra return.
- Direct plan excludes distributor commission, so its TER is lower and NAV higher than the regular plan's.