Mutual Fund 101: How Mutual Funds Work, Types, Risks, Costs, and Key Concepts
Disclaimer: Mutual Fund investments are subject to market risks, please read all scheme related documents carefully.
This article is for general information/education and is not investment advice. The information is shared in good faith and for general informational purposes only. Ujjivan SFB does not make any representations or warranties regarding the accuracy, completeness, or reliability of the content.
Mutual Fund Distributor: Ujjivan Small Finance Bank Ltd
ARN: 175676
January 29, 2026
Investing often feels complex when you’re starting out. Terms like NAV, equity, market risk, or portfolio can make investing seem intimidating or inaccessible. However, mutual funds were designed to simplify investing by offering a structured, regulated way to participate in financial markets without tracking individual securities daily.
In India, mutual funds have become a widely used investment vehicle for potential long-term wealth creation, goal-based savings, and retirement planning. Many investors begin with relatively small amounts using systematic investment methods. Understanding how mutual funds work, how they are classified, and what risks they carry is essential before investing.
This guide explains mutual funds in clear, simple language and brings together all key concepts, classifications, costs, risks, and commonly used terms in one place.
What is a Mutual Fund?
A mutual fund is an investment vehicle that pools money from multiple investors and invests it in a portfolio of securities according to a clearly stated investment objective.
When an investor invests in a mutual fund scheme, they are allotted units, which represent their proportionate ownership in the scheme. The value of each unit is known as the Net Asset Value (NAV) and changes based on the value of the underlying investments held by the scheme.
Types of Mutual Funds
In India, mutual funds are classified based on asset class, investment strategy, market exposure, and investment objective, in line with the categorisation framework prescribed by Securities and Exchange Board of India (SEBI). Understanding these classifications may help you how a scheme may behave across different market conditions.
1. Equity Mutual Funds
Equity mutual funds primarily invest in shares and equity-related instruments of listed companies. These funds aim to generate capital appreciation over the long term and are closely linked to stock market performance. Because equity prices can fluctuate significantly, equity funds tend to carry higher volatility, especially in the short term.
Equity Funds Based on Market Capitalisation
Equity Funds Based on Investment Style
Tax-Saving Mutual Fund (ELSS Fund)
An Equity Linked Savings Scheme (ELSS) is a category of equity mutual fund that offers tax benefits up to ₹1.5 lakh under Section 80C of the Income Tax Act, 1961. ELSS funds primarily invest in equity and equity-related instruments and come with a mandatory lock-in period of three years, which is the shortest lock-in among tax-saving investment options under Section 80C.
2. Debt Mutual Funds
Debt mutual funds invest in fixed-income instruments such as government securities, corporate bonds, treasury bills, and money market instruments. These funds aim to generate returns primarily through interest income and changes in bond prices.
Debt funds are exposed to:
Common Debt Fund Categories
3. Hybrid Mutual Funds
Hybrid funds invest in a combination of equity and debt instruments, with allocation varying based on the scheme’s strategy. The equity component influences growth potential and volatility, while the debt component may help reduce fluctuations.
Diversification across asset classes does not eliminate losses, especially during broad market downturns.
4. Passive Mutual Funds
Passive funds aim to replicate the performance of a market index rather than outperform it. In case of passive funds, there’s no active involvement of a fund manager pertaining to buying and selling of stocks, thereby mitigating human bias in investing.
Passive funds typically have lower expense ratios but are subject to market risk and tracking error.
5. Fund of Funds (FoF)
Fund of Funds invest in other mutual fund schemes instead of directly investing in securities. These may include domestic FoFs or international FoFs that provide exposure to overseas markets. Investors should note that FoFs involve an additional layer of expenses and are affected by the performance of underlying funds.
6. Solution-Oriented Mutual Funds
Solution-oriented funds are designed for specific long-term goals such as retirement or children’s education. These funds usually come with mandatory lock-in periods and predefined objectives. While they offer structure, they remain market-linked and subject to risk.
What is a Fund Manager?
A fund manager is a professional responsible for managing a mutual fund scheme in line with its stated investment objective and strategy. The fund manager makes decisions on what securities to buy, hold, or sell within the limits defined in the scheme’s documents, such as the Scheme Information Document (SID).
The role of a fund manager includes analysing market conditions, evaluating companies or debt issuers, monitoring portfolio risks, and ensuring that the scheme remains compliant with regulatory guidelines prescribed by Securities and Exchange Board of India (SEBI). Fund managers typically work with a broader investment team that may include research analysts, risk managers, and compliance professionals.
It is important to note that while fund managers use research, experience, and defined processes to make investment decisions, their involvement does not guarantee positive returns or protection from losses. Mutual fund outcomes remain market-linked and depend on factors such as economic conditions, market movements, interest rates, and issuer-specific risks.
What Are Active Funds?
Active funds are mutual fund schemes where the fund manager actively selects and manages investments with the objective of achieving outcomes that differ from, or potentially outperform, a chosen benchmark index. In active funds, decisions such as stock selection, sector allocation, timing of entry and exit, and portfolio rebalancing are made based on research, analysis, and the fund’s stated strategy.
Active funds are available across equity, debt, and hybrid categories. Investors should understand that active management aims to manage risk and seek better relative outcomes, but it does not assure returns and remains subject to market risks.
Mutual Fund Jargon Every Investor Should Know
Mutual fund documents and platforms use standard terminology that helps investors understand structure, costs, risks, and operations. Familiarity with these terms is essential for informed decision-making.
How Do Mutual Funds Work?
Mutual funds operate through a structured process that is broadly consistent across categories:
1. A Scheme Follows a Defined Mandate
Each scheme follows an investment objective and strategy disclosed in its documents. This mandate influences what the scheme can invest in, how diversified it is, and the type of risk it may carry.
2. NAV Reflects Portfolio Value
NAV generally moves up or down based on changes in the market value of the portfolio (for equity holdings) and changes in interest rates, credit quality, or valuations (for debt holdings). NAV is not a “fixed rate” or “assured return” figure.
3. Returns, if Any, Come from Portfolio Performance
Depending on the category, portfolio outcomes can come from price movements, interest income, and other distributable earnings. Outcomes can vary materially across market phases.
4. Transactions are Unit-Based
When an investment is made, units are allotted as per applicable NAV. When redeemed, units are removed and the value is calculated using the applicable NAV, subject to scheme rules like exit loads where relevant.
Potential Benefits and Risks of Mutual Funds
| Aspect | Potential Benefit | Associated Risk |
| Diversification | Exposure to multiple securities | Does not prevent market-wide losses |
| Professional Management | Structured decision-making | No assurance of performance |
| Accessibility | Convenient investment structure | Convenience does not reduce risk |
| Liquidity | Regular purchase and redemption | Exit loads and market conditions apply |
| Transparency | Mandatory disclosures | Requires investor understanding |
SIP, Lump Sum, and STP: Methods of Investing
SIP, lump sum, and STP are methods of investing, not types of mutual funds.
What Costs and Charges May Apply in Mutual Funds?
Costs matter because they reduce scheme returns over time. Key cost items include:
1. Expense Ratio
This is charged within the scheme and reflected in NAV. Lower cost does not automatically mean better outcomes, but cost is a measurable factor.
2. Exit Load
Some schemes charge an exit load if units are redeemed before a stated period. The exact rule is scheme-specific.
3. Transaction and Platform-Related Charges
Depending on the platform or intermediary used, there may be additional transaction-related charges. This varies by service provider.
How Can Mutual Funds Be Evaluated Using Objective Parameters?
Mutual funds are often compared using objective and disclosed parameters. No single metric is sufficient, so the evaluation is usually multi-factor.
Beginner Checklist Before Investing in Mutual Funds
Before investing in any mutual fund scheme, first-time investors should review a few essential points to ensure they understand what they are investing in and the risks involved.
Common Mistakes to Avoid When Investing in Mutual Funds
Are Mutual Funds Taxable?
Capital gains from mutual funds are classified as short-term or long-term depending on the type of fund and the holding period. The classification determines how gains are taxed.
Capital Gains Classification Table
| Fund Type | Short-Term Capital Gains (STCG) | Long-Term Capital Gains (LTCG) |
| Equity Mutual Funds | Up to 12 months | More than 12 months |
| Debt Mutual Funds (Purchased on or after 01 April 2023) | Always treated as short-term | Not applicable |
| Hybrid Equity-Oriented Funds | Up to 12 months | More than 12 months |
| Hybrid Debt-Oriented Funds (Purchased on or after 01 April 2023) | Always treated as short-term | Not applicable |
Tax Rates for Mutual Funds – Before and After 31 March 2023
Taxation differs based on purchase date, equity exposure, and holding period.
Detailed Capital Gains Tax Table
| Fund Category | Holding Period | Tax Rates (Purchased Before 31 March 2023) | Tax Rates (Purchased After 31 March 2023) |
| STCG | LTCG | ||
Equity Mutual Funds Arbitrage Funds Other Equity-Oriented Funds | 12 months | 20% | 12.5% |
| Aggressive Hybrid Funds | 12 months | 20% | 12.5% |
| Debt Mutual Funds | 24 months | Slab rate | 12.5% |
| Floater Funds | 24 months | Slab rate | 12.5% |
| Conservative Hybrid Funds | 24 months | Slab rate | 12.5% |
| Other Funds | 24 months | Slab rate | 12.5% |
| Balanced Hybrid Funds | 24 months | Slab rate | 12.5% |
| Other Hybrid Funds | 24 months | Slab rate | 12.5% |
Important Taxation Notes (As Applicable)
Final Thoughts
Mutual funds are market-linked investment products where outcomes depend on the underlying portfolio, market conditions, costs, and the scheme’s stated mandate. For first-time investors, the most relevant starting points are typically the basics that can be verified from scheme documents and disclosures—such as the fund category, investment objective, key risks, expense ratio, exit load, and portfolio disclosures—along with a clear understanding of how NAV and units work.
Disclaimer:
The contents herein are only for informational purposes and generic in nature. The content does not amount to an offer, invitation or solicitation of any kind to buy or sell, and are not intended to create any legal rights or obligations. This information is subject to updation, completion, amendment and verification without notice. The contents herein are also subject to other product-specific terms and conditions, as well as any applicable third-party terms and conditions, for which Ujjivan Small Finance Bank assumes no responsibility or liability.
Nothing contained herein is intended to constitute financial, investment, legal, tax, or any other professional advice or opinion. Please obtain professional advice before making investment or any other decisions. Any investment decisions that may be made by the you shall be at your own sole discretion, independent analysis and evaluation of the risks involved. The use of any information set out in this document is entirely at the user’s own risk. Ujjivan Small Finance Bank Limited makes no representation or warranty, express or implied, as to the accuracy and completeness for any information herein. The Bank disclaims any and all liability for any loss or damage (direct, indirect, consequential, or otherwise) incurred by you due to use of or due to investment, product application decisions made by you on the basis of the contents herein. While the information is prepared in good faith from sources deemed reliable (including public sources), the Bank disclaims any liability with respect to accuracy of information or any error or omission or any loss or damage incurred by anyone in reliance on the contents herein, in any manner whatsoever.
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