Basics of Mutual Funds
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Basics of Mutual Funds
India has one of the
highest Gross Domestic Savings rates at 28% of GDP but one of the lowest mutual
fund (MF) penetration levels at only 6% of GDP.
Moreover, there are
over 50,000 savings bank accounts per lakh of the population as against just
3,800 mutual fund portfolios. A Pricewaterhouse Coopers study found that
inadequate financial knowledge & awareness among the retail investors as one
of the reasons for this phenomenon.
As an investor
education initiative, this article provides an in-depth understanding of
financial jargons to the investor community to make their investment journey
smooth.
Mutual Fund (MF) is an
investment scheme wherein the Asset Management Company pools in money from a
group of investors and makes investments in various assets. Each scheme
allocates money in underlying asset classes like stocks, bonds, and other
securities in a particular ratio. When you invest in a scheme, you get a
specific number of units. The value of unit keeps fluctuating according to the
performance of the underlying asset.
Let me take you through some important Terms used in Mutual
Funds:
1. Net Asset Value (NAV)
NAV is the market
value of assets underlying a particular Mutual Fund (MF) scheme. The NAV of the
units changes daily or weekly on account of fluctuation in the value of the
underlying assets.
NAV of one unit = Fund Assets – Fund Liabilities
Number of outstanding shares
Number of outstanding shares
Suppose Market Value
of fund’s assets is Rs. 100 lakh & the fund has issued 10 lakh units of Rs
10 each then NAV of each unit is Rs. 10
2. Offer price
It is the price which
you pay to the asset management company when you buy units under a Mutual Fund
(MF) scheme.
3. Repurchase price
This is the price at
which you sell the units of the scheme to the asset management company. At
times it may be inclusive of exit load.
4. Front-end/entry load
It is the fee charged
by the Mutual Fund (MF) scheme when you buy units of the scheme. Schemes that
do not levy front-end load are called “no load” schemes. The loads reduce
the amount invested towards buying units. From August 2009, SEBI removed all
entry loads on mutual fund schemes.
5. Back-end/repurchase load
It is the fee charged
by the Mutual Fund (MF) scheme when you sell units of the scheme. It is levied
to dissuade investors from exiting the scheme.
Features of Mutual Funds
1. Professional Management
Qualified professionals
known as Fund Managers use your money towards building a portfolio. The
portfolio consists of various asset classes i.e. equity, bonds or other
securities. They select the securities based on quantitative & qualitative
analysis & also regularly monitor the portfolio to ensure that you get the
desired returns.
2. Fund Ownership
Unlike investing in
stocks directly, here you get units of the Mutual Fund (MF) instead of
individual securities. You may start an investment with a small amount but
benefit from being a contributor towards a large pool of money. You share the
fund’s profits & losses in proportion to your investment in the fund.
3. Diversification
Diversification
involves the creation of a portfolio which consists of securities of
uncorrelated nature to minimise the overall risk significantly. The
diversification prevents you from losing money by balancing out downs in one
asset with the ups in another asset.
4. Objective
The objective of the
fund determines rationale of investment & composition of the portfolio. The
objective may be long-term wealth maximisation, steady returns or regular
income. The risk-return profile of the portfolio would vary by its objectives.
Thus, you as an investor need to make sure that objective of the scheme is in
line with your requirements.
Types of Mutual Funds
You need to understand
that each Mutual Fund (MF) offers different risks & rewards. The basic
thumb rule says that higher returns attract greater risk of loss & vice
versa. The volatility of return assesses the risk inherent in a fund. Usually,
some funds have lower risk component than others.
Following categories
of Mutual Funds are available in India:
I. Based on Maturity Period
i. Open-Ended Funds
You can enter & exit
these schemes at any time of the year because these don’t have fixed maturity
dates. The scheme declares Net Asset Value (NAV) on a daily basis. These
schemes are highly liquid as these allow you to buy & sell units at the
prevailing NAV as per your convenience.
ii. Close-Ended Funds
This scheme remains
open for subscription only for a fixed period. You can buy units of this scheme
at the time of New Fund Offer (NFO) i.e. when it launches for the first time
for the subscription. Afterwards, you can buy/sell units of the scheme on the
stock exchange. The company provides repurchase option for those schemes which
are not listed on the stock exchange. Repurchase implies buy back of units by
the fund house from the investor at the current NAV. The NAV in these schemes
is declared on a weekly basis.
II. Based on Investment Objectives
i. Equity Funds
This fund is relevant
if you enjoy risk-taking & have an investment horizon of more than five
years. This fund enables wealth creation via appreciation of capital through a
majority investment in equity. While applying for the scheme, you may choose
from different investment options like dividend option, growth option, etc. You
are allowed to change your option while you remain invested. Go for such
schemes only if you can stay invested for a long term, as ad-hoc exits could
result in loss of principal as well.
Equity Fund has
following four categories:
a. Index Funds
These funds imitate
the investment mechanism of popular indices like Nifty, BSE Sensitive Index, etc.
These funds invest in the asset classes in the same proportion as is done by
the index. Consequently, the NAVs of these funds follow the price movements of
securities listed on the index.
b. Sector-specific Funds
Here, investment is
made in one of the sectors like IT, infrastructure, pharmaceuticals, FMCG,
petroleum, etc. as mentioned in the offer document. The returns fluctuate in
response to changes in the particular sector. These funds provide comparatively
higher returns but at the same time are exposed to sector-specific risks. You
should continuously monitor the performance of the industry & redeem your
investment at the opportune time.
c. Tax-Saving Funds
These are also called
Equity Linked Savings Scheme (ELSS) used to save taxes along with capital
appreciation. These funds offer the shortest lock-in period of 3 years, and the
portfolio diversifies into equities of small, mid & large caps as per fund
structure. Before investing, do check the composition of securities in the
portfolio in addition to other analytics.
d. Diversified Funds
Instead of sticking to
a particular sector/company, these funds invest in a variety of sectors like
the small, mid & large cap. The large caps provide a stable foundation for
the portfolio while mid & small caps ensure a higher rate of return.
ii. Debt Funds
If regular income and
steady returns on investment top your priority chart, then go for debt funds.
These funds are lesser risky than equity funds as these extensively invest in
fixed-income securities of the varied investment horizon. The NAV of these funds
tends to fluctuate in response to changes in the interest rates.
Debt Fund has
following five categories:
a. Liquid/Money Market Funds
If your investment
horizon is up to one year, then park your money in these funds for liquidity,
safety of capital & moderate returns. These funds invest in fixed-interest
bearing short-term instruments i.e. treasury bills, commercial paper,
certificate of deposit, etc.
b. GILT Funds
GILT funds invest
primarily in G-sec i.e. government security of medium to long term maturity
issued by the union & state governments. These securities have zero risks
of default. However, NAV of these schemes tends to fluctuate in response to
changes in the economy like a drop in overall interest rate.
c. Corporate Bond Funds
Corporate Bond Funds
are a good option if you have a moderate risk appetite coupled with an
investment horizon of around 5 to 10 years. You would get modest growth with
regular income but at the same time be prepared to face credit risk &
volatile returns. Also, the longer the maturity period, the more your
investment would be exposed to market vulnerabilities.
d. Short Term Funds, Medium Term Funds &
Long Term Funds
Short Term Funds
primarily invest in short-term debt securities partly in long-term debt. Go for
these funds when you want to fix your surplus funds for 1 to 9 months &
require a marginal increase in your risk appetite.
If you are a
conservative investor, then Medium Term Funds are suitable investment option.
These funds invest mainly in debt securities having maturity period of up to 3
years & give higher returns in a rising interest rate regime.
Long Term Funds have
investment tenure of more than a decade and the returns are affected by changes
in the interest rate regime in the economy. It is advisable to enter the fund
at the time of falling interest rates & monitor the interest rate movements
to exit at a favorable time.
e. Dynamic Bond Funds
These funds largely
invest in long-term debt securities i.e. corporate bonds & government
securities which are highly sensitive to the interest rate regime. Your fund
manager would track the interest rate movements & adjust the maturity
profile of the portfolio. When the interest rates rise in the short-run, he may
divert some funds in short-term papers to arrest interest rate risk.
iii. Hybrid/Balanced Funds
If you want moderate
growth & steady returns, then invest in these funds. These funds invest in
both equity & debt in a certain proportion as mentioned in the offer
document. You would enjoy investing in this fund if you want higher returns
corresponding to increased risk as compared to regular debt fund.
Hybrid Fund has
following three categories:
a. Monthly Income Plans (MIPs)
These funds allocate
comparatively higher money in debt as compared to equity to provide periodic
dividends coupled with benefits of long-term growth.
b. Fixed Maturity Plans
These are close-ended
schemes which aim at protection of capital & moderate growth by investment
in both debt & equity. The allocation in debt ensures that you get back the
original investment amount upon maturity & equity portion of allocation
provides the return for risk-taking. These plans need to secure mandatory
rating from at least one rating agency.
c. Capital Appreciation Plans
These are close-ended
schemes which invest both in rated debt instruments & shares of companies.
The aim is capital appreciation via participation in the growth of these
companies.
Final Words
Mutual funds offer
multiple benefits like convenience, diversification, professional management,
flexibility and transparency under a single umbrella. Investing in mutual funds
has become very simple with Systematic Investment Plans wherein you can start your
investment journey with an amount as less as Rs. 500. You may afterwards
step-up your investments alongside an increase in your income. So, get into
investment mode as soon as possible & enjoy as your money grows with time.
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