Mutual Funds Basic

MUTUAL FUNDS

Basic Terminology

Mutual Funds – Professionally managed investment scheme usually run by an Asset Management Company that brings together a group of people & invests their money in stocks, bonds and other securities.

  • Open-Ended – Open-ended funds are generally not listed on stock exchanges. They do not have any fixed maturity period. Unlimited capitalization i.e. they can issue and redeem the shares any time they want. Unit capital or total AUM (Assets under management) fluctuates every day.
  • Close-ended funds – Close-ended funds are listed on stock exchanges. They have fixed maturity period with limited capitalization i.e. they cannot issue or redeem shares any time they want as they usually have a window for buying the shares initially when they are launched. Market prices are different than the NAVs as the prices are affected by demand, supply, investor’s expectation, ratings, etc. A lot of closer-ended funds also use leverage in order to maximize the returns. But with leverage, there is also a risk of incurring higher losses.

ETFs (Exchange-traded Funds) are different from Mutual funds but Mutual Funds can invest in ETFs.

*Sometimes close-ended funds can issue bonus shares. The bonus issue is a zero-sum game (the increase in number of shares will be offset by a proportionate decrease in NAV/Market price.

 

Direct Plan vs. Regular Plan – There are plans the way you invest in mutual funds. Direct plan is where no commission is paid to the distributor. A regular plan is one in which mutual fund company or AMC pays a hidden % commission back to the distributor or broker. That is why it is observed that the direct plans offer higher returns over the regular plans.

 

Types of Mutual Funds based on Assets invested in:

  • Equity Funds – These are Mutual funds that only invest in Stocks of companies listed. They usually have a benchmark with respect to the equity indices. They have higher risk and demand a higher return. Also promise a high return if invested for long term ad they also have lesser tax liability in the long term as you have to bear only long term capital gains tax. They usually have an exit load of 1%-2% if redeemed within one year or 365 days.
  • Debt funds – Mutual funds that invest in debt securities, treasury bills, government bonds, debentures and money market instruments are debt funds. They have lower risk and offer low returns. Funds are safer than the equity funds. They may or may not have exit loads.
  • Hybrid Funds – The hybrid funds are mixed. They invest their pool in equities as well as debt. Hybrid funds are less risky than equity funds but are more risky than the debt funds or fixed income funds. They are often called balanced funds as they try to strike balance between risk and return.

 

*Usually Equity funds have longer exit loads than debt funds as they discourage early redemptions and frequent rebalancing of money in the portfolio.

 

Schemes in Mutual Funds:

  • ELSS (Equity Linked Savings Scheme)/Tax saver Funds – In India, you can get tax rebates under Section 80C if you invest in ELSS. Investors can now claim a deduction of up to `150,000 under section 80C. As the name suggests, ELSS are linked to Equities only. Dividends are tax-free.
  • SIP (Systematic Investment Plan) – SIP is a scheme that lets you distribute the total amount of your investment in monthly or quarterly instalments. This means you don’t have to invest the whole amount as lump –sum in a mutual fund. They are more convenient and offer flexibility to balance your portfolio at regular periods. They also are seen as ways to save or invest an optimal amount out of your income. In India, SIPs have as low as `100 investment per month.
  • MIP (Monthly Income Plan) – MIPs are usually debt oriented. They also invest in equity and promise regular payout to the investor every month from their investments.
  • FMP (Fixed Maturity Plan) – Fixed Maturity plans are schemes for close-ended mutual funds. They normally invest in debt instruments which mature with the scheme. The interest or coupon is earned on fixed period(s). These are passively managed and hence no active trading in the portfolio.

 

More on Debt Funds:

  • Ultra Short term Funds – These funds invest in short term maturity instruments and are very liquid. Investment horizon varies from a few hours to few days. There is no lock-in period and objective is to avoid interest rate risk. They sometimes charge an exit load unlike liquid funds. They are riskier than liquid funds.
  • Liquid Funds – Though a part of debt funds, liquid funds have their own features. They invest mostly in debt and as they are liquid funds, the investment is in short term maturity instruments like Treasury Bills (T-Bills), Commercial Paper (CP), Short-term Government bonds and overnight money market instruments. There is no specific lock-in period in liquid funds. No entry or exit load as well. The dividends or returns from these are not taxed. Majority players are Institutional investors and HNIs (High net-worth individuals).
  • Gilt Funds – Invests in Government Securities with medium and long term maturities. They have the least amount or close to zero credit risk as government debt is free from credit risk. They also invest in high quality corporate bonds.

 

Other funds:

  • Index funds – Index funds are mutual funds that are always benchmarked and tracked with specific indices like S&P 500, Dow Jones, Nifty, Sensex etc. They are always passively managed as the investor does not want a higher return than the benchmark and hence no need for active management and a higher fees/commission. Index fund copies the market index it is tracking and gives the exact same return of index. Same goes for the risk exposure of these funds, it is going to be the risk of the market.
  • Sector Funds – Sector funds are basically Mutual funds, Close-ended funds or ETFs (exchange traded fund) who invest in an industry or a specific sector. They lack diversification as they are exposed only to a particular industry. There may be really high gains or heavy losses depending on the industry’s demand or supply. If the demand increases substantially, there are high profits and if the demand falls or industry expectations go down, there may be heavy losses.
  • Arbitrage Funds – The fund leverages the price differential in the cash and derivatives market by buying in the cash segment and selling it in the futures market of the same company only if it is trading at a premium in the futures market. These types of funds carry very low risk. Arbitrage funds are usually more exposed to the equity side as they invest an average of more than 65% in equities.
  • Fund-of-funds – This is a type of investment where fund invests on other funds. Also called multi-manager investment, it invests in different kinds of mutual funds, hedge funds, private equity and investment trusts. They have a strategy to achieve diversification and optimal asset allocation. Small investors who want better risk management look out for fund-of-funds. Highly popular in the western countries, it is a relatively newer concept for the Indian economy.
  • International Funds – Funds that invest in companies or stocks those are foreign and are located outside the investor’s country of residence. These funds give nice opportunity for diversification. Also referred as ‘foreign fund’ and are often confused with global funds.
  • Global Funds – Global funds may be mutual funds, ETFs, Hedge funds or close-ended fund that invests in companies or stocks or financial instruments across the globe including investor’s home country. Provide more global opportunities for diversification and act as hedge against inflation and forex (foreign exchange/currency) risks.

 

Terms to consider:

  • NAV or Net Asset Value – NAV is the value per share of the mutual fund or ETF on a specific date or time. This is the number that is listed or quoted for mutual funds of any type. NAV is calculated as

NAV = (Assets – Liabilities)/Total Outstanding shares of the Mutual Fund

Net Asset Value (NAV) of Open-ended shares changes dynamically and sometimes drastic changes can also be seen within a day as they have unlimited capitalisation and can redeem or issue shares any time.

  • Entry Load – Entry load is the amount charged at the time of issue or purchase of shares of a mutual fund. Generally collected to cover distribution costs by the company.
  • Exit Load – It is the amount deducted from the NAV as percentage points at the time of redemption or when you exit the fund by selling shares.
  • Assets Under Management (AUM) – AUM sometimes called Funds under Management (FUM) is the total amount of money/total market value invested by the shareholders that is managed by a trust, financial institution or an investment company.
  • CAGR (Compounded Annual Growth Rate) – It describes the rate at which an investment would have grown if it had grown at a steady rate. If an amount is compounded, it earns an interest over interest if invested for more than one time period.
  • Absolute return – It is the return earned in an absolute number i.e. total return earned till date divided by the number of years from the time of purchase/issue.
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