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Understanding Mutual Funds

A mutual fund is a pool of money from numerous investors who wish to save or invest money just like you. The money collected is invested either in stocks, bonds and other securities, or in a combination of the three based on the investment objective of a particular scheme.

The fund adds value to the investment in two ways: income earned and any capital appreciation through sale. As an investor, you are issued units in proportion to the money you have invested.


Types of Mutual Funds

Mutual Fund schemes can be classified into different categories and subcategories based on the type of securities they invest in or their maturity periods.


Classification based on maturity period:

Open Ended

An open-ended fund or scheme is one that is available for subscription and repurchase on a continuous basis. These schemes do not have a fixed maturity period. Investors can conveniently buy and sell units at Net Asset Value (NAV) related prices which are declared on a daily basis. The key feature of open-end schemes is liquidity.


Closed Ended

A close-ended fund or scheme has a defined maturity period e.g. 1-3 years. The fund is open for subscription only during a specified period at the time of launch of the scheme. Investors can invest in the scheme at the time of the initial public issue and thereafter they can buy or sell the units of the scheme on the stock exchanges where the units are listed. In order to provide an exit route to the investors, some close-ended funds give an option of selling back the units to the mutual fund through periodic repurchase at NAV related prices. SEBI Regulations stipulate that at least one of the two exit routes is provided to the investor i.e. either repurchase facility or through listing on stock exchanges.


Classification based on type of securities invested in
Equity Oriented Schemes

Equity oriented schemes are those schemes which predominantly invest in equity and equity related instruments. The objective of such schemes is to provide capital appreciation over the medium to long term.

These types of schemes are generally meant for investors with a long-term outlook and with a higher risk appetite.

Debt Oriented schemes

The main objective of debt-oriented schemes is to provide regular and steady income to investors. These schemes mainly invest in fixed income securities such as Bonds, Money Market Instruments, Corporate Debentures, Government Securities (Gilts) etc. Debt-oriented schemes are suitable for investors whose main objective is safety of capital along with modest growth. These funds are not affected because of fluctuations in equity markets. However, the NAV of such funds is affected because of change in the interest rate in the country.

Hybrid Schemes

Hybrid schemes provide the best of both worlds i.e. equity and debt. The aim of the hybrid funds is to provide both capital appreciation and stability of income in the long run. The proportion of investment made into equities and fixed income securities is pre-defined and mentioned in the offer document of the scheme. This type of scheme is an effective asset allocation tool. These schemes are suitable for investors looking for moderate growth. NAVs of such funds are generally less volatile in nature compared to pure equity funds.

Money Market/ Liquid Funds

These are predominantly debt-oriented schemes, whose main objective is preservation of capital, easy liquidity and moderate income. To achieve this objective, liquid funds invest predominantly in safer short-term instruments like Commercial Papers, Certificate of Deposits, Treasury Bills, G-Secs etc.

These schemes are used mainly by institutions and individuals to park their surplus funds for short periods of time. These funds are more or less insulated from changes in the interest rate in the economy and capture the current yields prevailing in the market.


Other Funds/Schemes
Gold Funds

The objective of these funds is to track the performance of Gold. The units represent the value of gold or gold related instruments held in the scheme. Gold Funds which are generally in the form of an Exchange Traded Fund (ETF) are listed on the stock exchange and offers investors an opportunity to participate in the bullion market without having to take physical delivery of Gold. Like any other mutual fund scheme, investors can buy, sell, hold, and conduct SIP/STP/SWP in these funds.

Index Funds

Index Funds replicate the portfolio of a particular index such as the BSE Sensitive index, S&P NSE 50 index (Nifty), etc. These schemes invest in the securities in the same weightage comprising of an index. NAVs of such schemes would rise or fall in accordance with the rise or fall in the index, though not exactly by the same percentage due to some factors known as "tracking error" in technical terms. Necessary disclosures in this regard are made in the offer document of the mutual fund scheme. There are also exchange traded index funds launched by the mutual funds which are traded on the stock exchanges.

Sector specific funds/schemes

These are the funds/schemes which invest in the securities of only those sectors or industries as specified in the offer documents. e.g. Pharmaceuticals, Software, Fast Moving Consumer Goods (FMCG), Petroleum stocks, etc. The returns in these funds are dependent on the performance of the respective sectors/industries. While these funds may give higher returns, they are more risky compared to diversified funds. Investors need to keep a watch on the performance of those sectors/industries and must exit at an appropriate time. They may also seek advice of an expert.

Tax Saving Schemes

These schemes offer tax rebates to the investors under specific provisions of the Income Tax Act, 1961 as the Government offers tax incentives for investment in specified avenues. e.g. Equity Linked Savings Schemes (ELSS). Pension schemes launched by the mutual funds also offer tax benefits. These schemes are growth oriented and invest pre-dominantly in equities. Their growth opportunities and risks associated are like any equity-oriented scheme.

Fund of Funds (FoF) scheme

A scheme that invests primarily in other schemes of the same mutual fund or other mutual funds is known as a FoF scheme. An FoF scheme enables the investors to achieve greater diversification through one scheme. It spreads risks across a greater universe.

Professional Management

Qualified investment professionals who seek to maximize returns and minimize risk monitor investor's money. When you buy in to a mutual fund, you are handing your money to an investment professional who has experience in making investment decisions. It is the Fund Manager's job to (a) find the best securities for the fund, given the fund's stated investment objectives; and (b) keep track of investments and changes in market conditions and adjust the mix of the portfolio, as and when required.


Affordability & Diversification

Diversification in simple terms means to spread your portfolio across different assets, sectors, and companies so that the overall portfolio is relatively safeguarded from downturns in one or more sectors. Since small investors do not have enough money to make meaningful investments across different assets or sectors, a mutual fund does the job for them. Your money can probably afford just a handful of stocks, but by investing in just one fund, you could get yourself a number of units across a spread of companies and industries!. An investor can get an exposure to portfolios with an investment as modest as Rs.500/-.


More choice

Mutual funds offer a variety of schemes that will suit your needs over a lifetime. Different investors can choose different type of schemes depending upon their risk appetite and financial goals.


Liquidity

Open ended mutual funds provide easy liquidity and investors can buy or sell units anytime, at the prevailing NAV based prices. Close-ended schemes also provide periodic repurchase facility or are listed on a stock exchange where investors can redeem their units at the prevailing market price. Should you need your money at short notice, you can usually get it in four working days.


Convenience & Flexibility

You can invest directly with a fund house, or through your financial adviser, or even over the Internet. There are a lot of features in a regular mutual fund scheme, which imparts flexibility to the scheme. An investor can opt for Systematic Investment Plan (SIP), Systematic Withdrawal Plan etc. to plan his cash flow requirements as per his convenience. Mutual Funds offering multiple schemes allow investors to switch easily between various schemes. This flexibility gives the investor a convenient way to change the mix of his portfolio over time.


Transparency

The mutual fund industry in India works on a very transparent basis. As an investor, you get updates on the value of your units, information on specific investments made by the mutual fund and the fund manager's strategy and outlook.


Economies of scale

A mutual fund, by the sheer scale of its investments is able to carry out cost-effective brokerage transactions.


Tax Benefits

Over the years, tax policies on mutual funds have been favorable to investors and continue to be so.


Regulations

A mutual fund in India is registered with The Securities and Exchange Board of India or SEBI, which also monitors the operations of mutual funds to protect your interests. SEBI has clearly defined rules, which govern mutual funds. These rules relate to the formation, administration and management of mutual funds and also prescribe disclosure and accounting requirements. Such a high level of regulation seeks to protect the interest of investors.


Are you thinking about investing in a mutual fund, but aren't sure how to go about it or which one is the most appropriate based on your needs?


The first task is to define the following:

Objective of investing - are you investing for a short term or a long term financial goal? Your financial goal could be saving for a foreign vacation, marriage, child's education, wealth creation, down payment for house, retirement or any other.

How long would be your investment horizon? If you need your money back for a short term financial goal, an equity fund is probably inappropriate as equity funds offer the best potential for returns over the long term.

Your risk tolerance and thereafter select a fund type that suits your needs the best.

Few Indicators to help you in selecting the right Mutual Fund scheme

Percentage of the Mutual Fund

A strong parentage would ensure efficient processes and the capability to build a strong business. In turn, these processes, which are a combination of investment processes, risk measures and operational efficiency, would ensure a sustained performance over a longer period.


Track the Fund House record

Certain fund houses churn out consistently good results year after year across the product spectrum. They are able to do so because they have built a strong risk management system and process-driven approach. They also have highly skilled and experienced fund managers.


Consistency in performance

Though the past performance is not a guarantee of good performance in future, it makes sense to go with a fund which has been performing consistently over a period of 3-5 years or more. Select schemes that have consistently beaten their benchmark and compare reasonably with their peer set.


Risk adjusted returns

A good mutual fund is one which gives better returns than others for the same kind of risk taken


Expense Ratio

High expense ratio is a drag on performance. Be wary of a mutual fund with a high overall expense ratio, especially if its performance lags its index and peers over time.


Independent rating of the schemes, if available

Do not over-diversify

One of the great advantages of investing in mutual funds is built-in diversification. With diversification, you can reduce risk by spreading out your investments among various asset classes and investment styles. But do you run the risk of over-diversification by having too many different mutual funds?

Each equity fund holds an average of 40 different companies. In a portfolio with too many funds, you are likely to have duplication of companies or representation in the same sector. As well, you may be duplicating investment styles. Invest in as many funds as you need to achieve your investment objectives. If you find you are over-diversified, assess your holdings and consider selling less attractive funds.

Save Tax u/s 80c by investing in ELSS

What are Equity Linked Saving Schemes (ELSS)?

Equity linked savings schemes (ELSS) are mutual funds that help you gain the twin advantage of earning equity-linked returns with the additional benefit of saving tax. You can invest up to 1 lac in ELSS to avail of tax benefit under section 80C

Advantages of ELSS


Investments in equity delivers higher returns over a longer period, surpassing returns from other tax saving instruments.
Dividends and capital gains in an ELSS are tax free.
ELSS has a lock-in of only three years, which is very less compared to other avenues available for investment under section 80C.
One has the option of investing small amounts of Rs 500 each month in ELSS through Systematic Investment Plans (SIPs).
There is no compulsion to invest in ELSS every year. The investment can be based on your requirements.

Click here to see the list of recommended Tax Saving Funds.

Myth 1: A Fund with lower NAV is better

This is an erroneous perception that NAV of a mutual fund is similar to market price of stocks and therefore buying funds at low NAV is similar to buying stocks at cheaper prices. This wrong belief stems from the view that a low NAV fund holds more potential for appreciation. Besides, the low NAV seems to be cheaper because it allows you to buy more units.

A mutual fund's NAV represents the market value of all its investments. Any capital appreciation will depend on the price movement of its underlying securities. Say, you invest Rs 10,000 each in fund A (whose NAV is Rs 20) and fund, B (whose NAV is Rs 100). You will get 500 units of fund A and 100 units of fund B. Let's assume both schemes have invested their entire corpus in exactly same stocks in same proportions. If these stocks collectively appreciate by 10%, the NAV of the two schemes should also rise by 10%, to Rs 22 and Rs 110, respectively. In both cases, the value of your investment increases to Rs 11,000. Fund B's NAV is higher than fund A's because the former has been around longer and had bought the scrip much earlier, which itself saw some appreciation. Any subsequent rise and fall in the NAVs of both these funds will depend on how the underlying securities move.

Therefore, always remember that existing NAV of a fund does not have any impact on the returns.


Myth 2: A scheme that pays dividends is better than a scheme that doesn't.

This is completely untrue. Stock Dividend and Mutual funds dividend are completely different. When a Mutual fund announces dividend, the NAV is adjusted accordingly. Under the dividend payout option, a part of the profits made by the scheme are distributed to investors. The dividend is actually stripped from the NAV of the scheme and accordingly the NAV drops to the extent of dividend and dividend distribution tax paid. For Example Consider a scheme with Current NAV of Rs. 50.Dividend announced is 100%. Dividend is always calculated on the face value and not the NAV value. So the dividend per unit will be Rs. 10. Post dividend the NAV is reduced to Rs. 40

A fund that pays dividend is no better or worse than a fund that doesn't pay dividends.


Myth 3: The growth option is better as it delivers higher returns

A common misconception is that, opting for the growth option is better, since it delivers higher returns. This fallacy is rooted in the difference between the NAVs of the growth and dividend options.Investors expect the dividends declared till date to account for the difference between the two NAVs. On finding that the difference between the two NAVs is greater than the dividends declared, the conclusion drawn is that the growth option is better.

However, since the growth rate is being applied to different bases (higher NAV for growth vs. lower NAV for dividend), the eventual NAVs are different.

For example, assume a 50% growth being applied to a Rs 20.00 growth option NAV and a Rs 18.00 dividend option (after a 20% i.e. Re 2.00 dividend has been paid) NAV. The resulting NAVs would be Rs 30 (for growth) and Rs 27.00 (for dividend); the difference between the NAVs being Rs 3.00 which is greater than the Rs 2.00 dividend declared.

Don't select the growth option assuming that it will offer better returns. Instead, the need for liquidity and investment objective should play a role in deciding which option is chosen.


Myth 4: You need a demat account to invest in mutual fund

You DO NOT need demat account when investing in mutual fund. You can just need to fill up an application form, attach the cheque of the desired amount and submit the form at the mutual fund office or to your advisor. You can use online platform of mutualfundbazaar.com to transact in mutual funds.


Myth 5: Mutual Funds are the same as equity

This, most fund houses say, is a popular misconception. Investors need to know that there are various kinds of mutual funds. While some invest their money in equity, others invest the money contributed by unitholders into debt instruments, such as government issued bonds and bonds issued by companies and financial institutions.

There also exist funds that invest in money market instruments such as treasury bills issued by the government, call money market used primarily by banks and short-term paper issued by bluechip companies.

Mutual Funds, therefore, invest in all kinds of instruments and do not confine themselves to equity. Your choice of a fund, in this context, needs to be based on the risk you are willing to take and the time duration of your investment.


Myth 6: Mutual funds are very risky

You may have seen or heard the warning: "mutual funds are subject to market risks" on television or in a magazine. Does this mean that all mutual funds are very risky? No. The warning only means that the funds cannot promise guaranteed returns to the investor. There is risk, but it is lesser than the risk of going to the market directly. At the same time, the risk is more than that of investing in a government bond or bank account. Investments (by mutual funds) in securities are spread across a wide cross-section of industries and sectors and thus the risk is reduced. Diversification reduces the risk because all stocks may not move in the same direction in the same proportion at the same time.


Myth 7: A balanced fund will always have a 50:50 debt to equity ratio

Balanced funds aim to achieve a balance between equities and debt. But the balance can tip depending on the nature of the fund. The equity-oriented balanced funds usually invest at least 65% in equities and the rest in debt. The others do this in a 40:60 ratio.


Account Statement

A document issued by the mutual fund, giving details of transactions and holdings of an investor


Annual Return

The percentage change in net asset value of any fund over a horizon of one year, assuming reinvestment of distribution such as dividend payment and bonuses.


Annualized Returns

It is the absolute return over a period either greater or less than a year aggregated to a period of one year.


Asset Management Company (AMC)

It is the investment manager for the mutual fund. It is a company set up primarily for managing the investment of mutual funds and takes investment decisions in accordance with the scheme objectives, deed of Trust and other provisions of the Investment Management Agreement.


Balanced Funds

A class of mutual fund that aims at allocating the total assets with it in the portfolio mix of debt and equity instruments.


Bonus

Bonus is an allocation of additional units to the investors on the basis of their existing holdings. Basically, there is a split of existing units into more than one unit resulting in the reduction of the NAV per unit


Capital Gains

The difference between an asset's purchased price and selling price, when the difference is positive. A capital loss would be when the difference between an asset's purchase price and selling price is negative.


Debt /Income Funds

Funds that invest in income bearing instruments such as corporate debentures, PSU bonds, gilts, treasury bills, certificates of deposit and commercial papers. These funds are the least risky and are generally preferred by risk-averse investors.


Expense Ratio

Annual percentage of fund's assets that is paid out in expenses. Expenses include management fees and all the fees associated with the fund's daily operations.


Exit Load

It is the load charged by the fund when one redeems the units from the fund. It reduces the price of the units to less than the NAV and is expressed as a percentage of NAV.


Entry Load

It is the load charged by the fund when one invests into the fund. It increases the price of the units to more than the NAV and is expressed as a percentage of NAV.


Equity Schemes

Schemes where more than 65% of the investments are done in equity shares of various companies.


Face Value

The original issue price of one unit of a scheme


Fund Category

Classification of a scheme depending on the type of assets in which the mutual fund company invests the corpus. It could be a growth, debt, balanced, gilt or liquid scheme.


Gilt Funds

Funds, which invest only in government securities of different maturities. With virtually no default risk, they are very secure. While returns are steady and secure, they are lower than those from other debt funds.


Growth Fund

A mutual fund whose primary investment objective is long-term growth of capital. It invests principally in stocks with significant growth potential.


Index Fund

A type of mutual fund in which the portfolios are constructed to mirror a specific market index. Index funds are expected to provide a rate of return over time that will approximate or match, but not exceed, that of the market, which they are mirroring.


Lock In Period

The period after investment in fresh units during which the investor cannot redeem the units. It is normally a key feature of Tax schemes.


Money Market Fund

A mutual fund that aims to pay money market interest rates. This is accomplished by investing in safe, highly liquid securities, including certificates of deposit, commercial paper, and Government securities. Money funds make these high interest securities available to the average investor seeking immediate income and high investment safety.


Net asset value (NAV)

The value of fund's portfolio at market value less current liabilities divided by the number of units outstanding. Net asset value is normally computed daily or weekly


Purchase Price

The price at which a mutual fund's units can be purchased. The asked or offering price means the current net asset value per unit plus sales charge, if any.


Record Date

The date by which mutual fund holders are registered as unit owners to receive any future dividend or capital gains distribution


Redemption Of Units/Repurchase

Buying back/cancellation of the units by a fund on an on-going basis or on maturity of a scheme. The investor is paid a consideration linked to the NAV of the scheme.


Redemption Price

The price at which open-ended schemes repurchase their units and close-ended schemes redeem their units on maturity. Such prices are NAV related.


Registrar or Transfer Agent

The institution that maintains a registry of unitholders of a fund and their unit ownership. Normally the registrar also distributes dividends and provides periodic statements to unitholders.


Sale price

The price at which a fund offers to sell one unit of its scheme to investors. This NAV is grossed up with the entry load applicable, if any.


Value Fund

Fund which invests in stocks that are considered to be undervalued based upon such ratios as price-to-book or price-to-earnings (P/E). These stocks generally have lower price-to-book and price-to-earnings ratios, higher dividend yields and lower forecasted growth rates than growth stocks


Yield

Distributions from investment income, usually expressed as a percentage of net asset value or market price. Unlike total return, yield has the single component of investment income and does not include capital gains distributions or capital appreciation of underlying shares.


Yield To Maturity

Used to determine the rate of return an investor will receive if a long-term, interest-bearing investment, such as a bond is held to its maturity date. It takes into account purchase price, redemption value, time to maturity, coupon yield and the time between interest payments


Albert Einstein is quoted as saying, "The most powerful force in the universe is compound interest." Compound returns offer one of the most powerful ways to build wealth. Compounding means earning interest on interest. Over time, the more interest (or returns) you reinvest, the more money you have working for you, and the more you can earn. Mutual funds offer an ideal way to capture compound returns.

With simple interest, you earn interest only on the principal (that is, the amount you initially invested); with compounding, you earn interest on the principal and additionally earn interest on the interest. To understand better, let's take an example.

Say you've invested Rs.10, 000 for 10 years and it makes 10% interest per year. In case of simple interest, you will make Rs. 1000/- per year. At the end of the 10th year you will get back your principal of Rs. 10,000 and you would have accumulated total interest of Rs. 10,000.

In case of compound interest, in the first year, you make Rs.1, 000 in interest. But in the second year, you'll make Rs.1, 100 (not only does your initial investment of Rs.10,000 accrue interest but so does the additional Rs.1,000 you made in the first year). In the tenth year, you'll make Rs. 2,358. In 10 years, the power of compounding will grow your total investment of Rs. 10,000 to Rs. 27,070 as compared to only Rs. 20,000 in case of simple interest.

Now that you've understood the power of compounding, let's see how you can make that power work for you. Compounding will work for you if you:


Maximize benefit by starting early.

Returns turn out to be larger when the money remains invested for a longer duration of time. Consider two investment scenarios. Investor A invested Rs 1, 00,000 at 8 % compounded monthly when he was 30 years old. When he was 50 years old, his investment totaled Rs 4, 92,680. On the contrary, Investor B set out late - when he was 40 years old. When he was 50 years old, his investment would be worth Rs 2, 21, 96. By starting out 10 years later, investor B lost Rs 2, 70,716 in comparison with investor A who had started his investment journey 10 years earlier. The earlier you start, the more time compounding has to work for you, and the wealthier you can become.


Make regular investments.

Don't be haphazard. Remain disciplined, and make saving a priority. Do whatever it takes to maximize your contributions. Even small investments made regularly can surprise you some years down the line Click here for compound Interest calculator to check how interest on your interest really adds up!


Be patient.

Do not touch your investments. Compounding only works if you allow your investment to grow. Most of the magic of compounding returns comes at the very end.



Compounding with SIP

A systematic investment plan (SIP) is an effective means to beat market volatility and benefit from the enormous power of compounding over time. A SIP allows you to invest in any mutual fund by making smaller periodic investments instead of a lump sum one-time investment. Since this is small money flowing out at regular intervals , it doesn't affect your other financial commitments significantly.Click here for SIP Calculator to see how small investments made at regular intervals in various mutual fund schemes can yield much better returns over a long period of time.