Mutual Funds - explained

What is a Mutual Fund? The word 'mutual' in the name means exactly what it implies. A mutual fund is composed of the money that a large number of people have invested in it. A mutual fund is made up of all the money that its various investors have invested, combined. Mutual Funds are a well-diversified, low cost and tax efficient way of making your savings grow. They are an ideal investment vehicle for those who do not have the expertise to invest directly in stocks. You simply invest in a fund, and the fund manager will do the job of picking the stocks that he thinks will yield good returns. How do they work? You give money to a fund, which it invests in stocks. The gains or losses, whatever they may be, accrue to you. Equity funds are that simple. Here's an example: A fund is launched and a 1000 investors each invest 10,000 in it. In all, the fund has 1 crore of assets under its management. Just for convenience, a fund is divided into 'units' of a certain value, which is set to a round number initially. Typically, this is 10. In the above fund, each investor is said to own a 1000 units and in all, the fund has issued 100,000 units. Let's say that after a year, the investments have done well and the 1 crore grows to 1.1 crore. Now, the NAV of each unit is 11 (1.1 crore divided by 100,000). Each investor owns 1000 units so the value of his investments has grown to 11,000. From the investors' point of view, only the percentage change in the NAV is important, not the actual number. Who manages my money? Mutual funds follow a 3-tier structure: A Sponsor sets up a mutual fund and hires an Asset Management Company (AMC). The sponsor is then required to report to Board of Trustees who independently oversees the fund's operations. They have a fiduciary duty to investors, to dismiss the AMC or pull up the sponsor if they observe any irregularity in the fund's operations. Fund houses are also subject to regular return filings with SEBI as well as audit by an independent statutory auditor. AMCs will come up with different funds that are targeted at a different set of investors. A fund manager will be assigned to every fund who (along with the inputs he gets from the AMCs) manages your money. The fund manager is basically in charge of what stocks, bonds or other assets the fund will buy with investors’ money. Essentially, the fund manager will function as a stock-picker. Focusing on price-to-earnings ratios, price momentum, sales, earnings, dividends and other various metrics, the fund manager will build a portfolio of assets to accomplish the aims of the mutual fund, as stated in the fund’s prospectus. Charges: Expense Ratio: Expense ratio is the percentage of total assets that are spent to run a mutual fund. Like a doctor who charges you for his service, mutual funds too charge a fee for managing your money. This involves the fund management fee, agent commissions, registrar fees, and selling and promoting expenses. In other words, it states how much you pay a fund in percentage terms, every year, to manage your money. For example, if you invest Rs 10,000 in a fund with an expense ratio of 1.5%, then you are paying the fund Rs.150 to manage your money. Whether a fund generates positive or negative returns, expenses are always there & will be charged always. Entry load: Entry load is an expense you have to bear to participate in a mutual fund. The distributor who sells you a fund has to bear expenses towards running his business. A part of this cost is borne by investors in the form of load. You can opt for ‘Direct Plans’ (you only choose which funds to invest in instead of going to an advisor) if you do not wish to pay this fee. Exit Load: Exit load will be charged if an investor redeems or switches from a scheme before completion of one year from the date of allotment. Types of MFs No matter what type of investor you are, there is bound to be a mutual fund that fits your taste. It's important to understand that each mutual fund has different risk and reward profiles. In general, the higher the potential return, the higher the risk of potential loss. At the most basic level, there are 3 flavors of mutual funds: those that invest in stocks (Equity funds), those that invest in bonds (Income funds), those that invest in both stocks and bonds (Balanced funds), and those that seek the risk-free rate (Money market funds). Most mutual funds are variations on the theme of these three asset classes. Equity Funds: Equity Funds represent the largest category of mutual funds; these invest primarily in stocks. Generally, the investment objective of this class of funds is long-term capital growth. There are, however, many different types of equity funds because there are many different types of equities. A great way to understand the universe of equity funds is to use a style box, an example of which is below. Based on the type of stocks it invests, a fund can be categorized under one of these 9 different types. Income funds: Income funds are named for their purpose: to provide income to the investors on a steady basis. These funds invest primarily in government and high-quality corporate debt, holding these bonds until maturity in order to provide interest streams. While fund holdings may appreciate in value, the primary objective of these funds is to provide a steady cash flow to the investors. As such, the audience for these funds consists of conservative investors and retirees. Balanced funds: Balanced funds are a combination of both Equity funds & Income funds. They provide a mixture of safety & capital appreciation. The strategy of balanced funds is to invest in a portfolio of both fixed income and equities. A typical balanced fund will have a weighting of 50%-60% equity and 40%-50% fixed income. Fund manager of a balanced fund will have the freedom to switch the ratio of asset classes as the economy moves through the business cycle. Money market funds: Money market funds invest in safe (risk-free) debt instruments, mostly government bonds & Treasury bills, which are generally, not available for retail investors. These funds won't give you substantial returns, but you won't have to worry about losing your principal. A typical return is a little more than the amount you would earn in a regular savings account and a little less than the average bank FD returns. Opt for ultra-short-term bond funds, if you wish to invest for a time period of a month to six months. For six months to a period of two years, go for short-term bond funds. ELSS funds: ELSS (Equity Linked Savings Scheme) funds are an advantageous way to use the Rs 1.5 lakh limit for tax saving investments under Section 80C. A combination of equity and tax-saving makes them an ideal investment for all types of investors. Also, ELSS funds have the shortest lock-in period (just 3 years compared to a 5 year bank FD or a 15 year PPF) and the returns are completely tax free (unlike a bank FD) Other categories: When selecting a mutual fund, an investor has to make an almost endless number of choices. Among the more confusing decisions to be made is the choice between a fund with a Growth option and a fund with a dividend reinvestment option. Each type of fund has its advantages and disadvantages, and deciding which is a better fit will depend on your individual needs and circumstances as an investor. Growth option: The growth option on a mutual fund means that an investor in the fund will not receive any dividends that may be paid out by the stocks in the mutual fund. by selecting a growth option, the mutual fund holder is allowing the fund company to reinvest the money, which eventually, results in the increase in NAV of the fund. Dividend option: Unlike the growth option, investors opting for the dividend option will get a payout in the form of dividend. Dividend reinvestment option: Dividends that would otherwise be paid out to investors in the fund are used to purchase more shares in the fund. Again, cash is not paid out to the investor when dividends are paid on the stocks that comprise the fund. Instead, cash is automatically used by the fund's administrators to buy more fund units on behalf of the investors and transfer them to individual investors' accounts. How to transact? To start with, all that you need is a savings bank account & your PAN card (you need not have a demat account) For investing, broadly, we have two options: Lump sum investment; Systematic Investment Plans (SIP). Lump sum is, of course, investing the entire money that you want to invest at one go. SIP, on the other hand, means investing a fixed amount at a fixed frequency (generally monthly). For instance, if you have Rs. 1 lakh to invest, you may invest the entire amount in lump sum or you may create a monthly SIP with each installment of Rs.10,000 over a 10-month period. You can either buy funds directly from a fund house (Direct Plans) or through an intermediary (Regular plans). The expense ratio of a Direct plan will be lesser than a Regular plan (since there are no intermediaries involved) & the NAV will be slightly higher. Whenever an investor has to invest or redeem his money, he either buys fresh units or sells them at the NAV on that particular day. Happy Investing!!!