What are Mutual Funds?
Ramesh is an IT engineer who loves the experience of seeing new countries.
He visits a new country every year and he’s done so for over 7 years now!
But he slowly starts to notice that the price of his holidays increases every year. He’s puzzled. After a quick google search, he understands the concept of inflation.
He then looks at his savings account and realises that the money in his savings account is not growing at the same rate as inflation.
“If my vacation costs are going up by 7.66% every year and my money is growing only by 3% then as time goes by, I will not be able to afford my vacations anymore!”
He says “ENOUGH! I will not tolerate this any longer” and then he goes to his friend’s house.
He explains this inflation concept to his friend and realises that even his friend, Suresh, is facing the same problem. They decide to take action.
They find 8 other friends who have the same problem and then get on a conference call.
They then come up with a SUPER IDEA! 💡
What are mutual funds? Mutual funds as an investment alternative has been gaining prominence over the decade. Since it is integral to gain more information about it before investing, this article seeks to act as a starting point in your mutual fund journey.
They decide to pool all their money and they hire a “Money Manager” to manage their money.
The money manager split the entire pool into 10 parts and assigned 1 part to each friend.
This money manager then took this money and bought a lot of different shares and bonds.
With those shares and bonds, he made a return of 20% after 1 year.
All 10 friends were happy.
All of their money grew by 20%.
Ramesh knew he didn’t have to worry about running out of money for his travels ever again.
In the above example,
The “Pool” of money that is invested in different stocks or bonds is called a FUND.
The “Money Manager” who manages other people’s money in real life is called a FUND MANAGER.
The total value of all the investments in the fund minus the costs involved in managing the fund is called the Net Asset Value (NAV).
If one of the stocks in the portfolio does well and the price rises, the NAV will also rise.
If one stock goes up by Rs500 and another stock goes down by Rs500, the NAV may remain the same. You get the idea.
Mutual Funds are not free. There are many associated costs involved in holding a mutual fund. These costs include the fund manager’s fees,operational and administrative expenses & brokerage fees. All these costs put together are called Total Expense Ratio (TER). It is generally in the form of a %. So if the TER is 1% per annum, it means the total cost of running the fund is 1%.
This cost is deducted before your NAV is declared.
A very important thing to note here is that TER is not deducted every year but every working day. So if the TER is 1% and there are 250 working days in that year, the NAV is reduced by 0.004% everyday (1/250).
The other cost that you visibly incur is the exit load. When you exit a fund within a recommended time frame (set by the scheme), you may be charged a load on your NAV called the exit load. This is meant to discourage short-term investing and churn.
Now let’s look at where your fund manager invests and makes your money grow.
What are mutual funds?
A mutual fund is an investment vehicle that pools money from a multitude of people (investors like you and me). It uses this pool to purchase securities like stocks, bonds, and gold. As the prices of securities change, the mutual fund scheme makes its returns which is in turn the investor’s return. Professional money managers with decades of experience manage each mutual fund and take the call on which securities to buy and sell. The mutual fund is managed in a manner consistent with its stated objectives.
How are returns made in a mutual fund?
A mutual fund invests in a basket of securities. As the prices of these securities change (for stocks and some bonds) or as a fund earns the interest on the bonds it holds, its value changes. Gain in stock/bond prices sends value higher and vice versa. So as the fund value moves up, your investment value also rises.
- When you sell your fund – In this case, you earn capital gain. Capital gain is the profit on your investment when you sell your mutual fund units. It is the difference between the market value of your mutual fund units at the time of sale and the cost of such units. The gains come in from the appreciation in your fund’s value. If the selling value is lower than your investment cost, you’ve made a capital loss.
- When you earn dividends on your fund – This happens when a mutual fund declares dividend out of the accumulated profits it has made. This accumulated profit can be in the form of securities sold for profit, interest earned on bonds, or dividends earned on stocks.
Dividend vs growth options
In the growth option of a mutual fund scheme, all profits made by the fund are ploughed back into the scheme. In the dividend option of a mutual fund scheme, the profits made by the fund are distributed to the unit holders from time to time. This dividend is deducted from the NAV and given back to you. Therefore, dividend in a mutual fund is simply your own investment coming back to you and is not additional returns made.
Why should you invest in a mutual fund?
There are a host of reasons!
Diversification: Diversification is one key advantage of investing in mutual funds. Diversification is a potent way of reducing risk and ensuring that a portfolio delivers across market cycles. When you invest in different stocks in different sectors, you’re spreading your investments out since each sector and stock behave differently and have different drivers. But it’s hard to do so when investing directly in stocks, since it is hard to buy a large variety of stocks.
When you buy a mutual fund, it gives you exposure to a large basket of stocks. It’s a cheaper and easier way to own a portfolio of stocks than by buying individual securities. And because a mutual fund is a big pool of money, and is professionally managed, it can build a well-diversified portfolio. Large mutual funds typically own hundreds of different stocks in many different industries. It wouldn’t be practical for an investor to build this kind of a portfolio with a small amount of money.
Professional Management: A primary advantage of mutual funds is not having to pick stocks and manage investments yourself, which requires both time and skill. Instead, a professional investment manager takes care of all this using careful research and skilful trading. A mutual fund is an inexpensive way for a small investor to get a full-time manager to make and monitor investments. Most private, non-institutional money managers deal only with high-net-worth individuals.
Variety and Freedom of Choice: You have a wide variety of mutual fund types to choose from. There are equity, debt, and gold funds, besides funds that invest in a combination of these. Each fund is managed in a different way, and there are multiple strategies. For instance, a fund manager may focus on value investing, growth investing, developed markets, emerging markets among many other styles.
Therefore, no matter what the risk level, time-frame, age or any other requirement, there will be a mutual fund that suits the purpose. In addition, the variety allows investors to gain exposure to different stocks, bonds, commodities, or foreign markets, as well as different methods of investing that helps build an all-weather portfolio.
Transparency: Mutual funds are regulated by the Securities and Exchange Board of India (SEBI). SEBI has been adept at protecting investor interest in mutual funds and ensuring best practices by AMCs. Over the years, SEBI has brought in and continues to bring in regulations that prevent AMCs from taking on undue risks, overcharging investors, making false claims and so on. Mutual funds also score on disclosures – a mutual fund needs to disclose its full portfolio and asset size every month, its expense ratio and NAV every day. At all times, an investor is aware of where their money is being invested.
Ease of investment: Investing in mutual funds spares the investor of the numerous commission charges needed to create a diversified portfolio and large transaction fees. This apart, mutual funds allow any investor to build wealth. Investments in denominations as small as Rs 500 can be made. In this way, even smaller investors can slowly build up their wealth and still own a well-diversified portfolio. Mutual funds allow investors to set up periodic investments such as every month, every week and so on. They also allow investors to withdraw on a periodic basis too.
Risks in mutual funds and how to use them
Risk here means the probability of you losing money in a mutual fund. As mutual funds are linked to the equity or debt markets, their NAV swings to the volatility in the price of the instruments they hold. This also means that there can be NO FIXED RETURNS in mutual funds. Returns are volatile.
Every category of mutual fund has a different level of risk. You have to choose a mutual fund based on the fund’s inherent risk characteristics and also how much risk you can handle. A very important thing to know here is higher the risk, higher the potential return AND higher the potential of losses.
Given below are articles that will help you understood how to choose different categories of mutual funds based on their risk profile and your time frame:
Frequently-used terms in mutual funds
There are a lot of words thrown around when the topic of mutual funds crops up. But they aren’t as hard as they sound; here are the basics.
NAV (net asset value)
The price of one unit of a mutual fund or one share of a mutual fund. NAV is calculated by dividing the total market value by the total number of units after taking into account the expense ratios. The NAV reflects the value of the securities in the portfolio. It is influenced by the market price of the securities in the portfolio and how much of the security the scheme holds. The change in NAV over a period will tell you what the fund’s gain or loss is and it is this performance which is crucial to deciding whether or not to invest in a fund.The absolute NAV does not matter.
A fund category is a classification to put similar funds together. For example, all funds that invest primarily in large-cap stocks will fall under the large-cap category. The table gives the list of mutual fund categories, as defined by SEBI. A fund (whether equity, debt, or hybrid) should be able to beat its category average on a consistent basis for it to be called a good performer.
A benchmark is a stock market or bond market index whose returns the fund aims at beating. The benchmark is a reference point against which the performance and stock allocation of a mutual fund scheme are compared.
This is the fee that you will be paying the AMC on an annual basis. NAV and returns of a fund are calculated after factoring in expense ratios. SEBI regulates and limits expense ratios that funds can charge besides defining what expenses an AMC can charge to a fund.
A mutual fund fact sheet is an essential document that is designed to give an overview of the mutual fund and its performance. It is beneficial for potential investors to go through this report to analyse and evaluate a mutual fund scheme and learn the pros and cons of the same.
Exit load is a fee charged from an investor for exiting or leaving a scheme before a defined period. The intent is to discourage investors from making frequent redemptions, which can tend to make fund management hard or hurt other investors in the scheme. Different mutual fund charge different fees as an exit load, and it is not necessary for a fund to have an exit load. When you sell your fund in the exit load period, the load is deducted from your proceeds and the remaining amount is credited.
Scheme Information Document
This is a comprehensive document containing fund information such as investment objective and policies, asset allocation pattern, fees and liquidity provisions. It contains details of the fund manager and his team, risk factors, and other information.
Broad variants of mutual funds
Regular and direct mutual funds
A Direct plan is when you buy directly from the mutual fund company without involving a distributor. There are several platforms on which you can buy direct plans of mutual funds, in addition to an AMC’s website.
A Regular plan is when you use the services of a distributor or an agent, to whom the AMC pays a commission. This commission forms part of the expense ratio of a regular mutual fund. For this reason, a regular plan has a higher expense ratio than the direct plan and will generate lower return.
Active and passive mutual funds
In an actively managed fund, the fund manager picks securities with the aim of beating the benchmark. Securities in an active portfolio and their weights in the portfolio will differ from that of the benchmark index. In a passive fund, the fund manager simply replicates the index with exactly the same stocks and in the same proportion. The aim is to deliver only market returns and not beat it. Index funds and ETFs are passive funds.
Open ended and close ended funds
An open ended mutual fund allows investors to invest in and redeem from a fund at any time. The fund therefore receives perpetual inflows and redemptions. Investors are allotted units at the NAV prevailing at the time of investment.
A closed-end fund is open for subscription only for a defined period, and investments need to be made only in this period. Closed-end funds also have a maturity date, before which investors cannot redeem their investments. However, in order to provide an exit route, closed-end mutual fund units are listed on stock exchanges, through which units can be sold to another investor. This route, however, sees very poor participation.
Mutual fund categories
There is no dearth to the number of schemes that each mutual fund comes out with. In order to bring in uniformity and facilitate easier comprehension for investors, SEBI has designed categories for mutual fund schemes, along with broad guidelines for each. These categories are listed below.
Equity fund categories
All equity funds have the same taxation on capital gains and dividends. The categories are listed according to the risk level involved, moving from low to high in different shades.
|Equity index Funds/ETFs||Tracks a particular stock market or bond market index.||Suits investors who want to hold a particular index without taking the risk of a fund manager’s active calls|
|Large-cap||Needs to invest at least 80% of portfolio in large-cap stocks||Holds the lowest risk among equity fund categories. Suitable as part of any 5+ year portfolios for any investor|
|Multicap||Can invest across larege-cap, mid-cap, and small-cap stocks||Risk depends on the dynamism in market-cap allocations and the large-cap exposure. Suitable as part of long-term portfolios for any investor|
|Large-and-midcap||Needs to invest a minimum of 35% each in large-cap and mid-cap stocks||Risk depends on the dynamism in market-cap allocations and the large-cap exposure. Can be used by moderate and aggressive investors for long-term portfolios. If large-cap exposure is steadily higher, can be used by conservative investors as well|
|Dividend yield||Predominantly invests in dividend paying stocks.||Risk depends on nature of market-cap allocation. Despite the name, these funds do not need to pay dividends. Can be used for long-term portfolios|
|Value/ contra||Follows a value-based investment strategy, picking stocks trading below intrinsic valuations||High risk as value as a strategy can underperform for a long time before markets notice potential in under-valued stock picks. Need at least 7+ years in holding period|
|Focused||Can invest in a maximum of 30 stocks||High risk as concentrated holding in a few stocks can lead to volatility. Can be used by high-risk and moderate-risk investors with a long timeframe|
|ELSS||Needs to invest at least 80% of portfolio in equity||Qualifies for deductions under section 80C of the Income Tax Act. Each investment is locked in for 3 years. Suits any investor looking to make tax-saving investments.|
|Mid-cap||Needs to invest at least 65% in mid-cap stocks||High risk as mid-caps are volatile. Can be used by moderate and high-risk investors. Limit mid-cap allocation (along with small-cap allocation) to 30% of 5-7 and above portfolios. Do not use for short-term investments.|
|Small-cap||Needs to invest at least 65% in small-cap stocks||Very high risk as small-caps are volatile and several stocks can be illiquid. These funds can be used by moderate and high-risk investors. Limit mid-cap allocation (along with small-cap allocation) to 30% of 5-7 and above portfolios. Do not use for short-term investments.|
|Sectoral/thematic||Invests along a particular sector or theme with 80% of portfolio in such sectors/ themes||Very high risk as sectors and themes have only specific periods where they perform. Timing is crucial and can be done only by well-informed investors|
Debt fund categories
All debt funds have the same taxation on capital gains and dividends. The list is split based on approximate minimum holding period required. Do note that a shorter-term debt fund can be held beyond the recommended minimum timeframe. A fund meant for a long-term timeframe should not be used for short-term investment horizons.
|Extremely short term debt funds|
|Overnight||Invests in overnight securities having maturity of 1 day.||Suits any investor looking to park money for very short-term needs, and earn returns better than savings bank accounts. Holds extremely low risk|
|Liquid||Invests in debt and money market instruments with maturity of up to 91 days||Suits any investor looking to park money for very short-term needs and earn returns better than savings bank account. Very low risk, but may see slight volatility sometimes on a day-to-day basis.|
|Very short term debt funds|
|Ultra-short duration||Invests in debt and money market instruments such that the portfolio’s Macaulay duration is 3 to 6 months.||Suits investors looking to invest money for 6 months to 1 year, and want better returns than bank fixed deposits. Funds vary in risks based on credit quality of underlying portfolio, and those holding low-rated papers are unsuitable for this timeframe.|
|Low duration||Invests in debt and money market instruments such that the portfolio’s Macaulay duration is 6 to 12 months.||Suits investors looking to invest money for 6 months to 1 year, and want better returns than bank fixed deposits. Funds vary in risks based on credit quality of underlying portfolio, and those holding low-rated papers are unsuitable for this timeframe.|
|Money market||Invests in money market instruments up to 1 year in maturity||Suits investors looking to invest money for the short-term of about 1 year, and want better returns than bank fixed deposits.|
|Short-term debt funds|
|Short duration||Invests in debt instruments and maintains an average portfolio Macaulay duration of 1 – 3 years||Suits investors with a 1.5-3 year horizon, looking for returns above fixed deposits. Funds vary in risks based on credit quality of underlying portfolio, and those holding low-rated papers are unsuitable for this timeframe.|
|Banking and PSU||Invests at least 80% of portfolio in CDs and other bank debt instruments and debt instruments of PSU companies||Suits any investor with a 2-3 year timeframe looking for options that deliver higher than bank fixed deposits. Credit risk is usually low.|
|Floater||Invests at least 65% of portfolio in floating rate instruments||Suits any investor with a short-term timeframe, looking for returns above that of fixed deposits|
|Longer term debt funds|
|Corporate bond||Invests at least 80% of the portfolio in instruments rated AA+ and higher||Suits any investor with a 3+ year timeframe, or need debt allocation in long-term portfolios, looking for better returns and more tax efficiency compared to fixed deposits.|
|Medium duration||Invests in debt instruments and maintains an average portfolio Macaulay duration of 3-4 years||Suits investors with 3+ year holding periods or need debt allocation in long-term portfolios. Funds vary in risk based on credit quality of underlying portfolio. Funds with high credit risk do not suit conservative or moderate risk investors.|
|Dynamic bond||Aims to either make returns from bond price appreciation during downward interest rate cycles or earn interest accrual at other times||Suits aggressive and high-risk investors with a 3+ year timeframe. Returns can be volatile in the shorter term, and funds may see underperformance if interest rate calls are wrong or become unpredictable|
|Credit Risk||Invests at least 65% of the portfolio in instruments rated below AA+||Suits only high risk investors with a 3+ year timeframe. Risks include write-offs due to downgrades or defaults resulting in sudden NAV declines.|
|Medium to long duration||Invests in debt instruments and maintains an average portfolio Macaulay duration of 4-7 years||Suits investors with 3+ year holding periods or need debt allocation in long-term portfolios. Funds vary in risk based on credit quality of underlying portfolio. Funds with high credit risk will not suit conservative or moderate risk investors.|
|Long duration||Invests in debt instruments and maintains an average portfolio Macaulay duration of at least 7 years||Suits investors with 3+ year holding periods or need debt allocation in long-term portfolios. Funds may see short-term volatility due to fluctuations in prices of bonds held.|
|Gilt||Invests at least 80% in government securities of any maturity||Suits any investor who does not mind short-term volatility, and have a 3+ year timeframe. Can form part of the debt allocation of long-term portfolios.|
|Gilt fund with 10-year constant duration||Invests at least 80% in government securities such that the Macaulay duration of the portfolio is 10 years||Suits any investor who does not mind short-term volatility, and have a 5+ year timeframe. Can form part of the debt allocation of long-term portfolios.|
What is Macaulay duration? Macaulay Duration is simply the time for the investment cost in a bond to be repaid based on weighted coupon payments. It plays a key role in helping debt fund investors measure the risk of the fund they are buying into.
Hybrid fund categories
|Conservative Hybrid||Invests 10%-25% of portfolio in equity and the rest in debt||Suits investors with a higher risk appetite who want returns above pure debt funds in the 2-3 year period.||Taxed like a debt fund|
|Aggressive Hybrid||Invests 65-80% of portfolio in equity and the rest in debt.||Suits investors who want a lower-risk route to invest in equity. Require a timeframe of at least 3 years.||Taxed like an equity fund|
|Dynamic Asset allocation or Balanced Advantage||Invests in equity/debt that is managed dynamically, based on equity and debt market valuations||Suits investors who want changing allocations based on where opportunities are, or conservative investors looking for a low-risk route to equity. Returns tend to be lower than pure equity funds. Requires a minimum 1.5-2 years in holding period, but can be longer depending on fund strategy||If average equity holding is at least 65% for the 12 months preceding redemption date, equity tax rules apply. Else, debt fund tax rules apply.|
|Multi asset allocation||Invests in at least 3 asset classes with a minimum allocation of at least 10% each in all three asset classes||Suits investors who want exposure to different assets managed dynamically. Returns tend to be lower than pure equity funds. Requires a long-term holding period due to the extremely dynamic nature of funds.||If average equity holding is at least 65% for the 12 months preceding redemption date, equity tax rules apply. Else, debt fund tax rules apply.|
|Arbitrage||Invests at least 65% in equity and hedges the entire equity exposure through derivatives||Suits investors in the high tax brackets who have a holding period of 6 months-1.5 years, due to the tax advantage these funds have. Returns are generally on par with or even lower than liquid funds.||Taxed like an equity fund|
|Equity savings||Invests at least 65% of portfolio in equity (including derivatives) and at least 10% in debt||Suits investors with a 1-3 year timeframe who want tax-efficient returns that can beat debt funds or fixed deposits.||Taxed like an equity fund|
Other fund categories
|Retirement fund||Invest in equity, debt, or a combination. Investments are locked in for 5 years. Some funds qualify for deductions under section 80C of the Income Tax Act||Suit investors who are willing to remain locked in for a long period of time, and who would like to gradually reduce from equity allocations and move towards debt as they age. These funds typically come with high exit loads.||Equity tax rules apply when the fund is equity-oriented. Otherwise, debt tax rules apply|
|Children’s fund||Invest in equity, debt, or a combination. Investments are locked in for 5 years or the child attains majority, whichever is earlier||Suit investors who want to invest in their child’s name. Other family members can also make investments in these funds in a child’s name.||Equity tax rules apply when the fund is equity-oriented. Otherwise, debt tax rules apply|
|Index Funds/ETFs||Tracks a particular stock market or bond market index.||Suits investors who want to hold a particular index without taking the risk of a fund manager’s active calls||Index funds/ ETFs tracking domestic indices are taxed like equity funds. Else, debt fund tax rules apply.|
|Fund of Funds (overseas/ domestic)||Invest in other domestic equity or debt funds, or in international funds||Suit investors who are looking for dynamic allocations to different funds or want international exposure.||Taxed like debt funds, even if underlying funds are equity funds|
Click here to see the full categorization and rationalization of Mutual Funds Schemes by SEBI.
All set? Now, take a look at our Mutual fund explorer to look at various funds and their options – https://www.primeinvestor.in/prime-ratings