Mutual fund is a financial instrument which pools the money of different people and invests them in different financial securities like stocks, bonds etc. The Asset Management Company (AMC), i.e. the company which manages the mutual fund raises money from the public. The AMC then deploys the money by investing in different financial securities like stocks, bonds etc. The securities are selected keeping in mind the investment objective of the fund.
The Asset Management Company (AMC), i.e. the company which manages the mutual fund raises money from the public. The AMC then deploys the money by investing in different financial securities like stocks, bonds etc. The securities are selected keeping in mind the investment objective of the fund. For example, if the investment objective of the fund is capital appreciation, the fund will invest in shares of different companies. If the investment objective of the fund is to generate income, then the fund will invest in fixed income securities that pay interest.
Each investor in a mutual fund owns units of the fund, which represents a portion of the holdings of the mutual fund. On an on-going basis, the fund managers will manage the fund to ensure that the investment objectives are met. For the services the AMCs provide to the investors, they incur expenses and charge a fee to the unit holders. These expenses are charged against proportionately against the assets of the fund and are adjusted in the price of the unit. Mutual funds are bought or sold on the basis of Net Asset Value (NAV). Unlike share prices which changes constantly depending on the activity in the share market, the NAV is determined on a daily basis, computed at the end of the day based on closing price of all the securities that the mutual fund holds in its portfolio.
There are essentially two kinds of mutual funds.
There are 5 key advantages of investing in mutual funds:-
Units are the building blocks of a mutual fund scheme. A unit represents percentage ownership of the total pool of money managed by the Asset Management Company. Generally, Mutual fund units are priced at Rs 10 at the time of launch (known as New Fund Offer or NFO) of the scheme and its price fluctuates with change in value of the assets of the scheme
Suppose you have invested Rs 100,000 in a mutual fund. If the price of a unit of the fund is Rs 10, then the mutual fund house will allot you 10,000 units. Let us assume the total money invested in the fund by all the investors is Rs 100 Crores. The mutual fund invests the money to buy equity or fixed income securities. Each unit will represent 0.000001% value of all the securities the mutual fund has in its holdings. If you have 10,000 units, then your portion of the mutual fund holdings will be 0.01%.
As the value of portfolio of securities held by the mutual increases or decreases, so will the price of the units. If the value of assets increases from Rs 100 Crores to Rs 110 Crores, without the issue of new units, the price of the unit will be Rs 11 (0.000001% X 110 Crores). Please note that the percentage ownership represented by unit of the total assets of a scheme will change from time to time as new investors invest in the scheme or existing investors exit (redeem) from the scheme.
Mutual funds are bought or sold on the basis of Net Asset Value (NAV). NAV is essentially the price of a unit. NAV is calculated by dividing the net assets (market value of the securities and cash held by the fund minus the liabilities) of the fund by the total number of units outstanding. Unlike share prices which changes constantly during the day depending on the activity in the share market, the NAV is determined on a daily basis, computed at the end of the day based on closing price of all the securities that the mutual fund owns after making appropriate adjustments.
Contrary to popular misconception, schemes with high NAVs are not overpriced and funds with low NAVs are not attractively priced. Older the fund higher will be the NAV over a period of time. Low or high, the NAV by itself does not impact the return on investment from the mutual fund. The percentage change in a fund's NAV over a period of time denotes the percentage returns on investment of all the unit holders of the fund over the same period.
Expense ratio is the annual cost incurred by the AMC to operate a mutual fund scheme, expressed as a percentage of the total assets of the scheme. The cost includes fund manager expense, cost of the supporting infrastructure for the fund manager, transaction costs (for buying and selling securities), marketing and distribution costs (commissions paid to mutual fund distributors). If the total assets under management of a scheme is Rs 500 crores and the expense ratio is 1.5%, then it implies that, Rs 7.5 crores (1.5% X 500 crores) is the operating expenses of the scheme. This expense is deducted from the asset value of the scheme on a pro-rata basis; units are priced after deducting expense ratio. Investors should note that, the NAV of a scheme is net of the expense ratio. Expense ratios of different schemes and plans of the same AMC may be different.
Mutual funds have traditionally been distributed through MF distributors in India. MF distributors mandatorily need to have certification from AMFI (the nodal body of mutual funds in India) to ensure that they have sufficient knowledge to give investment advice to investors. Apart from investment advice, MF distributors also help investors with fulfilment of their purchase or redemption transactions (fulfilling KYC requirements, filling application forms and submission to AMCs or mutual fund registrars), as well as ongoing customer service. For their services, MF distributors get commissions from the AMC. If you make your mutual fund investment through a MF distributors, you will invest in, what is known as, regular plan of the scheme.
Some years back, investors were also provided with the option of investing directly with the AMC, without going through a MF distributors. If you submit your mutual fund investment application directly to the AMC (online or offline), you will invest in, what is known as, direct plan of the scheme. The most obvious difference between regular and direct plan is that, unlike in a regular plan, you need to have capability to decide which scheme to invest in and how to manage your investment on an ongoing basis. You will also have to devote time and effort to fulfil the transaction by yourself by providing necessary documents for KYC, filling forms and visiting the AMC (online or offline). The advantage of direct plan versus regular plan is in the expense ratio. Since in direct plans, AMCs do not have to pay commissions to the MF distributors, the expense ratio is lower. Hence, the returns are higher.
AMCs may charge a fee if you redeem (sell) your units within a specified period from the date of investment. This fee is known as exit load. Let us understand exit load with the help of an example. Suppose, you invested Rs 1 lakh in a scheme whose NAV was Rs 20; in other words, you bought 5,000 units of the scheme. Let us assume that, the exit load is 1% for redemptions within 12 months from the date of purchase. Suppose after 8 months, the NAV of the scheme is Rs 23. The value of the 5,000 units will be Rs 1.15 lakhs. However, if you redeem (sell) all your units after 8 months, you will not get a credit of Rs 1.15 lakhs to the bank because exit load will apply. Exit load per unit will be 23 paise (1% X 23) and total exit load will be Rs 1,150. This amount will be deducted from your redemption proceeds and only Rs 1,13,850 will be credited to your bank account. Investors should note that, exit load does not just apply for redemptions; they are also applicable for switches, Systematic Transfer Plans (STP) and Systematic Withdrawal Plans (SWP), as long as those transactions take place, within the exit load period.
Growth and Dividend are essentially options of how investors want cash-flows. During the course of a year, a mutual fund scheme may make profits through dividends from shares ownership or interests from bonds owned by the scheme and also through portfolio churn (profit booking by buying and selling shares and bonds). In a growth option the profit is re-invested to generate more returns whereas in dividend option the profits are distributed to the investors on a regular basis (annual, semi-annual, quarterly, monthly etc). Dividends are declared on a per unit basis. Capital appreciation is much higher in growth option because investors benefit from compounding over a long investment horizon; NAV in growth options grows much more than dividend options where the NAVs get re-adjusted whenever the scheme declares dividends. However, some investors may need income during the tenure of the investment and dividend option is suitable for such investors.
Dividend re-investment is another option available to investors. In this option the dividends instead of being distributed to investors, get re-invested to buy units of the scheme. A dividend re-investment option works very much like growth option. The major difference between growth and dividend re-investment option is that, in growth option investor gets capital appreciation through growth in NAV, whereas in dividend re-investment the investor gets capital appreciation through incremental units (the NAVs of dividend and dividend re-investment options are the same). Tax consequences of growth and dividend re-investment option are different (we will discuss in more details in a separate post).
Let us see some common terms associated with one of the most important aspects of mutual fund investments, i.e. returns and what it means to you.
There are various types of mutual fund schemes such as equity funds, debt funds and tax savings funds etc. Again within equity funds and debt funds there are various categories of schemes available for the investors to invest. We will now examine the various categories of funds within debt and equity.
Funds that invest in equity shares are called equity funds. They carry the principal objective of capital appreciation of the investment over a medium to long-term investment horizon. Equity Funds are high risk funds and their returns are linked to the stock markets. They are best suited for investors who are seeking long term growth. There are different types of equity funds such as Diversified funds, Sector specific funds and Index based funds.
As per definition, diversified equity mutual funds are purely equity funds which invest in a large number of stocks across different sectors. The objective is to diversify unsystematic risks and generate highest risk adjusted returns. Company specific and sector specific risks are unsystematic risks.
Some research houses (e.g. CRISIL) and publications employ a stricter definition for diversified equity funds. As per their definition diversified equity funds are equity funds, which invest in stocks across different sectors and market segments. In other words, as per this definition, diversified equity funds in addition to investing in stocks across different industry sectors (e.g. Banking, oil and gas, cement and construction, automobiles, technology, pharmaceuticals, capital goods, FMCG, power, infrastructure etc), also invest in stocks across different market segments in terms of market capitalization (i.e. large cap, midcap, small cap and micro cap companies). These funds are also known as flexicap or multicap funds.
Companies are categorized as large cap, mid cap, and small cap, based on their relative market capitalizations. Market capitalization is simply the market value of the company, calculated by multiplying the share price of a company with the company’s total number of shares outstanding. Bombay Stock Exchange (BSE) categorizes companies into market cap segments based on the 80-15-5 rule. In the 80-15-5 rule, companies listed on BSE are arranged in descending order of market cap (highest to lowest) and starting from the top (company with highest market cap), the largest market companies which cover 80% of the total market cap of all the companies listed on the BSE are categorized as large cap companies.
Large cap companies are typically at Market Capitalization > INR 70k crore; Mid Caps are INR 25k - 70k crore; Small Caps are INR 10k - 25k Crore and Micro Caps are INR 3k - 10k Crores.
Funds which invest amongst the large cap companies are known as Large Cap Equity Funds.
Bluechip companies are the largest of large cap companies. There is no standard definition of bluechip companies; usually, they are the very well-known leading companies in their industry sectors and have a strong track record of paying dividends regularly. Bluechip companies have a long history of strong financial performance and are sought after by both domestic and foreign investors. Examples of some bluechip stocks are TCS, Reliance, ONGC, ITC, HDFC Bank, etc.
The next set of companies which cover 80 to 95% of the total market cap of all BSE listed companies are categorized as mid cap companies. The last set of companies covering 95 to 100% of total market cap of all BSE listed companies, are small cap companies.
Mid cap companies are typically companies which have a market capitalization ranging from INR 25k - 70k crore. Mid cap companies tend to be less well known, less researched and are thought to be more risky than large cap companies. Mutual fund schemes which invest the majority portion of their portfolio in mid cap companies are called mid cap funds. Midcap funds tend to be more volatile than large cap funds. Midcap funds can also be less liquid than large cap funds in extreme market conditions.
The market capitalizations of small cap companies are INR 10k - 25k Crore. These companies are smaller than midcap companies and are thought to be riskier than even midcap companies. Mutual fund schemes which invest the majority portion of their portfolio in small cap companies are called small cap funds. Small cap funds tend to be more volatile and less liquid than mid cap funds.
Sector investing is an alternative approach that chooses investments according to a particular theme or sector. Sectoral funds are commonly known as where investment is done in a particular industry of the economy. Some of these industries are real estate, agriculture, FMCG, power and energy, pharmaceuticals, infrastructure, banking, technology, financial services, metal, etc. If an investor thinks that a particular industry will be growing in the near future, he can make his investments in the mutual fund of that particular sector instead of investing in different equity shares of that sector. Such sectoral portfolios are very volatile in nature and the gains and losses depend on how in or out of favour the sector is.
Balanced funds, as the name suggests, balance the risks and generate returns between a pure debt fund and a pure equity fund. These types of mutual funds buy a combination of equity stocks (minimum 65%) & long-term and short-term bonds (remaining 35%) to provide both income and capital appreciation while avoiding excessive risk. Investing in a Balanced Fund certainly comes as a more judicious choice. It benefits from the tremendous return-generating potential of equities and the risk reduction characteristic of fixed income investments. Balanced Funds not only provide growth to the invested corpus but also render stability to the investments made due to holding debt securities in its portfolio.
Fixed income or Debt mutual funds primarily invest in a variety fixed income securities like treasury bills, commercial papers, certificates of deposits, corporate bonds and government bonds, issued by different banks, companies and the Government. The fixed income securities are of a range of maturity profiles from short maturity period of 3 months to long maturity periods of 30 years or more. The primary investment objective of short term debt mutual funds (short term maturity profile) is to generate income while that of long term debt funds (long term maturity profile) is to generate both income and capital appreciation. Unlike bank deposits, debt funds are not risk free investments.
There are two kinds of risk associated with debt funds:-
Interest rate risk
Credit risk
Long term debt funds have higher sensitivity to interest rate risks, while short term debt funds have lower sensitivity to interest rate risks. Corporate bond funds are exposed to credit risks. However, for the vast majority of debt mutual funds credit risk is quite low. Even the corporate bond funds, which aim to generate few percentage points of additional yield by investing in slightly lower rated corporate bonds, majority of the bonds in the fund portfolios are rated AAA and AA.
There are broadly seven types of debt mutual funds in India.
Gilt funds invest in Government securities with varying maturities. Average maturities of government bonds in the portfolio of long term gilt funds are in the range of 15 to 30 years. The fund manager in long term gilt funds actively manage their portfolio and take duration calls with outlook on the interest rate. The returns of these funds are highly sensitive to interest rates movements. The NAVs of gilt funds can be extremely volatile. The primary objective of Gilt Funds is capital appreciation. Investors with moderate to high risk tolerance level, looking for capital appreciation, can invest in Gilt Funds.
Income funds invest in a variety of fixed income securities such as bonds, debentures and government securities, across different maturity profiles. For example they can invest in 2 to 3 year corporate non convertible debenture and at the same time invest in a 20 year Government bond. Their investment strategy is a mix of both hold to maturity (accrual income) and duration calls. This enables them to earn good returns in different interest rate scenarios. However, the average maturities of securities in the portfolio of income funds are in the range of 7 to 20 years. Therefore, these funds are also highly sensitive to interest rate movements. However, the interest rate sensitivity of income funds is less than gilt funds. Investors with moderate to high risk tolerance level, looking for both income and capital appreciation in different interest rate scenarios, can invest in income funds.
Short term bond funds invest in Commercial Papers (CP), Certificate of Deposits (CD) and short maturity bonds. The average maturities of the securities in the portfolio of short term bond funds are in the range of 2-3 years. The fund managers employ a predominantly accrual (hold to maturity) strategy for these funds. Short term debt funds are suitable for investors with low risk tolerance, looking for stable income.
Credit opportunities fund are similar to short term debt funds. The fund managers lock in a few percentage points of additional yield by investing in slightly lower rated corporate bonds. Despite the slightly lower credit rating of the bonds in the credit opportunities fund portfolio, on an average, majority of the bonds in the fund portfolios are rated AAA and AA. The average maturities of the bonds in the portfolio of credit opportunities funds are in the range of 2 to 3 years. The fund managers hold the bonds to maturity and so there is very little interest rate risk. Credit Opportunities funds are suitable for investors with low risk tolerance, looking for slightly higher income than short term debt funds.
Fixed Maturity Plans (FMPs) are close ended schemes. In other words investors can subscribe to this scheme only during the offer period. The tenure of the scheme is fixed. FMPs invest in fixed income securities of maturities matching with the tenure of the scheme. This is done to reduce or prevent re-investment risk. Since the bonds in the FMP portfolio are held till maturity, the returns of FMPs are very stable. FMPs are suitable for investors with low risk tolerance, looking for stable returns and tax advantage over an investment period of 3 years or more. They can provide better post tax returns than bank fixed deposits and are attractive investment options when yields are high.
Liquid fund are money market mutual funds and invest primarily in money market instruments like treasury bills, certificate of deposits and commercial papers and term deposits, with the objective of providing investors an opportunity to earn returns, without compromising on the liquidity of the investment. Typically they invest in money market securities that have a residual maturity of less than or equal to 91 days. Liquid funds give higher returns than savings bank. Unlike savings bank interest, no tax is deducted at source for liquid fund returns. There is no exit load. Withdrawals from liquid funds are processed within 24 hours on business days. Liquid funds are suitable for investors who have substantial amount of cash lying idle in their savings bank account.
Monthly income plans are debt oriented hybrid mutual funds. These funds invest 75-80% of their portfolio in fixed income securities and the 20-25% in equities. The equity portion of the portfolio of Monthly Income Plans provides a kicker to the generally stable returns generated by the debt portion of the portfolio. Monthly income plans can generate higher returns from pure debt funds. However, the risk is also slightly higher in monthly income plans compared to most of the other debt fund categories.
A money market fund is a type of open ended debt fund that invests solely in money market instruments. Money market instruments are fixed income securities like treasury bills, certificate of deposits and commercial papers and term deposits, which have very short term maturities and are highly liquid. The objective of money market mutual funds is to provide investors an opportunity to earn returns, without compromising on capital safety and liquidity of the investment. Typically money market mutual funds invest in money market securities that have a residual maturity of ranging from few days to at most few months. This helps the fund managers of liquid funds in meeting the redemption demand from the investors. Money market mutual funds are mainly used by institutional investors for parking money from time to time. Money market mutual funds, also known as Liquid funds, are also offered to retail investors to park their cash on a short term basis. While the terms money market mutual funds and liquid funds are used interchangeably, there are two kinds of money market mutual funds.
Liquid funds are money market mutual funds and invest primarily in money market instruments like treasury bills, certificate of deposits and commercial papers and term deposits, with the objective of providing investors an opportunity to earn returns, without compromising on the liquidity of the investment. Typically they invest in money market securities that have a residual maturity of less than or equal to 91 days.
Ultra short term bond funds invest in money market instruments that mature in 6 to 12 months. Longer average maturities, enable ultra short debt funds get higher returns than liquid funds. However for the same reason, the volatilities of the short term debt funds are also slightly higher than liquid funds.
Liquid fund are money market mutual funds and invest primarily in money market instruments like treasury bills, certificate of deposits and commercial papers and term deposits, with the objective of providing investors an opportunity to earn returns, without compromising on the liquidity of the investment. Typically they invest in money market securities that have a residual maturity of less than or equal to 91 days. This helps the fund managers of liquid funds in meeting the redemption demand from the investors.
Liquid funds provide a better alternative to investors who keep their surplus money parked in a savings bank account. While savings bank accounts typically pay interest rates in the range of 4 to 5%, liquid funds can potentially give much higher returns. Compared to other mutual fund categories, these funds have very low risk. Key benefits of liquid funds are:-
Liquid funds do not have any exit load. Therefore, they can be redeemed any time after investment without any penalty.
Liquid funds give higher returns than savings bank. Savings bank interest rate is around 4%, whereas liquid funds can give higher returns by at least a few percentage points. The returns of liquid funds rise when bond yields rise and fall when bond yields fall, but they can always provide higher returns than savings bank.
Liquid funds are less volatile than longer-term debt funds, since the underlying securities in their investment portfolio have short durations. Fixed income securities with short durations or maturities have lower interest rate risk, since the probability of the interest rates changing before the maturity of the securities is lower.
Unit Linked Insurance Plans (ULIPs) are combined life insurance cum investment products. Unlike traditional insurance plans e.g. endowment, money back plans, pension plans etc, ULIPs are market-linked and have the potential to deliver higher returns compared to traditional plans. However, ULIPs, unlike traditional life insurance plans, do not offer capital safety. ULIPs provide investors with life insurance cover and at the same time investment in a fund of their choice.
Mutual fund, on the other hand, is a purely market linked instrument, which pools the money of different people and invests them in different financial securities like stocks, bonds etc. Each investor in a mutual fund owns units of the fund, which represents a portion of the holdings of the mutual fund.
One can think of ULIP as a mutual fund with a term life insurance plan attached to it. In terms of gross investment returns ULIPs have performed comparably with mutual funds over a 5 year period. However, net returns to investors are lower in ULIP because various costs are deducted from ULIP premiums before they are invested in the ULIP fund. A portion of the ULIP premium goes towards buying the life cover or sum assured. Another portion goes towards a variety of fees like, premium allocation fees, policy administration fees, fund management etc. The balance premium is then invested in the ULIP fund.
An Exchange Traded Fund is essentially a basket of stocks that reflects the composition of an Index, like the Sensex or the Nifty. The price of the ETF reflects the net asset value of the basket of stocks. Exchange Traded Funds (ETFs) are listed and traded on exchanges like stocks. There are various categories of ETFs in India. They are:-
While an ETF is similar to a mutual fund in many ways, there are crucial differences between ETFs and mutual funds.
Unlike a mutual fund, where NAV is calculated at the end of the day, the price of the ETF changes in real time throughout the day, based on the actual share prices of the underlying stocks at any point in time during the day.
Mutual funds are actively managed, whereas ETFs are passively managed. Mutual funds aim to generate an alpha (or outperformance versus a market benchmark), whereas ETFs aim to track a particular index.
Mutual funds have specific investment objectives, like capital appreciation, income generation, large cap stock focus, midcap stock focus, sector focus etc. ETFs only aim to track the relevant index and reduce tracking errors.
Even though mutual funds aim to diversify unsystematic risks (or security-specific risk), and they do diversify, to a large extent, there is likely to be still some residual unsystematic risk in mutual funds because mutual funds do not exactly reflect the market portfolio. ETFs, on the other hand, are only subject to systematic risk (or market risk), since they reflect the market portfolio.
You need to have a demat account to invest in ETFs. On the other hand, you do not necessarily need to have a demat account to invest in mutual funds.