“Mutual Fund investments are subject to market risks, read the offer document carefully before investing”. How often have we heard this? Many times. On TV and on radio, this statement comes right after we have been encouraged by the commercial to invest in a mutual fund. We find mutual fund ads on the print media also, accompanied by a compelling visual and a catchy line asking us to start investing and be free of financial worries. But, how many of us actually understand a mutual fund and its technicalities? How to know if it will fulfill our desires or not? How to invest in it? By the time we understand or take initiative to understand and invest, it’s already too late (to understand why, read Time Value of Money and The Power of Compounding). Thus, in this post I’ll explain the basics of a mutual fund investment. Happy Learning…
A mutual fund pools the investment of investors and invests the same in a variety of different financial instruments. It’s nothing more than a collection of stocks and/or bonds. Each investor holds units which represent a portion of the holdings of the fund. The income earned through the investments and capital appreciation realized by the fund are shared among the unit holders in proportion to the number of units held by them. Money can be made from a mutual fund investment in three ways:
- Via dividends on stocks and interest on bonds.
- If the fund sells the securities that have appreciated in value, then there is a capital gain which is distributed on to the unit holders.
- The fund’s shares increase in price when the fund holdings increase in price but are not sold by the fund manager. The shares can be sold for a profit.
Often, the investor has a choice either to receive the payouts for income distribution or to reinvest the earnings and get more shares.
Each mutual fund has a specific stated objective laid out in its fund prospectus (the legal document containing the information about the fund, its history, its officers and its performance).
Let us understand the key terms related to Mutual Funds:
- AMC: A mutual fund is managed by an Asset Management Company (AMC). This is the organization that pools money from the investors and invests the same in a portfolio. An AMC may have several mutual fund schemes having similar or varied investment objectives. The AMC hires a professional money manager who does the buying and selling of securities in tune with the fund’s stated objective.
- NAV (Net Asset Value): It is the total asset value (net of expenses) per unit of the fund. It is calculated at the end of every business day by the AMC. Buying and selling into funds is done on the basis of NAV-related prices. NAV is calculated as follows:
NAV= Market value of the fund’s investments + Receivables + Accrued Income – Liabilities – Accrued Expenses
NAV per unit = net value of assets / number of units outstanding
In other words, the value of all the securities in the portfolio is calculated daily, and from it, all expenses are deducted and the resultant value is divided by the number of units in the fund to get the NAV per unit.
- Expense Ratio: Also known as Management Expense Ratio (MER), it represents the ongoing expenses of a mutual fund. It covers the administrative expenses, salaries, advertising expenses, broker fees and etc. A 1.5% expense ratio means for every Rs.100 in the assets under management, the AMC charges Rs.1.50. Administrative expenses include customer service, record keeping and etc.
- Loads: Loads are fees that a fund uses to compensate the brokers or the salespeople who sell you the fund. One should always avoid buying funds with loads. There are two types of loads:
- Front-end or Entry Loads: It is the non-refundable fee paid to the AMC at the time of purchase of mutual fund units and is added to the NAV (purchase price) when purchasing Mutual Fund units. For example, if you invest Rs.2,000 regularly monthly, and assume fund has no entry load, then the units will be allocated based on prevailing NAV price (say Rs.20), i.e. 100 units. However, if there is an entry load of 2%, then the NAV allocated will be slightly higher than Rs.20. So, if there is a 2% load, then the allotted NAV will be 2% more, around Rs.20.4. Thus the number of units you’ll get is 98. In other words, 2% entry load for an investment of Rs.2000 will lead to Rs.40 being paid towards sales charges and only Rs.1960 being invested in the fund.
- Back-end or Exit Load: Also known as deferred sales charges, it is the non-refundable fee paid to the AMC at the time of redemption/ transfer of units between schemes of mutual funds. It is deducted from the NAV (selling price) at the time of such redemption/ transfer. The fee is mostly charged when the investor redeems/transfers the units within a certain time period.
- Purchase Price: It is the price an investor pays to buy one unit of the fund. If an entry load is levied, the purchase price then, is the sum of NAV and the entry load.
- Redemption Price: Redemption price is the amount received upon selling of units of open-ended scheme. If no exit-load is levied, the redemption price is the same as the NAV, else it will be lower than the NAV.
- Repurchase Price: Repurchase price is the price at which a close-ended fund repurchases its units. Repurchase price can either be at NAV. It can have an exit load.
- Switch: Switch is the shifting of an investor’s investment from one scheme to another within the same mutual fund. Some Mutual Funds provide this option. Switch allows the investor to alter the allocation of his investment so that he can meet his changed investment needs and risk profiles.
- Lock-in period: A lock-in period is the period within which an investor is not allowed to redeem fund units. In India, if one is investing in ELSS funds, the lock-in period is three years. There’s no lock-in period in the case of open-ended funds.
Benefits of investing in a Mutual Fund:
- Professional Management of Investment: AMCs hire full-time, high-level investment professionals. Having real-time access to crucial market information, the managers are able to execute trades on the largest and most cost-effective scale.
- Diversification: As Mutual Funds invest in a wide variety of securities, the risk of losing money due to a decline in one security is limited. Unit holders can benefit from the diversification techniques usually available to wealthy investors.
- Liquidity: The investor can sell his mutual fund units on any business day and receive the current market value on his investments within a short time period (normally three to five days).
- Affordability: The minimum initial investment for a mutual fund is fairly low for most funds (as low as Rs.500 for some schemes).
- Flexibility and Variety: The investor can pick from conservative, blue-chip stock funds, sectoral funds, funds that aim to provide income with modest growth or those that take big risks in the search for returns. One can even buy balanced funds, or those that combine stocks and bonds in the same fund.
- Convenience and Transparency: The investor, has the convenience of periodic purchase plans, automatic withdrawal plans, and automatic reinvestment plans, and is provided with detailed reports of the value of his investment in addition to specific investments made by the mutual fund scheme.
I hope you have learnt the basics of mutual funds, today. In my next post, I’ll be discussing the different types of mutual funds that one can invest in, according to his needs and goals. Stay tuned to achieve your financial goals.
Understand your tools before using them, otherwise they might not serve the purpose you want them to.