Mutual Fund

““mutual fund” means a fund established in the form of a trust to raise monies through the sale of units to the public or a section of the pubic under one or more schemes for investing in securities, money market instruments, gold or gold related instruments, real estate assets and such other assets and instruments as may be specified by the Board from time to time.

In simple terms, a mutual fund is essentially a common pool of money in which investors put in their contribution. This collective amount is then invested according to the investment objective of the fund.
The money could be invested in stocks, bonds, money market instruments, gold, real estate and other similar assets. These funds are operated by money managers or fund managers, who by investing in line with the specified investment objective attempt to create growth or appreciation of the amount for investors.

For example, a debt fund will have its specified objective to invest in fixed income instruments or products like bonds, government securities, debentures, etc. Similarly, an equity fund will invest in equity related instruments which include convertible debentures, convertible preference shares, warrants carrying the right to obtain equity shares, equity derivatives and such other instrument as may be specified by the Board from time to time.

Some common categories of mutual funds are:

• Equity funds – funds that invest only in stocks and other equity related instruments
• Debt funds – funds that invest only in fixed income instruments
• Money market funds – funds that invest in short-term money market instruments
• Hybrid funds – funds that divide investments between equity and debt to create a balance

A mutual fund is set up in the form of a trust, which has a sponsor, trustees, Asset Management Company (AMC) and custodian. The trust is established by a sponsor who is like the promoter of a company. The trustees of the mutual fund hold its property for the benefit of the unit holders. The custodian, who is registered with the Securities and Exchange Board of India (SEBI), holds the securities of various schemes of the fund in its custody. The trustees are vested with the general power of superintendence and direction over the AMC. They monitor the performance and compliance with SEBI Regulations.

The AMC employs professional money managers, having expertise in investing in equity, debt or both, who then invest the collected amount from investors and manage it on their behalf.

The AMC may have several mutual fund schemes with their specific investment mandates. An investor can choose which scheme he or she wants to invest in, based on the given mandate or objective.

All AMCs are governed by a Board of Directors and come under the SEBI (Mutual Funds) Regulations, 1996. The regulator or SEBI has set clear mutual fund regulations and requires all mutual fund schemes of an AMC to clearly spell out the fund’s objectives in its prospectus that an investor must read before he/she invests in a mutual fund.

These are one of the most popular mutual fund schemes. They allow investors to participate in stock markets. Though categorised as high risk, these schemes also have a high return potential in the long run. They are ideal for investors in their prime earning stage, looking to build a portfolio that gives them superior returns over the long-term. Normally an equity fund or diversified equity fund as it is commonly called invests over a range of sectors to distribute the risk.

1. Equity funds can be further divided into three categories:

Sector-specific funds: – These are mutual funds that invest in a specific sector. These can be sectors like infrastructure, banking, mining, etc. or specific segments like mid-cap, small-cap or large-cap segments. They are suitable for investors having a high risk appetite and have the potential to give high returns.

Index funds: – Index funds are ideal for investors who want to invest in equity mutual funds but at the same time don’t want to depend on the fund manager. An index mutual fund follows the same strategy as the index it is based on. For example, if an index fund follows the BSE Index as the replicating index and if it has a 20% weightage in let’s say Stock A, then the index fund will also invest 20% of its assets in Stock A.

Index funds promise returns in line with the index they mirror. Further, they also limit the loss to the proportional loss of the index they follows, making them suitable for investors with a medium risk appetite.

Tax saving funds: – These funds offer tax benefits to investors. They invest in equities and are also called Equity Linked Saving Schemes (ELSS). These type of schemes have a 3 year lock-in period. The investments in the scheme are eligible for tax deduction u/s 80C of the Income-Tax Act, 1961.

2. Money market funds or liquid funds: – These funds invest in short-term debt instruments, looking to give a reasonable return to investors over a short period of time. These funds are suitable for investors with a low risk appetite who are looking at parking their surplus funds over a short-term. These are an alternative to putting money in a savings bank account.

3. Fixed income or debt mutual funds: – These funds invest a majority of the money in debt – fixed income i.e. fixed coupon bearing instruments like government securities, bonds, debentures, etc. They have a low-risk-low-return outlook and are ideal for investors with a low risk appetite looking at generating a steady income. However, they are subject to credit risk.

4. Balanced funds: – As the name suggests, these are mutual fund schemes that divide their investments between equity and debt. The allocation may keep changing based on market risks. They are more suitable for investors who are looking at a combination of moderate returns with comparatively low risk.

5. Hybrid / Monthly Income Plans (MIP): – These funds are similar to balanced funds but the proportion of equity assets is lesser compared to balanced funds. Hence, they are also called marginal equity funds. They are especially suitable for investors who are retired and want a regular income with comparatively low risk.

6. Gilt funds: – These funds invest only in government securities. They are preferred by investors who are risk averse and want no credit risk associated with their investment. However, they are subject to high interest rate risk.

Common terms and concepts

NFO: – NFO or New Fund Offer is the term given to a new fund offering for purchasing units of a mutual fund scheme by an AMC. For close-ended schemes, the NFO period is the only period for starting an investment.

SIP: – A mutual fund gives you an option of either investing in a lump sum or through a Systematic Investment Plan or SIP, breaking the amount into periodic investments over a long period. For example, if Ravi wants to invest Rs 60,000 annually in a mutual fund scheme and doesn’t have the lump sum amount available, he can opt for a SIP of Rs 5,000 every month.

NAV: – NAV or Net Asset Value is the price of each unit of a mutual fund. During the NFO, when the mutual fund scheme is introduced, it is priced at the face value – typically Rs 10. Later it may rise or fall depending on the performance of the fund. For example, if Ravi is investing Rs 60,000 as a lump sum during the NFO period, he will get 6000 units (Rs 60,000/Rs 10), each having an NAV of Rs 10.

Sales Price: – If the mutual fund scheme is an existing open-ended scheme, then sales price is the price or NAV charged per unit for sale of units to the unit holder.

Load: – Load is the fee charged (percentage of the NAV) by a mutual fund when you buy or sell units of a mutual fund. In India, presently there is no entry load when an investor buys mutual fund units. However, an exit load or a back-end load is applicable in some cases. It is the charge paid by an investor when he/she sells the units of a mutual fund before a specified period. It is deducted from the applicable NAV on redemption. It is generally levied to discourage early withdrawals.

Repurchase Price: – Repurchase price is the NAV minus the exit load (if applicable).

AUM: – Assets Under Management or AUM is the total value of all investments managed by the mutual fund. It can be at a scheme level or plan level.

Portfolio: – Similarly, portfolio refers to all investments made by a mutual fund scheme and the amount held in cash.

Expense Ratio: – The expense ratio of a mutual fund is calculated by dividing the total expenses the fund has incurred by its AUM. It gives the cost, a mutual fund incurs, for managing each unit. A mutual fund deducts these expenses from the NAV before declaring it on a daily basis. The expense ratio is also disclosed once every six months in the scheme financials. It is also made available on the website of the mutual fund.

Redemption/Repurchase: – Redemption/Repurchase is the buying back or cancellation of units by a mutual fund. It can happen on maturity or on an on-going basis.

Switch: – An investor also has an option of switching or transferring his or her investment from one scheme to another scheme of the same fund house.

STP: – An STP or Systematic Transfer Plan can be used in volatile markets to gradually transfer or switch small amounts of investments at chosen intervals (days/months/quarter) from one scheme to another scheme of a mutual fund. It is essentially used to transfer investments from one asset type to another.

SWP: – Many mutual funds provide the facility of Systematic Withdrawal Plans or SWPs whereby the investor receives a pre-determined amount on a periodic basis from the invested scheme. Investors who need regular income, like retirees, often go for this option. The payments are usually given from the fund’s dividend income or capital gain distribution.

Diversification – One of the biggest advantages mutual funds give you is that of immediate diversification. You may not have enough money to spread your investments in varied stocks and sectors, but by pooling money from thousands of similar investors, a mutual fund spreads your investment and hence, risk. It is highly unlikely that all the stocks will go down by the same proportion on any particular day. This ensures that you have not kept all your eggs in one basket and are safe from incurring huge losses from a single bad investment.

Professional Management – Another big benefit of investing in mutual funds is the professional expertise it provides for your investments. Asset Management Companies (AMCs) provide qualified fund managers who, with the help of strong research teams and their own expertise, pick the best options to meet the fund’s objective. This saves you time and the stress of constantly monitoring your investments and wondering if you made the right buy or sell decision. With mutual funds, you do not have to worry about market swings.

Affordability – You may want to buy shares of large companies or want to invest in big companies in a particular sector of choice. However, you may not have the money to make a big investment. Mutual funds trade in big volumes, giving their investors the advantage of lower trading costs. Anyone can start an investment in a mutual fund through a Systematic Investment Plan (SIP) with as little as Rs 500.

Liquidity – You can easily move your money in and out of mutual fund investments. Investments in open-ended funds can be redeemed in part or as a whole any time to receive the current value of the units.

Tax Benefits – There are various tax benefits available on your investments in mutual funds. For example, investments in Equity Linked Savings Schemes (ELSS) qualify for tax deductions under Section 80C of the Income Tax Act. There is no tax on capital gains on units of equity schemes held for more than 12 months.

Schemes other than equity-oriented schemes are treated in the debt category for tax purposes. Short term capital gain is applicable for redemption of debt mutual funds within 3 years. Long term capital gain (more than 3 years) from debt mutual funds is taxable after claiming the benefit of Indexation.

Well Regulated – In India, all mutual funds are regulated by the Securities and Exchange Board of India (SEBI). All mutual funds are required to follow transparent processes, as laid down by SEBI, protecting the interest of investors. Further, SEBI makes it compulsory for all mutual funds to disclose their portfolios every month.