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Mutual Fund Basics
Mutual Fund Basic

Mutual Fund Basics

Mutual funds are one of the best avenues for your money to flourish. Depending on your risk appetite, it gives you the option to choose stability, aggressive growth or both. Let’s explore the world of mutual funds and learn how you can make the most of it.

1. What is a mutual fund?

Quite simply, a mutual fund is a mediator that brings together a group of people and invests their money in stocks, bonds and other securities.

Each investor owns shares, which represent a portion of the holdings of the fund. Thus, a mutual fund is one of the most viable investment options for the common man as it offers an opportunity to invest in a diversified, professionally managed basket of securities at a relatively low cost.

2. What are the benefits of investing in a mutual fund?

Investing in a mutual fund offers you a gamut of benefits

Some of them are as below:

  • Small investments: With mutual fund investments, your money can be spread in small bits across varied companies. This way you reap the benefits of a diversified portfolio with small investments.
  • Professionally managed: The pool of money collected by a mutual fund is managed by professionals who possess considerable expertise, resources and experience. Through analysis of markets and economy, they help pick favourable investment opportunities.
  • Spreading risk: A mutual fund usually spreads the money in companies across a wide spectrum of industries. This not only diversifies the risk, but also helps take advantage of the position it holds.
  • Transparency and interactivity: Mutual funds clearly present their investment strategy to their investors and regularly provide them with information on the value of their investments. Also, a complete portfolio disclosure of the investments made by various schemes along with the proportion invested in each asset type is provided.
  • Liquidity: Closed ended funds can be bought and sold at their market value as they have their units listed at the stock exchange. In addition to this, units can be directly redeemed to the mutual fund as and when they announce the repurchase.
  • Choice: A wide variety of schemes allow investors to pick up those which suit their risk / return profile.
  • Regulations: All the mutual funds are registered with SEBI. They function within the provisions of strict regulation created to protect the interests of the investor

3. What is an asset management company (AMC)?

An AMC is a company that manages a mutual fund.

For all practical purposes, it is an organized form of a money portfolio manager which has several mutual fund schemes with similar or varied investment objectives. The AMC hires a professional money manager, who buys and sells securities in line with the fund's stated objective.

4. How are mutual funds classified?

Every investor has a different investment objective. Some go for stability and opt for safer securities such as bonds or government securities. Those who have a higher risk appetite and yearn for higher returns may want to choose risk-bearing securities such as equities. Hence, mutual funds come with different schemes, each with a different investment objective.

There are hundreds of mutual fund schemes to choose from. Hence, they have been categorized as mentioned below.

By structure: Closed-Ended, Open-Ended Funds, Interval funds.

By nature: Equity, Debt, Balance or Hybrid.

By investment objective: Growth Schemes, Income Schemes, Balanced Schemes, Index Funds.

5. What are the different types of mutual funds?

There are hundreds of mutual fund schemes to choose from. Hence, they have been categorized by structure, nature and investment objective.

Types of mutual funds by structure

Close ended fund/scheme: A close ended fund or scheme has a predetermined maturity period (eg. 5-7 years). The fund is open for subscription during the launch of the scheme for a specified period of time. Investors can invest in the scheme at the time of the initial public issue and thereafter they can buy or sell the units on the stock exchanges where they are listed. In order to provide an exit route to the investors, some close ended funds give an option of selling back the units to the mutual fund through periodic repurchase at NAV related prices or they are listed in secondary market.

Open ended fund/scheme: The most common type of mutual fund available for investment is an open-ended mutual fund. Investors can choose to invest or transact in these schemes as per their convenience. In an open-ended mutual fund, there is no limit to the number of investors, shares, or overall size of the fund, unless the fund manager decides to close the fund to new investors in order to keep it manageable. The value or share price of an open-ended mutual fund is determined at the market close every day and is called the Net Asset Value (NAV).

Interval schemes: Interval schemes combine the features of open-ended and close-ended schemes. The units may be traded on the stock exchange or may be open for sale or redemption during pre-determined intervals at NAV related prices. FMPs or Fixed maturity plans are examples of these types of schemes.

Types of mutual funds by nature

Equity mutual funds: These funds invest maximum part of their corpus into equity holdings. The structure of the fund may vary for different schemes and the fund manager’s outlook on different stocks. The Equity funds are sub-classified depending upon their investment objective, as follows:

  • Diversified equity funds
  • Mid-cap funds
  • Small cap funds
  • Sector specific funds
  • Tax savings funds (ELSS)

Equity investments rank high on the risk-return grid and hence, are ideal for a longer time frame.

Debt mutual funds: These funds invest in debt instruments to ensure low risk and provide a stable income to the investors. Government authorities, private companies, banks and financial institutions are some of the major issuers of debt papers. Debt funds can be further classified as:

  • Gilt funds
  • Income funds
  • MIPs
  • Short term plans
  • Liquid funds

Balanced funds: They invest in both equities and fixed income securities which are in line with pre-defined investment objective of the scheme. The equity portion provides growth while debt provides stability in returns. This way, investors get to taste the best of both worlds.

Types of mutual funds by investment objective

Growth schemes
Also known as equity schemes, these schemes aim at providing capital appreciation over medium to long term. These schemes normally invest a major portion of their fund in equities and are willing to withstand short-term decline in value for possible future appreciation.

Income schemes
Also known as debt schemes, they generally invest in fixed income securities such as bonds and corporate debentures. These schemes aim at providing regular and steady income to investors. However, capital appreciation in such schemes may be limited.

Index schemes
These schemes attempt to reproduce the performance of a particular index such as the BSE Sensex or the NSE 50. Their portfolios will consist of only those stocks that constitute the index. The percentage of each stock to the total holding will be identical to the stocks index weight age. And hence, the returns from such schemes would be more or less equivalent to those of the Index.

6. What does a mutual fund do with my money?

If you have even as little as a few hundred rupees to spare, you can start your investment journey with mutual funds.

Depending on your investment objectives and future needs, you can choose to buy a particular number of units of a fund. A mutual fund invests the pool of money collected from the investors in a range of securities comprising equities, debts, money market instruments etc., with a nominal AMC fees. In proportion to the number of units you hold, the income earned and the capital appreciation realised by the scheme will be shared with you accordingly.

7. How are mutual funds different from portfolio management schemes?

In mutual funds, your money along with many others is pooled to form a common investible corpus. Any profit/loss made during a given period will be the same for all investors. However, if you choose a portfolio management scheme, your individual investment remains identifiable to you. Here, even the profit/loss of all the investors will be different from each other.

8. How is investment in a mutual fund different from a bank deposit?

When you deposit money with the bank, the bank promises to pay you a certain rate of interest for the period you specify.

On the date of maturity, the bank is supposed to return the principal amount and interest to you. Whereas, in a mutual fund, the fund manager invests your money as per the investment strategy specified for the scheme. The profit, if any, minus manager expense, is reflected in the NAV or distributed as income. Similarly, loss, if any, with the expenses, is to be borne by you.

9. Does investing in mutual funds mean investing in equities only?

Mutual Funds, besides equities, can also invest in debt instruments such as bonds, debentures, commercial paper and government securities. Every mutual fund scheme is governed by the investment objectives that specify the class of securities it can invest in.

10. How are mutual funds regulated?

SEBI and/or the RBI (in case the AMC is promoted by a bank) regulates all Asset Management Companies (AMCs).

In addition, every mutual fund has a board of directors that represents the unit holders' interests in the mutual fund.

11. Why are mutual funds a safe investment option?

Diversification – Investors can spread out and minimize their risk up to a certain extent by purchasing units in a mutual fund instead of buying individual stocks or bonds. By investing in a large number of assets, the shortcomings of any particular investment are minimized by gains in others.

  • Economies of scale: Mutual funds buy and sell large amounts of securities at a time. This helps reduce transaction costs and bring down the average cost of the unit for investors.
  • Professional management: Mutual funds are managed by thorough professionals. Most investors either don’t have the time or the expertise to manage their own portfolio. Hence, mutual funds are a relatively less expensive way to make and monitor their investments.
  • Liquidity: Investors always have the choice to easily liquidate their holdings as and when they want.
  • Simplicity: Investing in a mutual fund is considered to be easier as compared to other available instruments in the market. The minimum investment is also extremely small, where an SIP can be initiated at just Rs.50 per month basis.

12. Why is diversification of funds important?

When it comes to mutual funds, putting all your eggs in a single basket is never a wise option. This is due to the market volatility and the risks that come with it.

But you can always minimise them by distributing your investments among various financial instruments, industries and other categories. Here the intent is to maximise returns by investing in different areas, where each would react differently to the same event. This not only buffers the impact of a market downturn, but also allows for more potential rewards by offering a broader exposure to various stocks and sectors.

13. What is a portfolio?

A portfolio of a mutual fund scheme is the basket of financial assets it holds. It consists of investments diversified in different securities and asset classes which help reduce the overall risk. A mutual fund scheme states the kind of portfolio it seeks to construct as well as the risks involved under each asset class.

14. What is net asset value (NAV)?

Net Asset Value (NAV) is the actual value of one unit of a given scheme on any given business day.

The NAV reflects the liquidation value of the fund's investments on that particular day after accounting for all expenses. It is calculated by deducting all liabilities (except unit capital) of the fund from the realisable value of all assets and dividing it by number of units outstanding.

15. What is load?

It is the charge collected by a mutual fund from an investor for selling the units or investing in it. Entry load or Front-end load or Sales load is the charge collected at the time of entering into the scheme.

An Exit load or Back-end load or Repurchase load is the charge collected at the time of redeeming or transferring between schemes (switch). There are also schemes that do not charge any load and are called "No Load Schemes".

16. What is sale price?

It is the price paid by an investor when investing in a scheme of a Mutual Fund. This price may include the sales or entry load.

17. What is redemption/repurchase price?

Redemption or Repurchase Price is the price at which an investor sells back the units to the Mutual Fund. This price is NAV related and may include the exit load.

18. What is repurchase or back end load?

It is the charge collected by the scheme when it buys back the units from the unit holders.

19. What is the role of a fund manager?

Fund managers constantly monitor market and economic trends and analyse securities in order to make informed investment decisions.

They play a vital role in implementing a consistent investment strategy that is in synergy with the goals and objectives of the fund.

20. What are sector funds?

These are funds that invest exclusively in stocks that fall into a certain sector of the economy. This scheme is perfect for investors who have decided to confine their risk and return to one particular sector. Thus, an Infrastructure Fund would invest in companies that manufacture and support companies which deal with construction, raw material production, etc.

21. What is the difference between Growth Plan and Dividend Reinvestment Plan?

Investors obtain capital appreciation on their investments under the Growth Plan. However, under the Dividend Reinvestment Plan, the dividends declared are reinvested automatically in the scheme.

22. What is a switching facility?

Investors have an option of transferring the funds amongst different types of schemes or plans with a switching facility.

Investors can opt to switch units between Dividend Plan and Growth Plan at NAV based prices. Investors can also switch into/from other select open-ended schemes currently within the fund family or schemes that may be launched in the future at NAV based prices. However, investors need to be careful of entry and exit loads while switching between Debt and Equity Schemes. There is an entry load on switching from a Debt Scheme to Equity scheme, while there is none on the other way round.

23. What is an account statement?

An account statement is a non-transferable document that serves as a record of transactions between the fund and the investor.

It contains details of the investor, the units allotted or redeemed and the date of transaction. The Account Statement is issued every time any transaction takes place.

24. Who is a registrar?

A Registrar is responsible for accepting and processing the unit holders' applications, carrying out communications with them, resolving their grievances and dispatching Account Statements to them.

In addition, the registrar also receives and processes redemption, repurchase and switch requests. The Registrar maintains an updated and accurate register of unit holders of the Fund and other records as required by SEBI Regulations and the laws of India. An investor can get all the above facilities at the Investor Service Centers of the Registrar.

25. What is a Systematic Investment Plan?

SIP is a method of investing a fixed/regular sum every month or every quarter. With the growing everyday expenses, it becomes difficult to accumulate a considerable sum which can be invested at one go.

But with an SIP, you can start with a modest amount of Rs. 250 every month and this can be invested in any scheme of your choice as most mutual funds have this facility for their schemes.

26. Why is SIP a great investment option?

The biggest advantage of an SIP is the habit of regular, disciplined savings. Every month, like all other EMIs, this also gets deducted from the bank a/c through electronic clearing service, which is convenient. A SIP does not pinch the pocket much if started at an earlier stage.

  • Another benefit is that when investing through SIP, it is not necessary to time the market. Investments will be made systematically every month or quarter depending on the option. It ensures investing in all phases of the market where more units will be accumulated during a bearish phase and a lesser number of units in a bullish phase. This way, the investor enjoys the benefit of rupee cost averaging under this method.
  • With an SIP investment, you give your savings the power of compounding. Here’s an illustration of this works:

Suppose Mr. Ranjan invests Rs. 60,000 at 12 per cent per annum. After 30 years it will add up to Rs. 1.60 crore (Rs. 16 million). If the savings were started 5 years later, the sum accumulated would be lower by Rs. 90 lakh (Rs. 9 million) to just Rs. 89 lakh (Rs. 8.9 million). Just an early start of five years, that is, an additional Rs. 3 lakh (Rs. 300,000) of incremental investment increases your sum by almost a crore (Rs. 10 million). That is the power of compounding.

  • SIP helps in averaging costs over a period of time. Since you are investing the same amount every month or every quarter, the average NAV at which you have acquired the units will be lower. Here’s an how:

Let's say, Mr. Pratap has started an SIP in June 2011 with Rs. 10,000 every month.

Month Amount invested (Rs.) NAV (assumed) Units allocated
June 2011 10,000 11 909.0909
July 2011 10,000 11.5 869.5652
Aug 2011 10,000 10 1,000.0000
Sept 2011 10,000 14 714.2857
Oct 2011 10,000 9 1,111.1111
Total: 50,000 4,604.0530

(Assuming a no load structure)

You might notice more units have been allocated when the NAV is lower and lesser number of units when the NAV is higher. The average cost per unit is Rs. 50,000/4604.0530 = 10.8600 and the average cost during the same period would work out to (Rs. 11 + 11.5 + 10 + 14 + 9 / 5 = 55.5)

However, if Mr. Pratap had invested his Rs. 50,000 all at once in June 2011, he would have been allotted 4,545.455 units at the cost of Rs. 11.

It’s clear that SIP, with its small investments goes a long way in helping you grow your money and achieve your goals.

27. What is a systematic withdrawal plan (SWP)?

The unit holder may set up a Systematic Withdrawal Plan on a monthly, quarterly or semi-annual or annual basis to redeem a fixed number of units. The systematic withdrawal plan, besides being popular among investors looking for consistent cash flows from their investments, is helpful for retirees to support their expenses.

28. What is a systematic transfer plan (STP)?

With an STP, you choose a particular amount to be transferred from one mutual fund scheme to another of your choice. You can go for a weekly, monthly or a quarterly transfer plan, depending on your needs.

29. How can STP help you?

If you are looking at gradually exposing yourself to equities or reducing exposure over a period of time, then STPs are a good option.

You than start an STP where every month a pre-determined amount will be invested into an equity fund. This helps in deploying funds at regular intervals in equities with minimum timing risk. This also gives you an opportunity to earn better than saving bank account rate of return.

Unfreezing equity assets

In case you want to cash out your funds from equity, there’s a momentary exposure to timing risk while exiting the market. To bypass the risk, you can transfer funds from equity schemes to liquid funds and withdraw the money as per your needs.

STP to save tax

If you have been investing in equities using diversified equity funds, and now keen to do some tax-saving investments. You can initiate an STP from the diversified fund to an ELSS of the same fund house. This ensures that you are saved on the transactions front. Instead of selling units of equity mutual fund first and then waiting for the proceeds before investing again, STP makes a smooth transfer of money from one fund to another.

You can initiate an STP for your funds in diversified fund to an ELSS of the same fund house. So instead of selling units of equity mutual fund first and then waiting for the proceeds before investing again, STP makes a smooth transfer of money from one fund to another.

30. What does it cost?

Mutual funds have a load structure that affects the transaction cost. While the entry load has been done away with by most mutual funds, there is an exit load applicable.

So when you opt for an STP, there is an exit load to be paid on the scheme from which the funds are transferred. Also, transfer of funds from one scheme to another is treated as sale for the purpose of taxation and you may have to pay the taxes applicable.

31. What are the types of returns one can expect from a Mutual Fund?

Capital Appreciation and Dividend Distribution are the two ways in which mutual funds give returns.

With the increase in the value of individual securities in the fund, its unit price increases and the investor can book a profit by selling these units at a higher price. In Dividend Distribution, the unit holders receive the profit earned by the fund in the form of dividends. Dividend distribution can however be re-invested in the fund or can be paid to the investor.

32. Can the NAV of a debt fund fall?

While the rate of interest on debt instruments stays the same throughout their tenure, their market value keeps changing, depending on how the interest rates in the economy shift.

A debt fund's NAV is the market value of its portfolio holdings at a given point in time. As interest rates change, so do the market value of fixed-income instruments - and hence, the NAV of a debt fund.

33. How do I track the performance of the Fund?

The NAVs are published in financial newspapers and also available on the AMFI website on a daily basis.

34. Does out performance of a benchmark index always connote good performance?

The index performance is volatile and may be driven by a few factors only. So it is better to keep other factors like risk adjusted returns (volatility of returns) and NAV movement in mind while deciding to invest in a fund.

35. Does higher return necessarily mean a better fund?

At one level, high return is equivalent to good fund. However, there might also be some risks involved to achieve these returns. Hence, statistical tools like Beta, Sharpe ratio, Alpha and Standard Deviation to measure this risk is always wise. A risk adjusted return is the best measure to use while judging a scheme. You can also refer to the ratings assigned by a reputed rating agency.

36. What should one keep in mind while choosing a good Mutual Fund?

Income, expenses, commitments, financial goals and many other factors vary from person to person.

So before investing your money in mutual fudns, you need to analyse the following:

  • Investment objective: The first step should be to evaluate your financial needs. It can start by defining the investment objectives like regular income, buying a home, finance a wedding, educating your children, or a combination of all these needs. Also your risk appetite and cash flow requirements form an important part of the decision.
  • Choose the right Mutual Fund: Once the investment objective is clear, the next step would be choosing the right Mutual Fund scheme. Before choosing a mutual fund the following factors need to be considered:
    • NAV performance in the past track record of performance in terms of returns over the last few years in relation to appropriate yardsticks and other funds in the same category
    • Risk in terms of unpredictability of returns
    • Services offered by the mutual fund and how investor friendly it is
    • Transparency indicated in the quality and frequency of its communications

It is always advisable to diversify your money by investing it in different schemes. This not only cuts down on the risk, but also gives you a chance to benefit from multiple industries and sectors.

37. How important are fund costs while choosing a scheme?

The cost of investing through a mutual fund warrants due consideration since management fees, annual expenses of the fund and sales loads can erode a significant portion of your returns. Generally, 1% towards management fees and 0.6% towards other annual expenses is acceptable.

But do check the fee charged by the fund for getting in and out of the fund.

38. How to decide if the New Fund is an appropriate one for you?

You can start by looking into your financial plan or your existing portfolio. You should analyse the kind of funds in your existing portfolio – if they large cap funds, mid cap funds, flexi cap funds, balanced funds, tax planning funds.

  • Then evaluate how the new fund adds value to your existing portfolio, fits in with the asset allocation and help you achieve your goals.
  • Understand the investment objective, strategy and asset allocation of the new fund.
  • You also need to check the fund manager’s track record in managing other schemes. Other schemes managed by this fund manager and how they have performed in the past.
  • It would also be recommended to verify the stability of the fund house investment team, the number of schemes managed by them and their track record of launching new funds.

39. Ideally how many different schemes should one invest in?

It is recommended to invest in two to three funds that match and/or complement your investment objective. This is to avoid dependence on any one fund and avert risks of market downturns. You can always split the pie as 60:40 with two funds and 40:30:30 in case of 3 funds.

40. What is Employee Unique Identification Number (EUIN)?

The EUIN is a seven digit unique alpha numeric number that is issued by AMFI to all the employees/relationship manager/sales persons of the distributor, interacting with the investor for the sale of Mutual Fund products. It is necessary that the EUIN be provided for transactions that are advisory in nature. This means that transactions, for which advice is sought by the investor from a distributor, should be accompanied by the EUIN.AMFI has allotted EUIN to all ARN holders and their employees who interact with the investor for the sale of mutual fund products. EUIN is alpha-numeric, with one alphabet and six numerals, for example E123456.

41. What is the benefit of providing EUIN?

EUIN will assist in tackling the problem of mis-selling even if the employee/relationship manager/sales person leave the employment of the ARN holder / Sub broker. Investors are requested to use new application forms having provision for ARN code, Sub Broker ARN code, EUIN, Sub broker code (as allotted by ARN holder).

42. Is it mandatory to provide the EUIN in transaction?

Yes. EUIN is applicable for transactions routed through an ARN holder, which are Advisory in nature, i.e. investment is being made on the basis of advice provided by the employee / relationship manager / sales person of the distributor.

In case of Execution-only transaction, the following declaration available in application form should be signed by the investor/s, depending upon the mode of holding. "I/We hereby confirm that the EUIN box has been intentionally left blank by me/us as this is an "execution-only Transaction without any interaction or advice by the employee / relationship manager / sales person of the above distributor or notwithstanding the advice of in-appropriateness, if any, provided by the employee/relationship manager/sales person of the distributor and the distributor has not charged any advisory fees on this transaction". Investor are requested to use new application forms having provision for ARN code, Sub broker ARN code, EUIN, Sub broker code (as allotted by ARN holder). For a transaction which is execution only in nature, the investor would need to sign a declaration which is incorporated in the new application form. For new application forms investors are requested to visit our website www.idfcmf.com or contact any of our branch or Investor Service Centers.

43. Which type of transactions is covered under EUIN?

Applicable Transactions:

  • Transactions for which EUIN is applicable - Purchases, Switches, and for Fresh Registrations of SIP / STP / Dividend Sweep Plan.
  • Transactions for which EUIN is not applicable - Ongoing SIP/ STP / SWP / STP Triggers (registered prior to June 1, 2013), Dividend Reinvestments, Bonus Units, Redemption, SWP Registration, Zero Balance Folio creation and installments under Dividend Sweep Plans
  • For transactions as mentioned above EUIN is effective from June 01, 2013, executed through all modes except for the following modes which shall be effective by August 1, 2013.
    • Mobile / SMS based transactions.
    • Transactions received through the Stock Exchange Platform.

44. Where can one find the euin number?

After logging into your online account, go to tab Transact Online. Under the section broker details, you can obtain the EUIN number by filling in the ARN number in the search tool. Alternatively, you can obtain it from your advisor.

 
 
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