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Mutual Fund Basics

  • WHAT IS A MUTUAL FUND?

    A mutual fund is essentially a mechanism of pooling together the savings of a large number of small investors for collective investment. The avowed objective of a mutual fund is to increase the wealth of the investors while reducing risk of loss and maintaining a fund of money for quick buyouts.

  • WHAT ADVANTAGES DO MUTUAL FUNDS HOLD FOR THE ECONOMY?

    • Channeling the savings of the public
    • Helps strengthen and develop a strong capital market
    • Thereby contributes to capital formation and the growth of the economy

  • WHAT ADVANTAGES DO MUTUAL FUNDS HOLD FOR THE INVESTING PUBLIC?

    • Professional Management
    • Easy Liquidity
    • Reduction / Diversification of Risk
    • Reduction in Transaction Costs
    • Return Potential
    • Convenience and Flexibility
    • Portfolio Diversification
    • Well Regulated
    • Investor Protection
    • Switchover Facility
    • Low Operating Costs
    • Tax Benefit

  • WHAT IS A REPURCHASE/REDEMPTION ?

    • Repurchaseis a facility to redeem the unit certificates or statements of account at Net Asset Value for hard cash before the tenure of the scheme is up.
    • Redemptionis the closure of the scheme at the expiry of the tenure of the scheme.

  • WHAT ARE THE VARIOUS TYPES OF SCHEMES AVAILABLE IN A MUTUAL FUND?

    OPEN ENDED SCHEMES CLOSE ENDED SCHEMES INTERVAL SCHEMES
    Accepts funds from investors on a continuous basis. Schemes are opened for specified time period. Basically a close ended scheme with a peculiar feature that every year for a specified period (interval) it is made open.
    Repurchase facility available. Principal normally does not change throughout the year. Prior to and at such interval the scheme operates as close ended.
    No listing in the stock exchange Such schemes are normally listed in the stock exchange. Otherwise repurchase facility provided. During the said period, mutual fund is ready to buy or sell the units directly from or to the investors.
    Better liquidity due to continuous repurchase. Liquidity normally at the time of redemption.  
    Sale and Repurchase based on NAV Long term investment strategies depending on the life of the scheme.  
      Market price may be below or above par.  

    Classification by Investment Objectives:

    INCOME SCHEMES Income Schemes maximize the current income through periodical income distribution. Money is invested in low risk securities and the yield distributed.
    GROWTH SCHEMES Growth Schemes achieve the highest capital appreciation through investment in growth oriented securities.
    BALANCED SCHEMES Balanced Schemes provide current income as well as capital appreciation. The investment is in Equity and Fixed income securities as per the offer document.
    TAX SAVING SCHEMES Tax Saving Schemes provide tax incentives; e.g. Equity Linked Saving Schemes under sec. 88 of Income Tax Act.
    SECTOR FUNDS Sector Funds invest in securities of certain sector of the economy so that the risk is confined to that particular sector. Example: Information Technology Funds invest only in companies dealing in hardware, software and other related activities.
    INDEX FUNDS Index Funds match the performance of the stock market by tracking an Index that represents the overall market. The investment is in a diversified market index.
    MONEY MARKET FUNDS These Funds invest in securities of short-term nature, which generally means securities of less than one- year maturity. The major advantages are the Liquidity and safety of principal that the investors can normally expect from short-term investments.
    GILT FUNDS Gilt Funds invest is in government securities. Since the issuer is the Government of India / State, these funds have little to no risk of default as there is no credit risk involved.

    Classification by Geography:

    DOMESTIC MUTUAL FUND SCHEMES: Schemes launched with a view to mobilize savings of the citizens of the country.
    OFF SHORE SCHEMES: Mutual fund schemes launched with a view to mobilize the savings of the foreign countries for the investments in local markets.

    Funds are normally collected through the countries enjoying zero status. The aim is normally long-term capital growth by investing in local equities.

  • WHAT IS THE DIFFERENCE BETWEEN FIXED DEPOSITS AND MUTUAL FUND SCHEMES

    Fixed Deposits Mutual Fund Schemes
    Investment for a fixed period No fixed tenure in Open ended schemes
    Assured return on fixed deposits No assurance for either returns or capital growth
    Interest income is taxable Income earned by way of distribution from the open ended schemes is exempt from income tax till MARCH 2002.
    High safety in Banks, otherwise depends upon rating
    Low returns Safety depends upon the investment objective
    Objective is to earn income High returns
      Objective is to earn income and capital growth

  • WHAT IS A LOAD?

    The charges made by the fund managers to the investors to cover the distribution / sales / marketing expenses are often called "load". The load charged to the investor at the time of entry into a scheme is called Entry Load. The load that the investor pays at the time of exit is called a back-end or Exit Load.

  • WHAT IS THE RISK INVOLVED IN AN INCOME SCHEME ?

    • Credit Risk:Risk of default by the issuer of the underlying securities invested by the Fund.
    • Liquidity Risk:When the market is extremely volatile the investment cannot be easy redeemed.
    • Inflation Risk:Erosion in value due to inflation.

  • WHAT ARE THE VARIOUS TYPES OF INCOME FUNDS?

    • Money Market Funds:Investment only in Government Securities and Treasury Bills.
    • Cash / Liquid Funds:Investment in a combination of money market instruments and short term debt like Commercial Paper of Certificate of Deposits. The above two funds are ideal to park the surplus funds for short periods.
    • Bond Funds:Investment in medium to long term Bonds issued by corporations and governments
    • INCOME FUNDS ARE IDEAL FOR INVESTORS WHO ARE AVERSE TO RISK.

  • WHY SHOULD YOU INVEST IN A GROWTH FUND?

    • Chances of appreciation over time
    • Better hedge against inflation
    • Growth funds have outperformed the other asset class over long term
    • Better than Gold and real estate due to better liquidity and low transaction cost

  • WHAT IS THE REASON FOR VOLATILITY IN GROWTH FUNDS?

    Volatility is due to the portfolio mix of stocks. The mix of stock itself depends upon the degree of diversification in the fund and the extent to which the fund manager tries to hedge.

    Look at equity as a long -term investment. Stocks may go up and down in the short term but in the long term it will always perform. For confirmation look at the BSE Sensex

    HIGH LOW

    1992 4547 (Apr) 2709 (Dec)
    1994 4643 (Sep) 3576 (May)
    1996 4131 (Jun) 2713 (Dec)
    1997 4605 (Aug) 3097 (Jan)
    1998 4322 (Apr) 2742 (Nov)
    1999 5151 (Oct) 3042 (Jan)
    2000 6151 (Feb) 3593 (Oct)
    2001 4462 (Feb) 2600 (Sep)

    This is given as on 5th November, 2001.

  • WHAT ARE THE VARIOUS TYPES OF GROWTH FUNDS?

    • Diversified funds: Ideal for the investors seeking appreciation over medium to long term investments in equities across various industries / sectors either large cap or small cap
    • Index funds: Ideal for the investor who wishes to, and is also satisfied with, returns equal to that of index
    • Sector funds: Sector specific fund ideal for investors who wish to invest in a particular segment or sector

  • HOW IS THE PERFORMANCE OF A FUND MEASURED?

    • From the investors’ point of view performance can be gauged from the returns over a period of 3 months, 6 months, and 12 months, and so on.
    • Compare the peer group in the category and benchmark the return.
    • Look at the risk - return relationship.
    • Analyze the long - term performance to understand the consistency of performance in bull and bear markets.
    • The performance of a fund can be measured by quantitative tools like Sharpe and Treynor ratios.

  • IS IT SAFE TO INVEST IN MUTUAL FUNDS?

    Risk can only be minimized by managing the fund professionally. RISK CANNOT BE ELIMINATED. In the long run the fund will always be profitable.

  • CAN MUTUAL FUNDS ASSURE RETURNS?

    No. There are no assured returns in mutual funds. The returns can be higher over a long period. In case any mutual fund wants to assure returns they can do so, by clearly expressing the safety net / safety cushion available equivalent to the amount assured and the source in place.

  • WHAT IS A SYSTEMATIC INVESTMENT PLAN?

    Systematic Investment Plan is a method for investing money at regular intervals into the fund of the investors' choice over a defined time frame. This helps the investor invest monthly, quarterly and so on.

    Since the amount is invested regularly and is constant, the investor gets more units in the falling market and fewer units when the price is high.

    This helps the investor to smoothen out market fluctuations and the investment will be at a low cost over a period of time. This investment strategy is called "Rupee Cost Averaging".

  • WHAT IS A SYSTEMATIC WITHDRAWAL PLAN?

    Just like the above, it is the process of withdrawing funds at a regular interval. It results in benefiting in the rising market to reap the benefit out of average increase in the earnings.

  • WHY ARE THERE NO ASSURANCES PROVIDED BY MUTUAL FUNDS?

    No assurances can be given as per SEBI Guidelines. Of their own accord mutual funds make no assurances because any investment has certain amount of risk like: Market volatility in case of investment in Equities, Credit risk / interest risks in case of debt funds etc. However in the medium to long run there is always growth in the mutual fund schemes due to their wide and varied portfolio.

Knowledge Glossary

  • ANNUITIES OR ANNUTISATIONA scheme or process that makes a periodic distribution of money during a specific period.
  • ANNUITYA series of periodic payments in a specified period.
  • ASKED PRICEA price at which a dealer is willing to sell a security. As regards to mutual funds, the ‘ask’ or ‘offer’ price equals the net asset value (NAV) plus any front-end load or charge.
  • ASSET ALLOCATIONA systematic process of allocating assets according to intended investment outcome and the ability of the asset to provide that. It is also the combination of various types of assets to bring about the intended investment outcome at a minimum risk.
  • ASSET MANAGEMENT COMPANY (AMC)An organisation that pools in money from many people. This pool is then treated as a portfolio, which is structured to achieve certain intended objectives like: investing in multinational stocks, having high growth. Since it manages a host of assets, it is termed as an Asset Management Company. The AMC then floats various types of mutual fund schemes.
  • ASSET MANAGEMENT FEEA fee charged by the asset management company (AMC) on an annual basis for portfolio management. It is calculated as percentage of net assets under management.
  • BALANCED FUNDA portfolio that seeks to have a balanced portfolio by investing in stocks and bonds.
  • BID PRICEA price at which a security dealer is willing to pay for a certain security. As regards to the mutual fund, the bid is usually called the redemption charge.
  • CASH FLOW OF FUNDNew unit holder's money flowing into a fund. Analysts are of the opinion that a portfolio having consistent cash inflow has an edge.
  • CHEQUE-WRITING PRIVILEGEA service enabling investors to write cheques against their mutual fund account balances.
  • CLOSED-END FUNDA fund that is open to subscription for a specified period. It then gets listed on the stock exchange and can be bought or sold there. After a specific period, mentioned in the offer letter, the scheme redeems the money back to unit holders.
  • COMMERCIAL PAPERA money-market instrument that is short-term in nature and is issued by large, creditworthy corporations.
  • COMPANY RISKThe danger that some misfortune, such as a lawsuit or accident or poor earnings, may hit the company.
  • COUNTRY RISKA risk faced by international investors that their investment in foreign nation might suffer a loss. These losses might be the result of severe socio-economic problems, political upheavals or even natural disasters.
  • CREDIT RISKA risk that the issuer of any bond or debenture will run into financial problems and default on the loans.
  • CUSTODIANAn independent organisation that keeps track of and physically handles mutual funds securities.
  • DAILY DIVIDEND FUNDA fund (money-market or bond) that calculates dividends on a daily basis, paying out or reinvesting the same.
  • DERIVATIVESDerivatives, as the name suggests, are derived financial instruments. These instruments are derived from a basic underlying real asset like a share or a commodity. These instruments allow the facility to buy or sell different quantities at different rates at a future date. These derivative instruments were designed to hedge or cover risks that the underlying assets had. Over a period, these instruments have been developed to meet other needs as well.
  • DISCOUNTA term used when a closed-end fund is trading in the market at a price below its net asset value or the NAV.
  • DIVERSIFICATIONThe strategy of spreading money among different securities to reduce risk.
  • DIVIDEND YIELDThe annual dividend divided by the current price of an investment. It shows what an investment in a particular share or mutual fund would yield at the current market price.
  • ENTRY LOAD (FRONT-END LOAD)The sales charge an investor pays when he purchases units of a scheme.
  • EX-DIVIDEND DATENormally, a business day after the "record date". Investors purchasing unit on or after the "ex-dividend" date are not entitled to collect dividends or bonus units.
  • EXIT LOAD (BACK-END LOAD)The sales charge an investor pays when he sells units of a scheme.
  • EXPENSE RATIOThe annual expenses of a fund (at the end of the financial year), including the management fee, administrative costs, divided by the number of units on that day.
  • FEE TABLEA table mentioned in the prospectus that explains various kinds of fees charged to the unit holder and the impact of these charges over time.
  • FLEXIBLE-BOND FUNDA fund that can invest in a variety of bonds and has the flexibility to change the portfolio.
  • FUNDS OF FUNDSMutual funds that invest in other mutual funds.
  • GROWTH/EQUITY FUNDA fund that invests in equity shares or high yielding instruments with a view to provide strong capital appreciation.
  • HEDGINGA general term used to describe risk reduction strategies.
  • INFLATION RISKA risk that returns from an investment avenue would be eaten away by the inflation level.
  • INITIAL PUBLIC OFFERING (IPO)The sale of a company's shares or a mutual fund's scheme to investors for the first time.
  • INVESTMENT ADVISERAn organisation that provides investment advice to the mutual fund for a specified fee or many a times acts as a money manager.
  • LOCK IN PERIODIt is the period during which you can neither redeem nor transfer your holdings. Generally, the lock in period varies from scheme to scheme and is mentioned in the offer document. Lock-in periods are imposed to prevent premature withdrawals which may destabilize the fund. Through the lock in the fund managers get adequate time to deploy the funds to earn a reasonable amount of return for the investor.
  • MARKET RISKA danger that the stock market would crash due to some unforeseen calamity.
  • MONEY-MARKET FUNDA fund that invests in short-term debt securities such as Treasury bills and Commercial paper.
  • NET ASSET VALUE (NAV)The price or value of one unit of a fund. It is calculated by adding the current market value of all securities held by the fund, further adding in cash and any accrued income, then subtracting liabilities and finally dividing the result by the number of units outstanding.
  • NET ASSETSThe total value of a fund's cash and securities less its liabilities or obligations.
  • NO-LOAD FUNDA fund with no front-end or back-end load. Essentially a fund that does not charge an entry or exit fee.
  • NOMINAL RETURNThe total return on an investment less the inflation rate.
  • PORTFOLIO TURNOVERA measure of the amount of buying and selling activity in a fund. Turnover is defined as the lesser of securities sold or purchased during a year divided by the average of monthly net assets.
  • PREMIUMWhen a closed-end fund is trading at a price above its NAV, it is said to be ‘quoting at a premium.’
  • RECORD DATEDate on which a fund determines its ‘unit holders on record' who are entitled to an impending dividend or bonus units. The record date is normally the business day prior to the ex-dividend or ex-bonus date.
  • REDEMPTION PRICEThe price you receive when you sell fund units. It equals NAV less any back-end load (contingent deferred sales charge or redemption fee).
  • REINVESTMENT DATEA date on which a dividend or bonus units will be reinvested in additional full and fractional fund shares. This is normally on the business day following the record date.
  • SECTOR FUNDA fund that invests exclusively in a specific industry or stock group.
  • SECTOR RISKThe danger that a particular industry, such as software or biotechnology, will plunge.
  • SYSTEMATIC INVESTMENT PLAN (SIP)/PERIODIC INVESTMENT PLAN (PIP)A systematic service that enables you to transfer a specified amount regularly from your bank account into investments.
  • TOTAL RETURNThe most complete measure of investment performance. It takes into consideration price increase or decrease of an asset along with its income or yield when sold off.
  • WITHDRAWAL PLANA service offered by many mutual funds that allows you to receive cheques from the fund account on a regular basis.
Mutual fund investments are subject to market risks, read all scheme related documents carefully.