1.What is a Mutual Fund?

A Mutual Fund is a trust that pools the savings of a number of investors who share a common financial goal. It is essentially a diversified portfolio of financial instruments – these could be equities, debentures / bonds or money market instruments. The corpus of the fund is then deployed in investment alternatives that help to meet predefined investment objectives. The income earned through these investments and the capital appreciation realised are shared by its unit holders in proportion to the number of units owned by them. Thus a Mutual Fund is a suitable investment 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?

The benefits of investing in mutual funds are as follows –

Access to professional money managers – Your money is managed by experienced fund managers using advanced scientific and mathematical techniques.

Diversification -Mutual funds aim to reduce the volatility of returns through diversification by investing in a number of companies across a broad section of industries and sectors. It prevents an investor from putting “all eggs in one basket”. This inherently minimizes risk. Thus with a small investible surplus an investor can achieve diversification that would have otherwise not been possible.

Liquidity – Open-ended mutual funds are priced daily and are always willing to buy back units from investors. This mean that investors can sell their holdings in mutual fund investments anytime without worrying about finding a buyer at the right price. In the case of other investment avenues such as stocks and bonds, buyers are not necessarily available and therefore these investment avenues are less liquid compared to open-ended schemes of mutual funds.

Tax Efficiency*

Equity Funds
Currently, dividends are tax-free in the hands of the investor. There is no distribution tax payable by a Mutual Fund on dividends distributed. There is no tax deduction at source on dividends as well. Investments for over 12 months qualify for long-term capital gains, which are currently, exempt from tax. Moreover for investors there is no TDS on redemption of the units in case they are “resident” under the Indian Income Tax Act, 1961(“the Act”). Securities Transaction Tax is applicable on redemption of equity fund investments.

Debt Funds
Currently, dividends are tax-free in the hands of the investor. However, there is distribution tax together with surcharge and education cess, as may be applicable, payable by the Mutual Fund on dividends distributed. There is no tax deduction at source on dividends as well. Investments for over 12 months qualify for long-term capital gains. For investors there is no TDS on redemption of the units in case they are “resident” under the Indian Income Tax Act, 1961(“the Act”).

*This information is general in nature and investors should seek appropriate legal advice in their own case.

Low transaction costs – Since mutual funds are a pool of money of many investors, the amount of investment made in securities is large. This therefore results in paying lower brokerage due to economies of scale.

Transparency – Prices of open ended mutual funds are declared daily. Regular updates on the value of your investment are available. The portfolio is also disclosed regularly with the fund manager’s investment strategy and outlook.

Well-regulated industry – All the mutual funds are registered with SEBI and they function under strict regulations designed to protect the interests of investors.

Convenience of small investments: Under normal circumstances, an individual investor would not be able to diversify his investments (and thus minimize risk) across a wide array of securities due to the small size of his investments and inherently higher transaction costs. A mutual fund on the other hand allows even individual investors to hold a diversified array of securities due to the fact that it invests in a portfolio of stocks. A mutual fund therefore permits risk diversification without an investor having to invest large amounts of money.

Types of Mutual Funds

Mutual fund schemes may be classified on the basis of their structure and their investment objective

By Structure

Open-ended Funds
An Open-ended Fund is one that is available for subscription all through the year. These do not have a fixed maturity. Investors can conveniently buy and sell units at Net Asset Value (NAV) related prices.

Close-ended Funds
A Close-ended Fund has a stipulated maturity period, which generally ranges from 3 to 15 years. The fund is open for subscription only during a specified period. Investors can invest in the scheme at the time of the initial public issue and thereafter they can buy or sell the units of the scheme on the Stock Exchanges, if they are listed. The market price at the stock exchange could vary from the scheme’s NAV on account of demand and supply situation, unit holders’ expectations and other market factors.

By Investment Objective

Growth Funds
The aim of growth funds is to provide capital appreciation over the medium to long term. Such schemes normally invest a majority of their corpus in equities. Growth schemes are ideal for investors who have a long-term outlook and are seeking growth over a period of time.

Income Funds
The aim of Income Funds is to provide regular and steady income to investors. Such schemes generally invest in fixed income securities such as bonds, corporate debentures and Government securities.
Income Funds are ideal for capital stability and regular income. Capital appreciation in such funds may be limited, though risks are typically lower than that in a growth fund.

Balanced Funds
The aim of Balanced Funds is to provide both growth and regular income. Such schemes periodically distribute a part of their earning and invest both in equities and fixed income securities in the proportion indicated in their offer documents. This proportion affects the risks and the returns associated with the balanced fund – in case equities are allocated a higher proportion, investors would be exposed to risks similar to that of the equity market.
Balanced funds with equal allocation to equities and fixed income securities are ideal for investors looking for a combination of income and moderate growth.

Money Market Funds
The aim of Money Market Funds is to provide easy liquidity, preservation of capital and moderate income. These schemes generally invest in safer short-term instruments such as Treasury Bills, Certificates of Deposit, Commercial Paper and Inter-Bank Call Money. Returns on these schemes may fluctuate depending upon the interest rates prevailing in the market.
These are ideal for corporate and individual investors as a means to park their surplus funds for short periods.

Other Equity Related Schemes

Tax Saving Schemes
These schemes offer tax rebates to investors under specific provisions of the Indian Income Tax laws, as the Government offers tax incentives for investments in specified avenues. Investors are advised to consult their financial advisors for more details.

Index Schemes
Index Funds attempt to replicate the performance of a particular index such as the BSE Sensex or the NSE S&P CNX 50.

Sectoral Schemes
Sectoral Funds are those which invest exclusively in specified sector(s) such as FMCG, Information Technology, Pharmaceuticals, etc. These schemes carry higher risk as compared to general equity schemes as the portfolio is less diversified, i.e. restricted to specific sector(s) / industry (ies).

3.What are the different options that mutual funds offer?

To cater to different investment needs, Mutual Funds offer various investment plans. Some of the important investment plans include:

Growth Option
Dividend is not paid-out under a Growth Plan and the investor realises only the capital appreciation on the investment (by an increase in NAV).

Dividend Payout Option
Dividends are paid-out to investors under a Dividend Payout Option. However, the NAV of the mutual fund scheme falls to the extent of the dividend payout.

Dividend Re-investment Plan
Here the dividend accrued on mutual funds is automatically re-invested in purchasing additional units in open-ended funds. In most cases mutual funds offer the investor an option of collecting dividends or re-investing the same.

Retirement Pension Plan
Some schemes are linked with retirement pension. Individuals participate in these plans for themselves, and corporates participate for their employees.

Insurance Plan
Certain Funds offer some schemes that offer insurance cover to investors.

Systematic Investment Plan (SIP)
Here the investor is given the option of preparing a pre-determined number of post-dated cheques (or a direct debit of the bank account) in favour of the fund. The investor is allotted units on a pre-determined date specified in the Offer Document at the applicable NAV.

Systematic Encashment Plan (SEP)
As opposed to the Systematic Investment Plan, the Systematic Encashment Plan allows the investor the facility to withdraw a pre-determined amount / units from his fund at a pre-determined interval. The investor’s units will be redeemed at the applicable NAV as on that day.

4.What is Net Asset Value (NAV)?

Net Asset Value is the market value of the assets of the scheme minus its liabilities. The per unit NAV is the net asset value of the scheme divided by the number of units outstanding on the Valuation Date.

Typically, NAV is calculated by summing the current market values of all securities held by the fund, adding in cash and any accrued income, then subtracting liabilities and dividing the result by the number of units outstanding.

For example:

Total Value of Securities (Equity, Bonds, Debentures etc.) INR1,000
Cash INR1,500
Liabilities INR500
Total outstanding units 100
NAV [(1000+1500-500)/100] INR20 per unit

5.What are loads?

Load is a charge collected by a mutual fund when it sells units. It can be levied as an exit load (i.e, the charge is collected when the investor sells back the units). * In accordance with the SEBI circular no. SEBI/IMD/CIR No.4/168230/09 dated June 30, 2009, no entry load will be charged for purchase / additional purchase / switch-in accepted by the Fund with effect from August 1, 2009. Similarly, no entry load will be charged with respect to applications for registrations under Systematic Investment Plan/ Systematic Transfer Plan / Systematic Investment Plan Plus accepted by the Fund with effect from August 1, 2009.

Schemes that do not charge any load are called No Load Schemes.

6.Can the sell price be different from the NAV?

The sell price of schemes can be different from the NAV due to exit loads. For example, if the current NAV of a scheme is Rs. 10 and the exit load is 1.5per cent then the effective sale price will be INR9.85.

7.What is redemption price?

Redemption price is the price received by the customer on selling units of an open-ended scheme to the fund. If the fund does not levy an exit load, the redemption price will be same as the NAV. The redemption price will be lower than the NAV in case the fund levies an exit load.

8.What is repurchase price?

Repurchase price is different from redemption price and refers to the price at which a close-ended scheme repurchases its units. Repurchase can either be at NAV or can have an exit load.

9.What is a switch?

Some Mutual Funds provide the investor with an option to shift his investment from one scheme to another within that fund. For this option the fund may levy a switching fee. Switching allows the Investor to move his investment wholly or partly from one scheme to another to meet his changed investment needs, changed risk profile or changing circumstances during his lifetime.

10.What are the regulations that govern a mutual fund?

The process of setting up a Mutual Fund is initiated by a sponsor. The sponsor creates a Trust (the fund) under the Indian Trust Act. The Trust in turn appoints an Asset Management Company (AMC). The trustees are responsible for safeguarding the interests of the investors in the Mutual Fund by ensuring that the operations of the fund comply with the relevant regulations. The fund also has to be approved by the market regulator, which is the Securities and Exchange Board of India (SEBI).

11.What is an Asset Management Company (AMC)?

Every Mutual Fund has an Asset Management Company (AMC) associated with it. The AMC is responsible for managing the investments for the various schemes operated by the Mutual Fund.

The Trust oversees the performance of the AMC. The AMC employs professionals to manage the funds. The AMC may be assisted by a custodian and a registrar.

AMCs are obliged to make investments in compliance with SEBI regulations.

12.Who is a custodian?

The custodian is responsible for the possession, handling and safekeeping of all securities purchased by the Mutual Fund.

13.Are mutual funds allowed to indulge in speculation / day trading?

No, Mutual funds are not permitted to speculate. As per SEBI regulations, all trades done by mutual funds should be settled by delivery except derivative trades, which are settled in cash.

14.What is an asset management fee?

The Asset Management Company (AMC) as the Investment Manager of the Mutual Fund charges a fee for portfolio management. The fee charged on an annual basis is calculated as a percentage of net assets under management.

15.What are the types of risks?

Risk is an inherent aspect of every form of investment. For mutual fund investments, risks would include variability, or period-by-period fluctuations in total return. The value of the scheme’s investments may be affected by factors affecting capital markets such as price and volume volatility in the stock markets, interest rates, currency exchange rates, foreign investment, changes in government policy, political, economic or other developments.

Market Risk: At times the prices or yields of all the securities in a particular market rise or fall due to broad outside influences. When this happens, the stock prices of both an outstanding, highly profitable company and a fledgling corporation may be affected. This change in price is due to “market risk”.

Inflation Risk: Sometimes referred to as “loss of purchasing power.” Whenever the rate of inflation exceeds the earnings on your investment, you run the risk that you’ll actually be able to buy less, not more.

Credit Risk: In short, how stable is the company or entity to which you lend your money when you invest? How certain are you that it will be able to pay the interest you are promised, or repay your principal when the investment matures?

Interest Rate Risk: Changing interest rates affect both equities and bonds in many ways. Bond prices are influenced by movements in the interest rates in the financial system. Generally, when interest rates rise, prices of the securities fall and when interest rates drop, the prices increase. Interest rate movements in the Indian debt markets can be volatile leading to the possibility of large price movements up or down in debt and money market securities and thereby to possibly large movements in the NAV.

Investment Risks: The sectoral fund schemes, investments will be predominantly in equities of select companies in the particular sectors. Accordingly, the NAV of the schemes are linked to the equity performance of such companies and may be more volatile than a more diversified portfolio of equities.

Liquidity Risk: Thinly traded securities carry the danger of not being easily saleable at or near their real values. The fund manager may therefore be unable to quickly sell an illiquid bond and this might affect the price of the fund unfavourably. Liquidity risk is characteristic of the Indian fixed income market.

Changes in the Government Policy: Changes in Government policy especially in regard to the tax benefits may impact the business prospects of the companies leading to an impact on the investments made by the fund.

16.Are returns from mutual funds guaranteed?

Generally, Mutual Funds do not offer guaranteed returns to investors. Although, SEBI regulations allow Mutual Funds to offer guaranteed returns subject to the Fund meeting certain conditions, most Funds do not offer such guarantees. In case of a guaranteed return scheme, the sponsor or the AMC, guarantees a minimum level of return and makes good the difference if the actual returns are less than the guaranteed minimum. The name of the guarantor and the manner in which the guarantee shall be met must be disclosed in the offer document by the Mutual Fund. Investments in mutual funds are not guaranteed by the Government of India, the Reserve Bank of India or any other government body.

17.Invest in Mutual Fund mean to invest in equity?

No, this is not necessary. Invest in Mutual Fund doesn’t mean invest in Equity. Mutual funds can be divided into various types depending on asset classes. They can also invest in debt instruments such as bonds, debentures, commercial paper and government securities apart from equity.

Every mutual fund scheme is bound by the investment objectives outlined by it in its prospectus. The investment objectives specify the class of securities a mutual fund can invest in. Based on the investment objective, the following types of mutual funds currently operate in the country.

  1. Growth Schemes
  2. Income Schemes
  3. Balanced Schemes
  4. Money Market Schemes

18.Can the NAV of a debt fund fall?

A debt fund invests in fixed-income instruments. These include Commercial Paper, Certificates of Deposit, debentures and bonds. While the rate of interest on these instruments stays the same throughout their tenure, their market value keeps changing, depending on how the interest rates in the economy move.

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. Thus it is a misnomer that the debt fund’s NAV does not fall.

19.How, and against what, should I benchmark the performance of a mutual fund?

A Mutual Fund’s performance can be benchmarked against other Mutual Funds of similar type – for example, the performance of a diversified equity fund should be compared to similar funds in the industry or against established market indices like the BSE Sensex or the NSE Nifty. One can also benchmark the fund against any other broad-based index for the particular asset class. The Investment Manager usually decides a benchmark index at the time of conceptualization of the scheme and this benchmark serves as a good tool for comparison.

The comparison period for benchmarking Mutual Fund schemes has to be carefully decided. Equity funds should be ideally compared over a 1-2 year horizon. Any comparison over a shorter period would be distorted by short term, volatile price movements. Similarly, the ideal comparison period for a debt fund would be 6-12 months while that for a liquid/money market fund would be 1-3 months.

20.Besides the NAV, are there any other parameters which can be compared across different funds of the same category?

Besides Net Asset Value the following parameters should be considered while comparing the funds:

AVERAGE RETURNS An investor should look at the returns given by the fund over a period of time. Care should be taken to see whether all dividends and bonuses have been accounted for. The higher and more consistent the returns the better is the fund.

VOLATILITY In addition to the returns one should also look at the volatility of the returns given by the fund. Volatility is essentially the fluctuation of the returns about the mean return over a period of time. A fund giving consistent returns is better than a fund whose returns fluctuate a lot.

CORPUS SIZE A Large corpus is generally considered good because large funds have lower costs, as expenses are spread over large assets but at the same time a large corpus has some inefficiencies too. A large corpus may become unwieldy and thus difficult to manage.

PERFORMANCE VIS A VIS BENCHMARKS / OTHER SCHEMES An investor should not only look at the returns given by the scheme he has invested in but also compare it with benchmarks like the BSE Sensex, S & P Nifty, T-bill index etc. depending on the asset class he has invested in. For a true picture it is advised that the returns should also be compared with the returns given by the other funds in the same category.
It is prudent to consider all the above-mentioned factors while comparing funds and not rely on any one of them in isolation.

21.How are mutual funds different from Portfolio Management Schemes?

In Mutual Funds, the investments of investors are pooled to form a common investible corpus and the gain/loss to all investors during a given period are same for all investors. In the case of portfolio management schemes, the investments of a particular investor remain identifiable to him. Here the gain or loss of investors will be different from each other. Invest in Mutual Fund, Now!

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