Mutual Funds Basic
I remember, as a beginner in the world of investing, thinking of investing in mutual funds and postponing investment decisions because I could not understand what mutual funds are, why there are so many of them, lost into their categories, how to choose, how to buy, how to monitor and so on. Complete analysis paralysis! So here is some basic information about mutual funds and answers to some frequently asked questions to help us overcome that analysis paralysis.
Mutual Fund Basics
What is a Mutual Fund?
A mutual fund is a professionally managed investment fund, where several investors pool their resources together in order to purchase stocks, bonds and other securities.
It is managed by a fund manager of a SEBI registered mutual fund company called Asset Management Company (AMC) and regulated by Securities and Exchange Board of India (SEBI) and Association of Mutual Funds in Indian (AMFI).
Total market value of asset/ fund managed by a mutual fund is referred to as Asset under Management (AUM).
The portfolio of a mutual fund is structured and designed to match the goals and category of fund mentioned in the prospectus/ factsheet of the fund.
The underlying holding of the fund is known as ‘Portfolio’ and each investor own a portion of this portfolio, in proportion to their invested amount, in the form of units.
The market price of each unit of mutual fund on a specified date or time is the NAV per unit of that fund.
How is a mutual fund setup?
A mutual fund is set up in the form of a trust, which includes sponsor, trustees, asset Management Company (AMC) and custodian.
A sponsor is like promoter of a company.
The trustee of the mutual fund holds its property for the benefit of the unit holder.
AMC is SEBI approved company who manages the funds.
Custodian, who is registered with SEBI, holds the securities of various schemes of the fund in its custody.
SEBI regulations require that at least 2/3rd of the directors of the trustee company or board of the trustees are independent i.e. they should not be associated with sponsors. Also, 50% of the directors of AMC must be independent.
All mutual funds are required to be registered with SEBI before the launch of any scheme.
What are different types of mutual funds?
Broadly there are two types based on the time period – Open- ended and close-ended Funds .They are further categorized based on the asset class to Equity, Debt, Hybrid and Gold funds. Details are as below.
An open-ended fund or scheme is one that is available for subscription and repurchase on a continuous basis. These schemes do not have a fixed maturity period. Investors can conveniently buy and sell units at Net Asset Value (NAV) per unit which is declared on a daily basis. The key feature of open-end schemes is liquidity.
Close- Ended Funds
A close-ended fund or scheme has a stipulated maturity period e.g. 3-5 years. The fund is open for subscription only during a specified period at the time of launch of the scheme. 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. SEBI Regulations stipulate that at least one of the two exit routes is provided to the investor i.e. either periodic repurchase facility or through listing on stock exchanges.
Mutual fund categories based on asset class:
|Type||Equity Find||Debt Fund||Hybrid Fund||Gold Fund|
|Asset composition||Minimum 65% Equities||Minimum 36% in Debt and Debt instruments||Debt + Equity 50 to 70% proportion||98- 100% in physical gold, Gold ETF|
|Investment objective||Long term capital appreciation||Capital preservation and small periodic returns||Periodic returns and Capital appreciation||Portfolio diversification|
|Time Horizon||More than 7 years||From few days to less than 3 years||From 3 to 7 years||Should be 5-10% of portfolio, long term|
|Long term returns expectations||12% to15%||6% to 9%||8%to 10%||3%-4%|
|Risk||High volatility, high risk. Subject to Market risk, Economy risk, Company risk, Global economy risk.||Low volatility, low to medium risk. Subject to Interest rate risk and Credit risk. Liquid funds are relatively risk free.||Low volatility, Medium to moderate risk. Subject to same risks as equity and debt funds risk, However debt component performs well when equity is not performing well and vice versa. Both asset classes balance out each other.||Low risk. Performs well in times of political and economy uncertainty.|
|Taxation||LTCG: Taxable at 10% when held for more than 1 year. STCG: anything above 1 Lac per annum; 15% when held for less than 1 year.||LTCG: Taxable at 20% with indexation or 10% without indexation, if held for more than 3 years. STCG: Added to personal income and taxable as per personal tax slab.||Equity component taxable as equity fund and debt component taxable as debt funds.||Taxable as debt fund.|
What are the benefits of investing in mutual fund?
Mutual funds are professionally managed at a reasonable cost of management.
They are safe and secure in terms of institution and company running away with your investments, as they are well regulated by SEBI.
They allow diversification of investment even with small capital.
They provide Systematic Investment Plan (SIP) option which helps maintain discipline and averages rupee cost of investment.
Liquidity, as you can sell your units anytime you want, at market value.
Goal based investing possible, as variety of options are available. Goals vary according to your financial requirements e.g. Growth, regular income, tax saving etc.
Tax efficient as you pay tax only when you sell your holdings
What is better – investing in mutual fund or direct investment in stocks?
Mutual funds are a good investment option for individuals with no prior knowledge of investing, and also for those who do not have the time to do their own research and track the performance of individual stocks.
Direct investment in stocks requires deep knowledge of stock markets, time and patience.
How to choose a mutual fund?
Define your financial needs and fiscal goal, decide your time frame and risk threshold according to your time frame and goals. This will help you choose right category of the fund – Equity, Debt, or Gold.
Apply CAARE criteria* and select a fund. It is advisable to go through the policy documents and factsheets before making an investment. The policy document contains information about the mutual fund’s investment objectives, risks, performance, and expenses. Factsheets are available with fund houses or also on the website of respective fund houses. INVEST IN DIRECT GROWTH PLAN OF THE SELECTED SCHEME.
Suggestion – you can use https://www.valueresearchonline.com/? to evaluate and choose a scheme.
*CAARE Criteria: copyright: ■ Dr Ram
of mutual fund: Large cap, Mid cap and Small cap
2. Asset under management: At least 100Cr.
3. Age of mutual fund: At least 5 years.
4. Return: Top 1/3rd in category at 1, 3, 5 years
5. Expenses Ratio: Least.
Follow step 1 to 5 to choose mutual funds.
How to invest in Mutual fund?
Once the fund is shortlisted, you can either directly go to fund house’s website, register and open an account and start investing or use free platforms like Mutual Fund Unit (MFUI) to do the same. https://www.mfuindia.com
There are many free platforms available to invest in mutual funds but their revenue model is not clear. MFUI is the platform provided by mutual fund industry/AMC houses collectively hence there are reasons to believe that there are no vested interests and it would remain free forever.
To start investing in mutual funds, you should be KYC- compliant. It is a one-time process and documents required are one self-attested photocopy of address proof, PAN card and one photo.
You need not have a DEMAT account to invest in mutual funds; your holdings are linked to a folio number and are safe. Rather if you choose to keep them in a DEMAT account, DEMAT charges may apply while selling the units.
Can NRI/ OCI/PIO Invest in mutual funds in India?
Yes, NRIs can invest in mutual funds in India. At the time of writing NRI from USA and Canada had limited options. Please check with fund house, only few fund houses offer schemes to NRI from Canada and USA, this is because of stringent additional regulatory requirements
What are direct plans and regular plans? What is advantage of a direct plan over a regular plan?
All funds except gold fund have direct and regular plans for the same scheme.
Direct plan is when you buy a mutual fund direct from an asset management company. There is no commission involved; hence expense ratio is low, leading to higher return on investment.
Regular fund is when you buy a mutual fund through an intermediary – distributor, agent or broker. The expense ratio of these funds is higher than the direct funds; hence the return on investment is lower compared to its direct counterpart.
Remember, the commission to intermediary is recurring annually till the age of investment and is a percentage of total amount invested through the intermediary.
How to convert a regular mutual fund to a direct mutual fund?
Technically you cannot convert a regular mutual fund holding to a direct plan. You can however switch from a regular to a direct plan.
“Switching” means selling of units in one fund and purchasing the units of other fund, it may attract exit load* and tax implication. It is prudent to check how it may affect you and plan your switch accordingly.
Meanwhile stopping further investment in regular plan and starting new investment in direct plan of same or different mutual fund of your choice is an option. That would allow you to plan your switch gradually as per exit load and tax period requirements.
*Some mutual funds do not charge exit load if you are switching to direct plan of same fund. Please check the rules with fund house.
What is Net Asset Value or NAV?
In the context of a mutual fund or an exchange traded fund (ETF), the NAV is the per unit (or per share) price of a fund on a specific date or time.
NAV= Market value of the fund’s investments + Receivables+ Accrued income -Liabilities – Accrued expenses.
NAV per Unit= (Market value of the fund’s investments + Receivables+ Accrued income – Liabilities- Accrued expenses) / Total number of outstanding Units.
A fund works by collecting money from a large number of investors. It then uses the collected capital to invest in a variety of stocks and other financial securities that fit the investment objective of the fund. Each investor gets a specified number of Units in proportion to their invested amount, and they are free to sell (redeem the value of) their fund Units at a later date and pocket the profit/loss. Since regular buying and selling (investment and redemptions) of fund Units start after the launch of the fund, a mechanism is required to price the units of the fund. This pricing mechanism is based on NAV.
NAV for mutual funds varies everyday and calculated at the end of the day and updated on AMFI’s and the mutual funds website by 9 PM every day.
If schemes in the same category of different mutual funds are available, should one choose a scheme with lower NAV?
In case of mutual fund schemes, lower or higher NAVs of similar type of schemes of different mutual funds have no relevance.
NAV is a reflection of assets held by a mutual fund, its value and not the cost! The NAV is nothing but the value of the total underlying assets of the fund divided by the number of units.
Return on investment in mutual funds is nothing but the percentage change in the NAV of that fund. This is reflection of the performance of the portfolio of that particular fund. Meaning more units of a lower NAV fund and less units of higher NAV fund both will achieve 10% return assuming both the schemes have performed equally well and their assets have gone up by 10% at the same time.
Note: NAV of regular funds are lower than direct funds of the same scheme, as the commission paid yearly to agent is deducted from their NAV.
From the return perspective percentage return for regular fund is lower than direct fund of the scheme. Say for example if 0.5% of NAV is paid as commission per year in regular fund, return of regular fund will be 0.5% lower than direct fund. Meaning for the same scheme: If return from direct fund is 10%, return from regular fund will be 9.5%.
How many mutual funds from each category should one invest in?
Wealthcon recommends max 2 mutual funds from each category.
Large cap : 2 Mutual funds
Mid cap : 2 Mutual funds
Small cap :2 Mutual funds
ELSS :2 Mutual funds
To avoid over diversification and dilution of returns, it is advisable not to invest in more than 2 funds from each category, and not more than 8 mutual funds in total.
What is a Systematic Investment Plan (SIP)? What are its advantages?
Through an arrangement called SIP, mutual funds provide investors an option to invest fixed amounts at regular intervals like monthly, weekly, or quarterly period.
Once set up, a fixed amount is deducted automatically from the linked bank account, and units of specified mutual funds are purchased based on NAV on that date.
The advantage of SIP is that investment is disciplined and on autopilot, and there is no need to remember and execute the order each time.
SIP also prevents investor from the urge to time the market.
Also SIP gives investors the advantage of rupee cost averaging, meaning you buy more units when market is down and less units when market is up, thus averaging the cost of buying over the long term.
What is better SIP or Lump-sum investment?
Theoretically SIP works best in falling market and lump sum works best in the bull market.
However it is hard to time the market.
Generally, when switching between the asset classes, i.e. from one equity fund to other equity fund, lump sum investment is advisable.
Does the date of SIP matter?
No it does not matter; what matters is that the SIP is in a well selected fund.
Can we go for MF in case of short term investment, say 6 month?
You can go for Liquid mutual funds or Arbitrage funds for investments of less than 6 months duration. However keep in mind that Liquid mutual funds are taxed as per your income tax slab and Arbitrage funds are taxed as equity funds. Both may have exit loads, please read offer document before investingJ.
What is exit load?
Exit load are charges levied by mutual fund for exiting the fund before pre-defined period. It is expressed as percentage of NAV effectively percentage of total redeemed amount. Exit load and defined period is mentioned in the offer document and also in the fund fact sheet.
Most mutual funds charge exit fee around 1-2% if investor exits/ redeems fund within 1 year of joining the fund. This is to discourage investors from leaving the mutual fund in short period.
In a liquid fund, most schemes do not charge exit load as these funds are meant for short term investments.
What is total expense ratio (TER)?
Total expense ratio is the annual operating charges levied by a fund. Operating expenses of fund includes administration, management, and also commission paid to intermediaries (in case of regular fund).
An expense ratio of 1% per annum means each year 1% of the fund’s total assets will be used to cover expenses. Information on TER that may be applicable to a scheme is mentioned in the offer document.
The NAV of a mutual fund is net of all liabilities including TER, and hence a lower TER means higher returns and vice versa.
How does TER affect returns on mutual fund?
All other factors remaining the same, an investor should ideally invest in a scheme which charges a lower TER compared to peers as higher expenses reduce the returns of the fund.
What is folio number?
In mutual funds, a folio number is a unique number identifying your account with the fund. Like a bank account number, the folio number can be used as a way to uniquely identify fund investors and keep records of items such as how much money each investor has placed with the fund, their transaction history, and contact details.
How much should one invest in debt or equity oriented schemes?
It depends on individual’s financial goals, age, and risk taking capacity.
GRED is a general guide for asset allocation by Wealthcon.
Consider asset allocation in 4 main asset classes – Gold: Real Estate: Equity: Debt.
An age wise asset allocation guideline is as below,
However, one should tailor one’s asset allocation based on one’s requirement.
30 years- 5:40:55:5
40 years -10:40:40:10
50 years- 10:40:30:20
60 years- 10:40:20:30
70 years -10:40:10:40
80 years 5:40:5:55
Note- Ratios are arbitrary, but, can be guidelines for a balanced portfolio.
Do banks sell direct mutual funds?
No, banks do not sell direct mutual funds, they are distributors/agents.
Where can an investor look for information on mutual funds?
Almost all the mutual funds have their own web sites.
Investors can also access the NAVs of all mutual funds on the web site of association of mutual funds in India (AMFI) www.amfiindia.com.
Investors can log on to the web site of SEBI www.sebi.gov.in and go to “Mutual Funds” section for information on SEBI regulations and guidelines, data on mutual funds, draft offer documents filed by mutual funds, etc.
Also, in the annual reports of SEBI available on the web site, information on mutual funds is given.
There are a number of other web sites like www.valuresearchonline.com which give a lot of information on various schemes of mutual funds including returns over a period of time.
Where can one see the distributor’s commission?
From 01 October 2016, the Consolidated Account Statement (CAS) issued to investors is required to provide information in terms of total purchase value/cost of investment in each scheme.
Further, CAS issued for the half-year (ended September/March) also provides the amount of actual commission paid by AMCs/Mutual Funds to distributors (in absolute terms)
What is a consolidated account statement (CAS) for mutual funds?
A CAS is the summary of all the mutual fund transactions linked to a PAN.
It lists mutual funds holdings, folio number, all the financial transactions including commission paid to distributor, investment method lump sum or SIP, NAV and current market value of investment.
It also lists investor details like name, contact details, bank contact details and nominee.
It is issued half yearly (September/March), and also whenever new transaction happens in an account.
Where to get CAS?
You can get this statement emailed to your inbox by providing your PAN (Permanent Account Number) to any of the mutual fund registrars – CAMS, Karvy, Franklin Templeton or Sundaram BNP Paribas Financial Services (SBFS). However, please note that your email address must be registered with your mutual fund scheme in order to avail of this service. All the funds in which your email address is registered will be included in this statement.
How to evaluate performance of a mutual fund?
- Compare with benchmark return- return should be above or just equal to benchmark.
- Compare with Index return – return should be above or just equal to Index.
- Compare with peer mutual funds – returns should be at par with best performing peer funds.
- Compare with same category funds – returns should be above or comparable to same category funds.
How frequently should one monitor mutual funds?
Equity mutual funds should be monitored yearly, if evaluation is satisfactory, one may wait for 3 -4 years to see good returns (as full market cycle, ups and down is approximately 3-4 years).
When is the right time to exit a fund?
- When your specific investment goal is reached.
- If fund is underperforming to its benchmark and its peers.
- If there is change in your goal, financial situation, the expected returns and risk bearing capacity and you are rebalancing your portfolio based on these changes.
- When fund deviates from its initial objective.
- When there is change of fund manager, watch the performance of the fund closely, and exit if the new management’s style does not suit your goal.
What is capital gain and how is it taxed?
The profit realized on the sale of capital assets, including mutual funds, is called capital gain.
Depending on the asset class and holding period, it is classified as LTCG and STCG.
For equity fund
Long term capital gain (LTCG) – holding period more than 12 months
Short term capital gain (STCG) – holding period less than 12 months.
For Debt fund
Long term capital gain (LTCG) – holding period more than 3 years.
Short term capital gain (STCG) – holding period less than 3 years.
Tax liability based on asset class and holding period is as below,
For debt funds (e.g. Liquid funds)
STCG, up to 3 years holding period are taxed as per tax slab of an individual.
LTCG, after 3 years of holding period flat 20% tax after indexation benefit is applicable.
For equity funds (e.g. Arbitrage funds)
STCG, up to 1 year holding period are taxed at 15%.
LTCG, after 1 year holding period capital gain up to 1 lac per annum is tax free. Any amount over 1 lac per annum is taxed at 10% without indexation.
What is the difference between Stopping the SIP and selling or redeeming the units?
When one stops the SIP, new investment stops, but the previous amount invested in the scheme remain invested as it is, until redemption is requested.
Redeeming refers to selling one’s units. Units are sold and amount credited in your bank account; tax and exit load may apply.
What is Extended internal rate of return (XIRR)?
XIRR is a method used to calculate returns on investments where there are multiple transactions happening at different times. It is a good function to calculate returns when your cash flows (investments or redemption) are spread over a period of time. In the case of Mutual funds, if you are investing through SIP, XIRR can help you calculate a consolidated return considering timings of your investment.
You can think of XIRR as an aggregation of multiple CAGR’s. If you make multiple investments in a fund, you can use the XIRR formula to calculate your overall CAGR for all those investments taken together.
What is Compounded annual growth rate (CAGR)?
CAGR is a method to calculate returns on investments where there is one time lump-sum investment.
N= number of years of investment.
Is it worth switching all existing mutual fund units (after exit load) to direct plans considering LTCG tax?
If there is LTCG, tax is applicable irrespective of timing of exiting the fund.
However LTCG amount up-to 1 lac per financial year is exempted from tax, so you can plan your exit accordingly.
Also if you wish to set it off against Long term capital loss (LTCL) at some point, you may time it accordingly.
What are sector specific funds/ schemes?
These are funds investing in particular sector or industry, as specified in their offer document, e.g. Pharmaceuticals, Fast moving consumer goods, infrastructure, banking, technology etc.
They are more risky as their portfolio consists mainly of investment in one particular type of sector. They are suitable for highly aggressive skilled active investors, as investor needs to monitor them closely and exit at an appropriate time.
What are the pros and cons of investing in sector specific and thematic funds?
Sector specific and thematic funds are high risk and should be avoided by average investors.
They are specialized funds with exposure to one particular sector or theme. They require good understanding of sector/ theme and economy. Timing of entry and exit should be right too. Because of the cyclical nature of the market no sector or theme performs continuously well over long period. Chances of investor picking them up at wrong time or not exiting at right time are high.
What is a Fund of Funds (FoF) scheme?
A scheme that invests primarily in other schemes of the same mutual fund or other mutual funds is known as a FoF scheme. A FoF scheme enables the investors to achieve greater diversification through one scheme. The expense ratios of such schemes are higher hence they should be avoided.
What are Exchange Traded Funds (ETFs)?
ETFs are mutual fund units that investors can buy or sell at the stock exchange.
In the ETF structure, ‘Units’ are issued to a few designated large participants called Authorised Participants (APs). The APs provide buy and sell quotes for the ETFs on the stock exchange, which enable investors to buy and sell the ETFs at any given point of time when the stock markets are open for trading.
ETFs therefore trade like stocks and experience price changes throughout the day as they are bought and sold. Buying and selling ETFs requires the investor to have demat and trading accounts. For example:
– Niftybees is a Nifty 50 ETF available to buy on stock exchange from your trading account.
– Liquidbees is a Liquid fund ETF available to buy on stock exchanges from your trading account.
What is the role of Securities and Exchange Board of India (SEBI) in mutual funds industry?
SEBI formulates policies, regulates and supervises mutual funds to protect the interest of the investors.
All mutual funds whether promoted by public sector or private sector entities including those promoted by foreign entities are governed by the same set of Regulations. There is no distinction in regulatory requirements for these mutual funds and all are subject to monitoring and inspections by SEBI.
How can investors redress their complaints?
Investors would find the name of contact person in the offer document of the mutual fund scheme who they may approach in case of any query, complaints or grievances. Trustees of a mutual fund monitor the activities of the mutual fund. The names of the directors of AMC and trustees are also given in the offer documents. Investors should approach the concerned Mutual Fund / Investor Service Centre of the Mutual Fund with their complaints. If the complaints remain unresolved, the investors may approach SEBI for facilitating redressal of their complaints. On receipt of complaints, SEBI takes up the matter with the concerned mutual fund and follows up with it regularly
Other Useful Links
- Securities and Exchange Board of India
- SEBI Investor Awareness Website
- SEBI Complaints Redress System (SCORES) – View Circular
- National Institute of Securities Markets
- MF Utilities India Pvt. Ltd (MFU)
- Reserve Bank of India
- NSE – National Stock Exchange of India Ltd.
- BSE – Bombay Stock Exchange of India Ltd.
- Income Tax India