What is a Mutual Fund?
How does one calculate the NAV and What does an NAV signify?
What is the difference between open-ended and close-ended schemes?
Why do shares of a close-ended scheme trade at discount to its NAV?
How safe are Mutual Funds?
What is entry load and exit load?
What advantages do mutual funds offer over equity stocks?
What are the different schemes available under mutual funds?
How does one choose the right fund?
What is a Mutual Fund?
A mutual fund collects money from various investors, and then invests this pool in various financial instruments. The fund managers attempt to generate returns superior than what the investors themselves would have managed.
Each mutual fund has its own investment objective, which falls into two categories: capital appreciation and current income. Suppose a mutual fund sells one million units or shares (used as synonyms in this context) at Rs 10 a unit and collects a total Rs 10 million. If the fund objective stated investment in blue-chip stocks, the fund manager would invest the entire proceeds (less any commissions and management fee) of that sale in buying equity shares of companies like Hindustan Lever, Reliance Industries, Hero Honda and so on. And each individual who bought shares of the fund would own a percentage of the total portfolio only to the extent of money invested.
The value of the fund’s portfolio would depend on how shares of these companies perform on the stock market (given their financial prospects). If the total market value of these companies (as reflected in the fund) increases to Rs 12 million, then each original share of the fund would be worth Rs 12 (Rs 12 million divided by one million shares). This per share value is what is known as the net asset value (NAV) of the mutual fund. It equals the market value of all its assets (after adjusting for commissions, expenses, and liabilities, if any) by the number of such units or shares outstanding.
How does one calculate the NAV and What does an NAV signify?
Net asset value on a particular date reflects the realisable value of a mutual fund’s portfolio in per share or per unit terms. It is the worth of an investment with an open-end mutual fund quoted in terms of its net asset value. That is also the amount an investor can expect if he or she were to sell his or her units back to the issuer.
Daily closing prices of all securities held by the fund are used as a starting point. Subtract from this amount liabilities (including expenses and commissions). And divide the result by the number of outstanding shares and you get the NAV. If the realisable worth of the portfolio is Rs 12 million, divided it by shares outstanding, let’s say one million units, then the NAV is Rs 12 (12mn/1mn). If your fund’s NAV a year ago was Rs 10.5 and is currently Rs 12, then your pre-tax return is 14.28 per cent ((12-10.5)/(10.5)*100). An NAV signifies nothing more than the current worth of a portfolio.
The returns from a fund, based on NAV, makes better sense when compared to a benchmark index. First, it tells you the extent to which, the securities that comprise the fund’s portfolio have outperformed or under performed the index. Two, the use of certain statistical measures can also tell you whether a fund was able to derive above-average risk-adjusted returns. Having said this, a fund’s historical NAV performance is not the best indicator of its future performance. For equity funds, this NAV changes almost everyday with fluctuations in stock prices. The NAV of a fixed-income fund is driven more by changes in rate of interest. On its own, a rising NAV only means that assets, which form a part of the fund’s portfolio, are rising and vice-versa.
What is the difference between open-ended and close-ended schemes?
A mutual fund can be either open-ended or close-ended. The difference between the two is in the way each operates after the new fund offering. A close-ended scheme operates like any other public entity whose shares are traded on the stock market. Thus, to buy or sell units of a close-ended scheme, you have to transact on the BSE or on the NSE. That’s why the market price of its units is also determined by supply and demand for its units (apart from quality and performance of its portfolio).
On the contrary, open-ended funds continue to price, sell and repurchase shares after the new offer on the basis of the NAV. The mutual fund will sell additional units of the fund at the NAV (at par or adjusted for expenses), or buy back (redeem) shares of the fund at the NAV (at par or adjusted for expenses). That’s why the unit capital of open-ended funds can fluctuate on daily basis. But a close-ended fund may or may not offer more units after its listing. It may or may not also repurchase its units. That is up to the issuing mutual fund to decide.
Why do shares of a close-ended scheme trade at discount to its NAV?
It is important know that the NAV and the market prices of close-ended schemes are never the same. Close-ended schemes always trade at a discount. What explains this discount? And why does this discount differ from one fund to another? The discount is partly explained by the time frame of investment. Most close-ended funds have a rather long time frame of investment, typically, five to 15 years (while some may never be redeemed).
That makes it impossible to predict the ability of the fund to liquidate its portfolio at market prices or even close to market prices (since they often have large holdings in companies). This discount, however, reduces (market price comes closer to NAV) as the fund nears redemption. Or if it is being converted into an open-ended fund, where the pricing is based on the NAV. Otherwise, any other difference in the rate of discount from one fund to another has got to do with the fund objective, quality of its portfolio and so on. If the stock markets view on the quality of its portfolio and the fund’s manager are positive, its share price will trade closer to NAV.
How safe are Mutual Funds?
Just like any other financial instrument, mutual funds are not without risk. When defined in terms of chances of losing money, the risk in mutual funds is no different than that present in other financial instruments. Still they are relatively safer and a more convenient way on investing.
In mutual funds, you can control risk by choosing a fund that suits your risk profile. On the other hand, picking stocks individually that will both meet your objectives and match your profile can be tough.
A mutual fund portfolio is easier to monitor than equity shares. They also come with less systemic risks. They offer quick liquidity. Most private mutual funds can be redeemed in three to four working days. This too cuts the overall risk associated with investing, often not so visible and hence not accounted by many investors. But the market risk or the risk that exists due to economy-wide factors remains. And there is always the possibility that a fund fail to stick to its pre-determined objectives or invests in securities that alter its risk profile. In which case, the blame goes straight to the fund manager and the Asset Management Company (AMC), which manages the mutual fund.
What is entry load and exit load?
The asset management company (AMC) that manages your mutual fund has to spend on people, technology and infrastructure to generate returns. So it recovers part of this regular expenses from the investor. It is broken into two parts: annual management fee (up to 1.25 per cent for funds less than Rs 1 billion and one per cent for funds above Rs 1 billion) and entry & exit loads. Loads normally apply to only open-ended schemes. An entry load is also called the sales load, which is mainly to help the AMC recover expenses relating to sales literature, distribution, advertising and agent/broker commissions.
The price at which an investor buys into the fund is a function of both the NAV and sales load. For instance, if the fund’s NAV is Rs 12 and the applicable sales load is 6 per cent, your cost of entry is Rs 12.77 (12/(1-0.06)). If the investor applied for Rs 10,000 worth of units he would receive 783.085 units (10,000/12.77).
On the other hand, exit load (if you withdraw within a specified period) is charged while redeeming your units. The latter is for more logical reasons, especially with income or money market funds, where a quick withdrawal by too many investors can put pressure on the fund’s asset maturity profile. So to ensure that longer-term investors are not penalised, short-term investors are charged an exit load. But an exit load can also be applied by the AMC, if it wants to prevent unit holders from selling their units. This happens when the fund has done poorly against the benchmark index.
An established fund can also manipulate investor entry into a fund by charging or not charging a sales load. An AMC can charge a stiff entry load if it wants to prevent more investor from pouring money into its schemes. However, that rarely happens. More often, the AMC welcomes investors by advertisements screaming “no load” if invested within a certain time frame. Smart investors have to recognize this tactic used by an AMC.
What advantages do mutual funds offer over equity stocks?
Here are a few considerations :
Diversification : Most mutual funds spread the money over a number of shares depending on the fund size. This lowers the risk from an investment loss in a few shares. Even if any one or two shares were to under perform, their impact on the NAV may be only restricted to their proportion of holding. You can’t get much diversification from buying equity shares of a company, unless you buy into a conglomerate.
Systematic Investment Plan : Small sums (starting from Rs 500) of money can be invested monthly or quarterly. A plan for systematic withdrawals is also available from some funds.
Easy entry and exit : Filling a mutual fund application or a redemption form, even online, is all that it takes while entering or exiting a mutual fund. But with equity shares, you need an account with a stockbroker (for buying & selling) and another with a depository participant (which maintains your shares in an electronic form). Some investors may find this cumbersome.
Reinvesting dividends : Funds provide for automatic reinvestment of dividends. In India, this facility is not so far available with equity shares.
Tax benefits : Equity linked savings schemes are covered under the overall limit of Rs. 1 lakh under section 80C.
Professional management : When you are investing in a mutual fund, professionals with experience in fund and portfolio management take care after your money. They are also supposed to monitor the economy and the stock markets to change the portfolio accordingly.
What are the different schemes available under mutual funds?
The schemes or funds (often used synonymously) can be classified as :
Growth Funds : They promise pure capital appreciation with equity shares. They buy shares in companies with high potential for growth (some of which might not pay dividends). The NAV of such a fund will tend to be erratic, since these so-called growth shares experience high price volatility. They also make quick profits by investing in small cap shares and by investing in initial public. However, growth strategies may differ from one fund to another. Not all growth funds operate similarly.
Income Funds : They aim to provide safety of principal and regular (monthly, quarterly or semi annually) income by investing in bonds, corporate debentures and other fixed income instruments. The AMC in this case will also be guided by ratings given to the issuer of debt by credit rating agencies. Wherever a debt instrument is not rated, specific approval of the board of the AMC is required. Since most of corporate debt is illiquid, the fund tries to provide liquidity by investing in debt of varying maturity.
Money Market Fund : Also known as Liquid Plans, these funds are a play on volatility in interest rates. Most of their investment is in fixed-income instruments with maturity period of less than a year. Since they accept money even for a few days, they are best used to park short-term money, which otherwise earns a lower return in a savings bank account.
Gilt Fund : They generate returns commensurate with zero credit risk, by investing securities created and issued by the central and/or the state government securities and/or other instruments permitted by the Reserve Bank of India. Since they ensure zero risk, instant liquidity, tax-free income, their return is lower than an income fund.
Balanced Fund : The idea is to get the best of both worlds: equity shares and debt. Investing in equities is supposed to bring home capital appreciation, while that in fixed income is to impart stability and assure income for distribution. The proportion of the two asset classes depends on the fund managers’ preference for risk against return. But because investments are highly diversified, investors reduce market risk. Normally about 50 to 65 per cent of a balanced fund’s funds are invested in equity shares.
Sector Fund : The goal is once again pure capital appreciation, but the strategy is to buy into shares of only one industry. And not diversify like a growth fund. Such funds forgo the principle of asset allocation for high returns. That’s why they are also the riskiest.
Tax Plan : Also known as Equity Linked Saving Schemes, they operate like any other growth fund (and that’s why are as risky). However, an investor in these schemes gets an income-tax rebate of 20 per cent (for a maximum of Rs. 1 lakh) under section 80C.
Essentially, it is an incentive for the investor (who is otherwise investing in fixed-income instruments like the Public Provident Fund, National Savings Scheme, life insurance policies etc under the same section can also include tax saving mutual funds under the Income Tax laws) to participate in capital appreciation that can be delivered by investing in equity shares. That’s also why these schemes also come with a three-year lock-in period. Also while other tax planning schemes guarantee returns, an ELSS offers no such assurance.
Index Fund : Their goal is to match the performance of the markets. They do not involve stock picking by so called professional fund managers. An index fund essentially buys into the stock market in a way determined by some market index (BSE Sensex or S&P CNX Nifty) and does almost no further trading. Index funds are optimally diversified portfolios and only carry along with it the due to economy-wide factors.
But remember that the term ‘growth’ is often used in a very generic sense to denote every equity mutual fund. Also ‘growth’ in fixed income funds, comes from reinvesting dividends. That’s why in such fixed income funds, investors have an option: they can choose either growth through reinvestment of dividends, or regular income by ticking on the income option. If you understand the types of funds, you should have a decent grasp on how funds invest their money.
How does one choose the right fund?
A few tips :
Acquaint yourself with the fund manager’s investment philosophy. Compare the returns he or she has generated on funds previously managed against funds with similar objectives. Both the experience of the fund manager and his past performance are important.
Recognise the risk that emanates from an investment style. An investment philosophy and an investment style are distinct from one another. A philosophy has got to do the overall logic of picking stocks. That may not differ substantially, but an investment style can. For instance, within a given philosophy, one fund manager may believe in taking large concentrated bets on stocks, while another may prefer to diversify. The former is certainly a riskier style.
Lastly, figure out whether the fund’s investment objective and style suit your risk profile. The latter is a function of your investment time horizon, knowledge of capital markets, current net worth and future income, emotional makeup to accept losses and so on.