Mutual Funds

WHAT ARE MUTUAL FUNDS?

A mutual fund is a pool of money managed by a professional Fund Manager.

It is a trust that collects money from a number of investors who share a common investment objective and invests the same in equities, bonds, money market instruments and/or other securities. And the income / gains generated from this collective investment is distributed proportionately amongst the investors after deducting applicable expenses and levies, by calculating a scheme’s “Net Asset Value” or NAV. Simply put, the money pooled in by a large number of investors is what makes up a Mutual Fund.

Here’s a simple way to understand the concept of a Mutual Fund Unit.

Let’s say that there is a box of 12 chocolates costing ₹40. Four friends decide to buy the same, but they have only ₹10 each and the shopkeeper only sells by the box. So the friends then decide to pool in ₹10 each and buy the box of 12 chocolates. Now based on their contribution, they each receive 3 chocolates or 3 units, if equated with Mutual Funds.

And how do you calculate the cost of one unit? Simply divide the total amount with the total number of chocolates: 40/12 = 3.33.

So if you were to multiply the number of units (3) with the cost per unit (3.33), you get the initial investment of ₹10.

This results in each friend being a unit holder in the box of chocolates that is collectively owned by all of them, with each person being a part owner of the box.

Next, let us understand what is “Net Asset Value” or NAV. Just like an equity share has a traded price, a mutual fund unit has Net Asset Value per Unit. The NAV is the combined market value of the shares, bonds and securities held by a fund on any particular day (as reduced by permitted expenses and charges). NAV per Unit represents the market value of all the Units in a mutual fund scheme on a given day, net of all expenses and liabilities plus income accrued, divided by the outstanding number of Units in the scheme.

Mutual funds are ideal for investors who either lack large sums for investment, or for those who neither have the inclination nor the time to research the market, yet want to grow their wealth. The money collected in mutual funds is invested by professional fund managers in line with the scheme’s stated objective. In return, the fund house charges a small fee which is deducted from the investment. The fees charged by mutual funds are regulated and are subject to certain limits specified by the Securities and Exchange Board of India (SEBI).

India has one of the highest savings rate globally. This penchant for wealth creation makes it necessary for Indian investors to look beyond the traditionally favoured bank FDs and gold towards mutual funds. However, lack of awareness has made mutual funds a less preferred investment avenue.

Mutual funds offer multiple product choices for investment across the financial spectrum. As investment goals vary – post-retirement expenses, money for children’s education or marriage, house purchase, etc. – the products required to achieve these goals vary too. The Indian mutual fund industry offers a plethora of schemes and caters to all types of investor needs.

Mutual funds offer an excellent avenue for retail investors to participate and benefit from the uptrends in capital markets. While investing in mutual funds can be beneficial, selecting the right fund can be challenging. Hence, investors should do proper due diligence of the fund and take into consideration the risk-return trade-off and time horizon or consult a professional investment adviser. Further, in order to reap maximum benefit from mutual fund investments, it is important for investors to diversify across different categories of funds such as equity, debt and gold.

While investors of all categories can invest in securities market on their own, a mutual fund is a better choice for the only reason that all benefits come in a package.

TYPE OF MUTUAL FUND SCHEMES

Mutual Fund schemes could be ‘open ended’ or close-ended’ and actively managed or passively managed.

OPEN-ENDED AND CLOSED-END FUNDS

An open-end fund is a mutual fund scheme that is available for subscription and redemption on every business throughout the year, (akin to a savings bank account, wherein one may deposit and withdraw money every day). An open ended scheme is perpetual and does not have any maturity date.

A closed-end fund is open for subscription only during the initial offer period and has a specified tenor and fixed maturity date (akin to a fixed term deposit). Units of Closed-end funds can be redeemed only on maturity (i.e., pre-mature redemption is not permitted). Hence, the Units of a closed-end fund are compulsorily listed on a stock exchange after the new fund offer, and are traded on the stock exchange just like other stocks, so that investors seeking to exit the scheme before maturity may sell their Units on the exchange.

ACTIVELY MANAGED AND PASSIVELY MANAGED FUNDS

An actively managed fund is a mutual fund scheme in which the fund manager “actively” manages the portfolio and continuously monitors the fund's portfolio, deciding on which stocks to buy/sell/hold and when, using his professional judgment, backed by analytical research. In an active fund, the fund manager’s aim is to generate maximum returns and out-perform the scheme’s bench mark.

A passively managed fund, by contrast, simply follows a market index, i.e., in a passive fund , the fund manager remains inactive or passive inasmuch as, she does not use her judgment or discretion to decide as to which stocks to buy/sell/hold , but simply replicates / tracks the scheme’s benchmark index in exactly the same proportion. Examples of Index funds are an Index Fund and all Exchange Traded Funds. In a passive fund, the fund manager’s task is to simply replicate the scheme’s benchmark index i.e., generate the same returns as the index, and not to out-perform the scheme’s bench mark.

SEBI CATEGORIZATION OF MUTUAL FUND SCHEMES

As per SEBI guidelines on Categorization and Rationalization of schemes issued in October 2017, mutual fund schemes are classified as –

1. Equity Schemes

2. Debt Schemes

3. Hybrid Schemes

4. Solution Oriented Schemes – For Retirement and Children

5. Other Schemes – Index Funds & ETFs and Fund of Funds

– Under Equity category, Large, Mid and Small cap stocks have now been defined.

– Naming convention of the schemes, especially debt schemes, as per the risk level of underlying portfolio (e.g., the erstwhile ‘Credit Opportunity Fund’ is now called “Credit Risk Fund”)

– Balanced / Hybrid funds are further categorized into conservative hybrid fund, balanced hybrid fund and aggressive hybrid fund.

EQUITY SCHEMES

An equity Scheme is a fund that –

– Primarily invests in equities and equity related instruments.

– Seeks long term growth but could be volatile in the short term.

– Suitable for investors with higher risk appetite and longer investment horizon.

The objective of an equity fund is generally to seek long-term capital appreciation. Equity funds may focus on certain sectors of the market or may have a specific investment style, such as investing in value or growth stocks.

Equity Fund Categories as per SEBI guidelines on Categorization and Rationalization of schemes

*Also referred to as Diversified Equity Funds – as they invest across stocks of different sectors and segments of the market. Diversification minimizes the risk of high exposure to a few stocks, sectors or segment.

SECTOR SPECIFIC FUNDS

Sector funds invest in a particular sector of the economy such as infrastructure, banking, technology or pharmaceuticals etc.

– Since these funds focus on just one sector of the economy, they limit diversification, and are thus riskier.

– Timing of investment into such funds are important, because the performance of the sectors tend to be cyclical.

Examples of Sector Specific Funds - Equity Mutual Funds with an investment objective to invest in

• Pharma & Healthcare Sector

• Banking & Finance Sector:

• FMCG (fast moving consumer goods) and related sectors.

• Technology and related sectors

THEMATIC FUNDS

• Thematic funds select stocks of companies in industries that belong to a particular theme - For example, Infrastructure, Service industries, PSUs or MNCs.

• They are more diversified than Sectoral Funds and hence have lower risk than Sectoral funds.

VALUE FUNDS (STRATEGY AND STYLE BASED FUNDS)

• Equity funds may be categorized based on the valuation parameters adopted in stock selection, such as

– Growth funds identify momentum stocks that are expected to perform better than the market

– Value funds identify stocks that are currently undervalued but are expected to perform well over time as the value is unlocked

• Equity funds may hold a concentrated portfolio to benefit from stock selection.

– These funds will have a higher risk since the effect of a wrong selection can be substantial on the portfolio’s return

CONTRA FUNDS

• Contra funds are equity mutual funds that take a contrarian view on the market.

• Under-performing stocks and sectors are picked at low price points with a view that they will perform in the long run.

• The portfolios of contra funds have defensive and beaten down stocks that have given negative returns during bear markets.

• These funds carry the risk of getting calls wrong as catching a trend before the herd is not possible in every market cycle and these funds typically underperform in a bull market.

• As per the SEBI guidelines on Scheme categorization of mutual funds, a fund house can either offer a Contra Fund or a Value Fund, not both.

EQUITY LINKED SAVINGS SCHEME (ELSS)

ELSS invests at least 80% in stocks in accordance with Equity Linked Saving Scheme, 2005, notified by Ministry of Finance.

• Has lock-in period of 3 years (which is shortest amongst all other tax saving options)

• Currently eligible for deduction under Sec 80C of the Income Tax Act upto ₹1,50,000

DEBT SCHEMES

• A debt fund (also known as income fund) is a fund that invests primarily in bonds or other debt securities.

• Debt funds invest in short and long-term securities issued by government, public financial institutions, companies

– Treasury bills, Government Securities, Debentures, Commercial paper, Certificates of Deposit and others

• Debt funds can be categorized based on the tenor of the securities held in the portfolio and/or on the basis of the issuers of the securities or their fund management strategies, such as

– Short-term funds, Medium-term funds, Long-term funds

– Gilt fund, Treasury fund, Corporate bond fund, Infrastructure debt fund

• Floating rate funds, Dynamic Bond funds, Fixed Maturity Plans

• Debt funds have potential for income generation and capital preservation.

Debt Fund Categories as per SEBI guidelines on Categorization and Rationalization of schemes

Dynamic Bond funds alter the tenor of the securities in the portfolio in line with expectation on interest rates. The tenor is increased if interest rates are expected to go down and vice versa

Floating rate funds invest in bonds whose interest are reset periodically so that the fund earns coupon income that is in line with current rates in the market, and eliminates interest rate risk to a large extent

Short-Term Debt Funds

The primary focus of short-term debt funds is coupon income. Short term debt funds have to also be evaluated for the credit risk they may take to earn higher coupon income. The tenor of the securities will define the return and risk of the fund.

– Funds holding securities with lower tenors have lower risk and lower return.

• Liquid funds invest in securities with not more than 91 days to maturity.

• Ultra Short-Term Debt Funds hold a portfolio with a slightly higher tenor to earn higher coupon income.

Short-Term Fund combine coupon income earned from a pre-dominantly short-term debt portfolio with some exposure to longer term securities to benefit from appreciation in price.

Fixed Maturity Plans (FMPs)

– FMPs are closed-ended funds which eliminate interest rate risk and lock-in a yield by investing only in securities whose maturity matches the maturity of the fund.

– FMPs create an investment portfolio whose maturity profile match that of the FMP tenor.

– Potential to provide better returns than liquid funds and Ultra Short Term Funds since investments are locked in

– Low mark to market risk as investments are liquidated at maturity.

– Investors commit money for a fixed period.

– Investors cannot prematurely redeem the units from the fund

– FMPs, being closed-end schemes are mandatorily listed - investors can buy or sell units of FMPs only on the stock exchange after the NFO.

– Only Units held in dematerialized mode can be traded; therefore investors seeking liquidity in such schemes need to have a demat account.

Capital Protection Oriented Funds

Capital Protection Oriented Funds are close-ended hybrid funds that create a portfolio of debt instruments and equity derivatives

– The portfolio is structured to provide capital protection and is rated by a credit rating agency on its ability to do so. The rating is reviewed every quarter.

– The debt component of the portfolio has to be invested in instruments with the highest investment grade rating.

– A portion of the amount brought in by the investors is invested in debt instruments that is expected to mature to the par value of the capital invested by investors into the fund. The capital is thus protected.

– The remaining portion of the funds is used to invest in equity derivatives to generate higher returns

HYBRID FUNDS

Hybrid funds Invest in a mix of equities and debt securities.

Invest in a mix of equities and debt securities. They seek to find a ‘balance’ between growth and income by investing in both equity and debt.

– The regular income earned from the debt instruments provide greater stability to the returns from such funds.

– The proportion of equity and debt that will be held in the portfolio is indicated in the Scheme Information Document

– Equity oriented hybrid funds (Aggressive Hybrid Funds) are ideal for investors looking for growth in their investment with some stability.

– Debt-oriented hybrid funds (Conservative Hybrid Fund) are suitable for conservative investors looking for a boost in returns with a small exposure to equity.

– The risk and return of the fund will depend upon the equity exposure taken by the portfolio - Higher the allocation to equity, greater is the risk

Multi Asset Funds

• A multi-asset fund offers exposure to a broad number of asset classes, often offering a level of diversification typically associated with institutional investing.

• Multi-asset funds may invest in a number of traditional equity and fixed income strategies, index-tracking funds, financial derivatives as well as commodity like gold.

• This diversity allows portfolio managers to potentially balance risk with reward and deliver steady, long-term returns for investors, particularly in volatile markets.

Arbitrage Funds

“Arbitrage” is the simultaneous purchase and sale of an asset to take advantage of the price differential in the two markets and profit from price difference of the asset on different markets or in different forms.

• – Arbitrage fund buys a stock in the cash market and simultaneously sells it in the Futures market at a higher price to generate returns from the difference in the price of the security in the two markets.

• – The fund takes equal but opposite positions in both the markets, thereby locking in the difference.

• – The positions have to be held until expiry of the derivative cycle and both positions need to be closed at the same price to realize the difference.

• – The cash market price converges with the Futures market price at the end of the contract period. Thus it delivers risk-free profit for the investor/trader.

• – Price movements do not affect initial price differential because the profit in one market is set-off by the loss in the other market.

• – Since mutual funds invest own funds, the difference is fully the return.

Hence, Arbitrage funds are considered to be a good choice for cautious investors who want to benefit from a volatile market without taking on too much risk.

Index Funds

Index funds create a portfolio that mirrors a market index.

• – The securities included in the portfolio and their weights are the same as that in the index

• – The fund manager does not rebalance the portfolio based on their view of the market or sector

• – Index funds are passively managed, which means that the fund manager makes only minor, periodic adjustments to keep the fund in line with its index. Hence, Index fund offers the same return and risk represented by the index it tracks.

• – The fees that an index fund can charge is capped at 1.5%

Investors have the comfort of knowing the stocks that will form part of the portfolio, since the composition of the index is known.

Exchange Traded Funds (ETFs)

An ETF is a marketable security that tracks an index, a commodity, bonds, or a basket of assets like an index fund.

• ETFs are listed on stock exchanges.

• Unlike regular mutual funds, an ETF trades like a common stock on a stock exchange. The traded price of an ETF changes throughout the day like any other stock, as it is bought and sold on the stock exchange.

• ETF Units are compulsorily held in Demat mode

• ETFs are passively managed, which means that the fund manager makes only minor, periodic adjustments to keep the fund in line with its index

• Because an ETF tracks an index without trying to outperform it, it incurs lower administrative costs than actively managed portfolios.

• Rather than investing in an ‘active’ fund managed by a fund manager, when one buy units of an ETF one is harnessing the power of the market itself.

• Suitable for investors seeking returns similar to index and liquidity similar to stocks

Fund of Funds (FoF)

• Fund of funds are mutual fund schemes that invest in the units of other schemes of the same mutual fund or other mutual funds.

• The schemes selected for investment will be based on the investment objective of the FoF

• The FoF have two levels of expenses: that of the scheme whose units the FoF invests in and the expense of the FoF itself. Regulations limit the total expenses that can be charged across both levels as follows:

– TER in respect of FoF investing liquid schemes, index funds & ETFs has been capped @ 1%

– TER of FoF investing in equity-oriented schemes has been capped @ 2.25%

– TER of FoF investing in other schemes than mentioned above has been capped @2%.

Gold Exchange Traded Funds (FoF)

• Gold ETFs are ETFs with gold as the underlying asset

– The scheme will issue units against gold held. Each unit will represent a defined weight in gold, typically one gram.

– The scheme will hold gold in form of physical gold or gold related instruments approved by SEBI.

– Schemes can invest up to 20% of net assets in Gold Deposit Scheme of banks

• The price of ETF units moves in line with the price of gold on metal exchange.

• After the NFO, units are issued to intermediaries called authorized participants against gold or funds submitted. They can also redeem the units for the underlying gold

Benefits of Gold ETFs

• Convenience --> option of holding gold electronically instead of physical gold.

– Safer option to hold gold since there are no risks of theft or purity.

– Provides easy liquidity and ease of transaction.

• Gold ETFs are treated as non-equity oriented mutual funds for the purpose of taxation.

– Eligible for long-term capital gains benefits if held for three years.

– No wealth tax is applicable on Gold ETFs

International Funds

• International funds enable investments in markets outside India, by holding in their portfolio one or more of the following:

• – Equity of companies listed abroad.

• – ADRs and GDRs of Indian companies.

• – Debt of companies listed abroad.

• – ETFs of other countries.

• – Units of passive index funds in other countries.

• – Units of actively managed mutual funds in other countries.

• International equity funds may also hold some of their portfolios in Indian equity or debt.

• – They can hold some portion of the portfolio in money market instruments to manage liquidity.

• International funds gives the investor additional benefits of

• – Diversification, since global markets may have a low correlation with domestic markets.

• – Investment options that may not be available domestically.

• – Access to companies that are global leaders in their field.

• There are risks associated with investing in such funds, such as –

• – Political events and macro economic factors that are less familiar and therefore difficult to interpret

• – Movements in foreign exchange rate may affect the return on redemption

• – Countries may change their investment policy towards global investors.

• For the purpose of taxation, these funds are considered as non-equity oriented mutual fund schemes.

SIP or Lumpsum: Which investment method to choose?

All investments that you are going to make should be in line with your investment profile, which includes your income, expenditures, risk profile, and financial goals. Depending on your affordability, you can choose to invest through a Systematic Investment Plan (SIP) or making a lump-sum payment. 

Lump sum investment

It is a one-time investment you make, like say, Rs 1,00,000. If you have a substantial disposable amount in hand and have a higher risk tolerance, then you may opt for making a lump-sum investment.

SIP(Systematic Investment Plan)

You can invest in mutual funds in a staggered manner through a SIP (Systematic Investment Plan). Under SIPs, you invest a small amount regularly, say Rs 10,000 a month over twelve installments. SIP is an ideal choice if you don’t have a lump sum to invest. As SIPs allow periodic investments, it has gained popularity recently.  

Benefits of SIP over lumpsum investments:-

• No need to time and constantly watch the market :-Investors, especially the inexperienced ones, are often not sure as to when to enter the market. If you invest a significant amount in a lump sum, then there is always a risk of losing a substantial portion when the market crashes. You also stand to benefit significantly during a market high. With a SIP, your money is spread over time, and only some part of your entire investment will face market volatility.
• Rupee cost averaging:-SIP helps you to invest across different market cycles. When the market has fallen, you will buy more units. Likewise, you will buy fewer units when the stock markets start rising. It will help in reducing the per-unit cost of purchasing the units. This phenomenon is known as rupee cost averaging.
• Build the habit of investing:-As investing through SIPs requires an investor to set aside a fixed sum periodically, you will inevitably become financially disciplined.
• Ideal for budding investors:-If you have just commenced your professional career, then starting a SIP is the stepping stone to enter the world of investing. This way, you gain exposure to equities with a nominal amount as low as Rs 500 per installment. Later, you can venture into riskier equity schemes that are in line with your investment needs and risk appetite.
• Better past performance:-SIP investments have consistently earned higher long-term (5+ years) returns than lump-sum investments. 

SIP and lumpsum explained with an example

Suppose you have Rs 10 lakh in your bank account that you wish to invest in ELSS. Unless you are a market whiz who knows which scheme to select, it’s not advisable to make a lump-sum investment. There are two ways to invest this amount:

• Start a monthly SIP of an amount that you are comfortable with, and this could be Rs 10,000, Rs 20,000, or Rs 50,000. Let the money stay in your bank account till all of it gets invested systematically in the chosen equity funds.

• Invest the lump sum in a liquid fund. Then start a Systematic Transfer Plan (STP) from the debt fund to the ELSS. Your corpus will not only earn higher returns than a savings bank account but will also allow for systematic investment.

Disclaimer

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

The NAV's of the schemes may go up or down depending upon the factors and forces affecting the securities market including the fluctuations in the interest rates. The past performance of the mutual funds is not necessarily indicative of future performance of the schemes. The Mutual Fund is not guaranteeing or assuring any dividend under any of the schemes and the same is subject to the availability and adequacy of distributable surplus. Investors are requested to review the prospectus carefully and obtain expert professional advice with regard to specific legal, tax and financial implications of the investment/participation in the scheme.

While all efforts have been taken to make this web site as authentic as possible, please refer to the print versions, notified Gazette copies of Acts/Rules/Regulations for authentic version or for use before any authority. We will not be responsible for any loss to any person/entity caused by any short-coming, defect or inaccuracy inadvertently or otherwise crept in the web site.

For More details Contact Fenil Arunkumar Panwala. He is registered with Association of Mutual Fund in India, ARN- 248327.