Among various investment options, like Savings account, FDs, PPFs, EPFs and Gold, Mutual funds are often less understood instrument, even by those who are actively investing in it. More so because of jargons the advisers and people throw at you. I am here to explain all those things to help you better understand the mutual fund investment in as simple language as possible.
Few basic terms before we start
- AMC – Asset management company, is the entity that creates, manages and offers you mutual funds. Like SBI , Aditya birla, Nippon, DSP, Parag Parikh and so on.
- Fund Manager – Every fund created by an AMC has one or more dedicated experts who manage the funds.
- AUM – asset under management, that is, the total money the fund is managing.
- SEBI – Securities and exchange board of India, a regulatory body to oversee the Stock markets and mutual funds.
1. What are mutual funds, how do they work and grow your money?
Mutual fund is a form of investment where fund managers do the investment in different instruments depending upon the type of fund. Possible instruments mutual funds can invest in are stocks, corporate bonds, gold bonds, government securities, debentures etc. Different instruments have different returns and risks associated with them. That’s why different funds can give you different returns. Fund managers invest your money and as their investment proliferate the returns, value of your investment increases (or decreases).
2. Type of funds
Now we know stocks are not the only source a fund can generate returns from, let’s see how funds are categorized. SEBI oversees the categorization thus, all funds have to follow the standards. The instruments I mentioned earlier fall in 2 major categories. Equity, that is stock investments and rest are debt instruments. Now, based on this, there are 3 categories of funds. Equity, Debt and Hybrid, where hybrid funds are those which invest in both equity and debt instruments. Hybrid funds are further subdivided into equity oriented, debt oriented and balanced funds. In fact there are even more categories each underlying a different theme, but these are the broader categories.
3. SIP or Lump-sum
With banking analogy, consider SIP as a recurring deposit, while lump-sum payment as a Fixed deposit. One difference here is, there is no end-date or maturity date of your investment. You can keep it going for as long or short as you want.
Here I want to clarify things often misunderstood. Unlike an RD, SIP is an open-ended way of investment, meaning, it comes without a fixed duration. You want it only for a month, or want to continue it for 1 year, 2 year, 5 year or 10 year or even longer, it’s your wish.
Also, it’s not an EMI. You are not bound to pay it every month as well. If, for a month or two, your budget doesn’t allow you to contribute, you can simply skip on payment, without incurring any penalties.
Beside, when you decide to stop contributing to a fund, it doesn’t mean that you have to withdraw the money too. It will only add up to your tax liability. Leave the money in the fund until you need it. Your money is safe with the AMC. And it will not incur any penalty and it will still continue to earn you returns.
4. NAV and Units
If you have some idea about stock market, this will be a little easier to understand. As stocks are listed in stock market, different stocks carry different prices, like ITC costs about 200Rs, TCS costs about 3000. When you buy a stock, you get a share of that company. Price of a share changes every now and then depending upon how much the demand of that stock is on stock market.
Similarly, when you buy a fund, you basically buy units of the fund. Just like share price, a fund unit also has a price, called net asset value, or NAV. It is the price of fund unit at the end of the latest trading session.
5. Effective NAV
When you pay to buy a fund, the money goes to AMC. As soon as AMC gets the money it allots you number of units depending upon NAV. Now, every fund has a cut-off time decided by SEBI. If AMC gets money before the cutoff time, NAV of that day is considered, if after, NAV of the next day will be considered. The same is true for when you place a withdrawal request.
6. Cost of investment
It’s highly unlikely someone mentioned you the price you pay for this so far. There are no free lunches. You pay for your investment, from your investment only. The price is basically covered under NAV itself. Thus you never get to see it deducting from your returns. The cost, that can include management, administration and distribution charges, is called Total Expense Ratio, or TER. This can vary like 0.1 to even 2.5%. And same kind of funds from different AMCs can charge different TER. And while you might think, a higher TER means lower returns, this may not be true necessarily, because for AMCs, returns ultimately depend on quality and timing of investments. For example, Fund FA, with TER 2.1 generates a return of 14%, Fund FB, with TER 0.2 generates a return of 12%. For you, return from FA comes to be 11.9% while from FB comes to be 11.8%. So ultimately, your return will still be higher from a fund with higher TER.
Now, there can be an exception, when the funds are index funds, and tracking the same index. Both funds will generate almost similar returns that will match up the returns of the index, but in this case, your benefit will be from the one with lower TER. However, index funds generally have very low expense ratio, as the curation is not required in the fund.
7. Exit load
From mutual funds, you can basically withdraw money anytime you want. The process generally takes 3-5 working days to get the money to your account. And there is no charge for withdrawal. There is one catch though. Many funds have a prescribed minimum duration for investment. And if you want to withdraw money sooner than that, AMCs charge some fee for the withdrawal, called exit load. The duration and fee can vary fund to fund, but is generally shorter for index funds.
8. Actively and passively managed funds
As by now you probably would have understood that it’s the fund managers who decide how much to invest in which instrument. That is, a fund manager is actively making decisions. Thus, these funds are called actively managed funds.
There are other kind of funds too, where fund manager doesn’t manage the investment directly, but the fund follows the investment pattern of a particular index. These are passively managed funds, generally known as index funds.
9. Index funds
To understand index funds, we need to know what an Index is. Index is basically a list or group of funds, usually curated by stock exchange, based on different categorizations, each company in the list may have equal or different weight based on various parameters.
If you have heard a stock news sometime, you might have heard of the terms Sensex or Nifty. These are the primary indices of BSE and NSE respectively. Sensex is a list of 30 most impactful companies listed on BSE from different sectors, Nifty is a list of 50 such companies listed on NSE. Similarly, Nifty Pharma or Nifty Banks are indices of companies from Pharma and Financial sector respectively.
Now, a fund is called index fund, if it follows a particular index and has only those companies, with similar weight as in index it is following.
10. Direct or Regular Funds
In older times, the funds were primarily sold through some agents or brokers. But they wouldn’t charge you any money, as their commissions are paid by the AMCs. Their agents or brokers are basically advisors, and they are paid for their advisory service, all the document processing. These funds are basically “regular funds”.
On the other hand, now there are digital platforms, who act as the agents, well, almost. They take care of all the processing, and sometimes will even help you decide on funds. The offer you a variant called “direct funds”, these funds basically do not pay any commissions to these platforms, thus, have lower TER, and in turn have higher returns. Note that, some digital platforms, offer regular funds as well. So make sure you have selected the correct fund before investing.
11. Growth or IDCW
Every direct or regular fund can have these two variants. Growth variant is kind of a reinvestment plan. If fund makes significant profits, that is invested back in the fund, and thus value of your investment grows further. However, the other plan, income distribution cum withdrawal plan, or IDCW, formerly know as dividend option, instead of reinvesting, credits the money back to your account. The amount and frequency however, are not guaranteed, and can only be declared solely at the discretion of the fund manager. In simpler terms, think of these variants as cumulative and payout variants of the FDs respectively.
While there can be different reasons and opinions to opt for either, I just want to point out that, in case of IDCW, you are losing the benefits of compounding and might end up with more tax liability.
12. Tax liability
To understand the taxation on return from funds, might need a whole new article. But let me try to give an abridged summary. Returns from mutual funds are considered for taxation depending upon whether the gains are short term or long term. For equity funds, investment beyond 1 year is considered as long term and for debt funds, investment beyond 3 years is considered as long term. Gains within any duration shorter than the mentioned will be your short term gains. Equity oriented hybrid funds are treated as equity funds in this regard, while rest of the hybrid funds are treated as debt funds only. One thing I want to point out is, if you are investing in SIP mode, every single transaction is calculated separately. Like if you have invested in an Equity fund for last 13 months, only the units allotted in the 1st month will be considered for LTCG, while units from remaining 12 months will count toward STCG.
Note that, the definition and tax liability of LTCG and STCG may be updated by central government. Keep yourself updated after every budget session.
13. The risk
As you already know, mutual funds are subject to market risk, so you should read schemes related documents carefully. To know all of the things I explained earlier, but also to know the risk level of the fund. While there are various factors to asses the risk, SEBI tries to make your life a little bit easier. It clearly provides a guideline to label a fund with appropriate risk level. And when you read the document, you would find this risk-o-meter image which would give you a relative risk of that particular fund.
While there is still lot to talk about mutual funds, I hope this gave you a good technical understanding. You will see few below articles about investments and mutual funds in coming days:
1. Should you invest in mutual funds?
2. Why you must always opt for direct mutual funds?
3. How much exposure you should have of mutual funds and stocks?
4. What is a bluechip fund, and what do largecap, midcap, smallcap mean?
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