A beginner's guide to the basics of mutual funds.
What is a mutual fund?
A mutual fund is a pooled investment vehicle. It collects money from a large number of investors, and invests the money on their behalf.
When someone says "mutual fund", does it mean the mutual fund company? Or does it mean a specific scheme or product offered by a mutual fund company? To understand this, we need to know how mutual funds are structured.
How is a mutual fund structured?
Sponsor :
The sponsor is the promoter of the mutual fund. A mutual fund can have more than 1 sponsor. For example, ICICI Prudential Mutual Fund has ICICI and Prudential Group as the co-sponsors.
Trustees :
The trustees are responsible for ensuring that the mutual fund company operates within the guidelines and regulations required by SEBI, RBI, and the Government. There must be at least 4 trustees or a trustee company can be appointed with at least 4 directors.
AMC :
Asset Management Company (AMC) is the company which actually takes the money from investors, operates the business, and makes the investment decisions. The AMC is appointed by the Sponsor and Trustees. At least 50% of the board of directors of the AMC must be independent.
Scheme :
These are the various products offered by the AMC. Every AMC offers a wide variety of schemes to suit the requirements of different investors. However, an AMC can have only one scheme in each category. The categories have been defined by SEBI. We will cover the categories of mutual funds in another post.
To answer the question - when someone says "mutual funds", they may be referring to the asset class, AMC, or Scheme.
Example 1 : I have invested in mutual funds.
Reference : They are referring to mutual funds in general as an asset class.
Example 2 : I have invested in a HDFC mutual fund.
Reference : They are referring to a mutual fund sponsored by HDFC. However, the exact scheme is not specified.
Example 3 : I have invested in HDFC Balanced Advantage Fund (Direct Plan) - Growth.
Reference : They are referring to a specific scheme offered by HDFC AMC.
Where do mutual funds invest?
A mutual fund can invest in stocks, bonds, or a combination of both. A mutual fund scheme can only invest in the specific category which it belongs to.
Equity mutual funds invest most of their funds into stocks.
Debt mutual funds investment most of their funds into bonds.
Hybrid mutual funds invest into both stocks and bonds.
Global mutual funds invest into stocks and/or bonds of foreign countries.
What are the advantages of mutual funds?
Expertise :
Most individual investors do not have the time or expertise to research stocks and bonds. Investing in mutual funds is an easier way to invest because the investment decisions are left to the professionals. Every fund has a fund manager who is responsible for selecting the securities in the fund's portfolio. The fund manager is assisted by an expert research team.
Diversification :
Mutual funds are well-diversified and most have more than 40-50 securities in their portfolio. This ensures that a wide array of sectors are represented in the portfolio. The maximum exposure to any single company or sector is limited, which lowers the risk of investment.
SIP :
SIP means "Systematic Investment Plan". Investments into mutual funds can be made systematically every month. This helps individual investors save in a disciplined way over the long-term. This also gives the benefit of rupee-cost averaging.
Low minimum investment :
SIPs in mutual funds start from just ₹500 per month. This makes mutual funds a great option for everyone. Investors can invest according to their capacity.
Flexibility :
SIPs can be increased, decreased, paused or stopped anytime. Although it is recommended to continue SIPs without any break, the option is always available for investors.
Multiple options :
There are a wide variety of schemes available to suit the needs of different investors. Building long-term wealth, creating an emergency fund, goal-based investing, international diversification and generating regular income are some of the ways in which mutual fund investments can be planned. Mutual fund schemes can be selected to suit your investment objectives.
Liquidity :
They can be sold at the click of a button, and the funds will be received in the bank account in 2 working days. This makes them highly liquid. Note - ELSS funds have a lock-in period of 3 years.
Loan facility :
They can be used as collateral for obtaining a loan. Equity funds can be pledged to avail a loan of upto 50% of their market value, whereas debt funds can be used to obtain a loan of upto 80% of their market value.
Tax benefits :
As per Section 80C, upto ₹1.5 lakhs deduction can be availed per year by investing into ELSS funds (old tax regime).
The long-term profits (more than 1 year) of equity funds are taxed at a lower rate of 10%. The long-term profits of debt funds (more than 3 years) of equity funds are taxed at a rate of 20%. This makes mutual funds attractive for investors in the higher tax slabs.
Regulated :
Mutual funds are regulated by SEBI. They are subject to frequent audits and scrutiny to verify that they are operating within the guidelines. A mutual fund license is only given to sponsors who have the necessary qualifications, net-worth and capability to operate a mutual fund, since they deal with thousands of crores of investor's money.
Key terms explained
Units :
The mutual fund issues units to investors who invest in the fund. Each unit is like one share in the mutual fund. Although they are not exactly like shares, we can assume this for our understanding.
When a mutual fund is launched, let us say it receives investments of ₹100 crores from investors. Let us also assume that the AMC has fixed the initial unit price as ₹100 per unit. Then, the AMC will issue 1 crore units of ₹100 each to the investors.
NAV :
NAV is short for "net asset value".
NAV per unit = (total assets - liabilities) / total number of units
In the above example, assume the fund invests the ₹100 crores immediately, and the value of the portfolio after 1 month is ₹101 crores.
NAV per unit after 1 month = ₹101 crores / 1 crore = ₹101.00
When a new investor wishes to purchase units in the fund, they will have to pay ₹101.00 per unit. Similarly, existing investors can sell their units at ₹101.00 per unit.
Expense ratio :
This is the expense incurred by the unitholders for investing in the fund. It includes management fee (which is charged by the AMC for managing the fund) and expenses such as brokerage, stamp duty, custodian charges, legal expenses etc.
It is expressed as a percentage. It is lower for debt funds, and higher for equity funds. A lower expense ratio is better because the investor's net returns will be higher.
AUM :
AUM is short for "Assets under management". It is the total investor's money that is invested in the fund. AUM is usually shown for each scheme separately.
Redemption :
When an investor sells their units in the fund, it is called redemption.
Exit load :
Some funds have an exit load. This is the percentage of the NAV that will be deducted by the AMC before paying out the redemption proceeds to the investor.
Direct Plan :
Mutual funds which are purchased directly from the AMC. There is no distributor involved, and hence the expense ratio is lower because no commissions are paid.
Regular Plan :
Mutual funds which are purchased through a distributor. Since the distributors are paid commissions, the expense ratio is higher and the investor's returns are lower.
At WealthEase, we only recommend Direct Plans. This ensures there is no conflict of interest, and our recommendations are based on the funds best suited for you (and not which fund gives us more commission). We do not earn any commission on the mutual funds recommended by us. We only earn the advisory fee which you directly pay to us.
How can you invest in mutual funds?
You can invest in mutual funds by opening an investment account with us. The instant e-KYC process is a breeze and you can get started with your mutual fund investments immediately! If you already have existing mutual fund investments, you can transfer them to our platform and track all your investments with a single login.
With this, we have covered the basics of mutual funds. In the following posts, we will cover a lot of these terms in detail.
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