In this series of posts we will explain various terms that you come across in mutual fund literature, be it research sites, factsheets, financial blogs, journals and newspaper reports. I have seen that, many retail investors have a superficial understanding of these terms (e.g. NAV, Expense Ratio, Rolling Returns, Volatility, Sharpe Ratio, Alpha, Beta, Modified Duration, YTM etc). In the first part of the series, we will explain what mutual funds are, the building blocks of mutual funds, how they are priced and the costs of mutual funds.
Mutual fund is a financial instrument which pools the money of different people and invests them in different financial securities like stocks, bonds etc. The Asset Management Company (AMC), i.e. the company which manages the mutual fund raises money from the public. The AMC then deploys the money by investing in different financial securities like stocks, bonds etc. The securities are selected keeping in mind the investment objective of the fund. For example, if the investment objective of the fund is capital appreciation, the fund will invest in shares of different companies listed on stock exchanges. If the investment objective of the fund is to generate income, then the fund will invest in fixed income securities that pay interest.
Units are the building blocks of a mutual fund scheme. A unit represents percentage ownership of the total pool of money managed by the AMC. Mutual fund units are priced at Rs 10 at the time of launch of the scheme and its price fluctuates with change in value of the assets of the scheme. Let us understand with the help of an example. Suppose you invest Rs 100,000 in a mutual fund. If the price of a unit of the fund is Rs 10, then the mutual fund house will allot you 10,000 units.
Let us assume the total money invested in the fund by all the investors is Rs 100 Crores. The mutual fund invests the money to buy equity or fixed income securities. Each unit will represent 0.000001% value of all the securities the mutual fund has in its holdings. If you have 10,000 units, then your portion of the mutual fund stock holdings will be 0.01%. As the value of securities held by the mutual increases or decreases, so will the price of the units. If the value of assets increases from Rs 100 Crores to Rs 110 Crores, without the issue of new units, the price of the unit will be Rs 11 (0.000001% X 110 Crores). Please note that the percentage ownership represented by unit of the total assets of a scheme will change from time to time as new investors invest in the scheme or existing investors exit (redeem) from the scheme.
At what price will new investors buy units or existing investors sell units?
Net Asset Value (NAV)
Mutual funds are bought or sold on the basis of Net Asset Value (NAV). NAV is essentially the price of a unit. NAV is calculated by dividing the net assets (market value of the securities and cash held by the fund minus the liabilities) of the fund by the total number of units outstanding. Unlike share prices which changes constantly during the day depending on the activity in the share market, the NAV is determined on a daily basis, computed at the end of the day based on closing price of all the securities that the mutual fund owns after making appropriate adjustments.
Expense ratio is the annual cost incurred by the Asset Management Company (AMC) to operate a mutual fund scheme, expressed as a percentage of the total assets of the scheme. The cost includes fund manager expenses, cost of the supporting infrastructure for the fund manager, transaction costs (for buying and selling securities), marketing and distribution costs (commissions paid to mutual fund distributors). If the total assets under management of a scheme is Rs 500 Crores and the expense ratio is 2.5%, then it implies that, Rs 12.5 Crores (2.5% X 500 Crores) is the operating expenses of the scheme. This expense is deducted from the asset value of the scheme on a pro-rata basis; units are priced after deducting expense ratio. Investors should note that, the NAV of a scheme is net of the expense ratio. Expense ratios of different schemes and plans of the same AMC may be different.
Regular and Direct Plans
Mutual funds have traditionally been distributed through Mutual Fund Distributors and Financial Advisors in India. Mutual Fund Distributors or Financial advisors mandatorily need to have certification from Association of Mutual Funds in India (AMFI) - the nodal body of mutual funds in India - to ensure that they have sufficient knowledge to give investment advice to investors. Apart from investment advice, Mutual Fund Distributors or financial advisors also help investors with fulfilment of their purchase or redemption transactions (fulfilling KYC requirements, filling application forms and submission to AMCs or mutual fund registrars), as well as ongoing customer service. For their services, financial advisors or Mutual Fund Distributors get commissions from the AMC. If you make your mutual fund investment through them, you will invest in, what is known as, regular plan of the scheme.
Some years back, investors were also provided with the option of investing directly with the AMC, without going through a financial advisor. If you submit your mutual fund investment application directly to the AMC (online or offline), you will invest in, what is known as, direct plan of the scheme. The most obvious difference between regular and direct plan is that, unlike in a regular plan, you need to have capability to decide which scheme to invest in and how to manage your investment on an on-going basis. You will also have to devote time and effort to fulfil the transaction by yourself by providing necessary documents for KYC, filling forms and visiting the AMC (online or offline). The advantage of direct plan versus regular plan is in the expense ratio. Since in direct plans, AMCs do not have to pay commissions to the distributors / advisors, the expense ratio is lower. Hence, the returns are higher.
Open ended and close ended schemes
Investors can buy units of open ended schemes at any time. Investors can also sell units of open ended schemes at any time, though some schemes (e.g. equity linked savings schemes) may have a lock in period during which the investor cannot sell the units. The percentage ownership of investors in the assets of open ended schemes changes whenever investors purchase or sell units. Since you can sell units of open ended schemes at any time, high liquidity is ensured to the investors. However, costs may apply if you sell units of open ended scheme before a certain period of time from the date of investment. We will discuss this in more details later.
Close ended schemes are open for subscription only for a limited period of time, during the new fund offer (NFO) period. These schemes have fixed tenure and the investors can sell or redeem only after the maturity of the scheme. Upon maturity, depending on the scheme, the units get automatically redeemed or in some cases, the investors can switch to a different scheme. The percentage ownership of investors in the assets of close ended schemes is unchanged throughout the tenure of the scheme. Some close ended schemes are listed on stock exchanges and you can buy or sell them through your share trading / demat account in the stock exchange, but the liquidity of these schemes listed on the exchanges is still quite low in India.
AMCs may charge a fee if you redeem (sell) your units within a specified period from the date of investment. This fee is known as exit load. Let us understand exit loads with the help of an example. Suppose, you invested Rs 1 lakh in a scheme whose NAV was Rs 20; in other words, you bought 5,000 units of the scheme. Let us assume that, the exit load is 1% for redemptions within 12 months from the date of purchase. Suppose after 8 months, the NAV of the scheme is Rs 23. The value of the 5,000 units will be Rs 1.15 lakhs. However, if you redeem (sell) all your units after 8 months, you will not get a credit of Rs 1.15 lakhs in the bank account because exit load will apply. Exit load per unit will be 23 paise (1% X 23) and total exit load will be Rs 1,150. This amount will be deducted from your redemption proceeds and only Rs 113,850 will be credited to your bank account. Investors should note that, exit load does not just apply for redemptions; they are also applicable for switches, Systematic Transfer Plans (STP) and Systematic Withdrawal Plans (SWP), as long as those transactions take place, within the exit load period.
Growth and Dividend Options
Growth and Dividend are essentially options of how investors want cash-flows. During the course of a year, a mutual fund scheme may make profits through dividends from shares ownership or interests from bonds owned by the scheme and also through portfolio churn (profit booking by buying and selling shares and bonds). In a growth option the profit is re-invested to generate more returns whereas in dividend option the profits are distributed to the investors on a regular basis (annual, semi-annual, quarterly, monthly etc) at the discretion of the fund manager.
Dividends are declared on a per unit basis. Capital appreciation is much higher in growth option because investors benefit from compounding over a long investment horizon; NAV in growth options grows much more than dividend options where the NAVs get re-adjusted whenever the scheme declares dividends. However, some investors may need income during the tenure of the investment and dividend option is suitable for such investors.
Dividend re-investment is another option available to investors. In this option the dividends instead of being distributed to investors, get re-invested to buy units of the scheme. A dividend re-investment option works very much like growth option. The major difference between growth and dividend re-investment option is that, in growth option investor gets capital appreciation through growth in NAV, whereas in dividend re-investment the investor gets capital appreciation through incremental units (the NAVs of dividend and dividend re-investment options are the same). Tax consequences of growth and dividend re-investment option are different (we will discuss in more details in a separate post).
In this post, we discussed some basic terms and concepts of mutual fund investing. Many of you may have been familiar with these terms, but a better understanding of these terms will help you understand other mutual fund concepts better and by the end of this series, hopefully, you will be able to make better financial planning and investment decisions. In the next part of the series, we will discuss various terms associated with mutual fund returns.
Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.