FAQs
- Q01. What is a mutual fund?
- Q02. What are Open-end and Close-end schemes?
- Q03. What are Debt, Equity and Hybrid funds?
- Q04. What is NAV?
- Q05. How can a fund’s performance be tracked?
- Q06. What do the terms growth, dividend payout and dividend reinvestment mean?
- Q07. Are mutual funds completely risk free?
- Q08. What happens to my money if a scheme is closed?
- Q09. What are the disadvantages of investing in mutual funds?
- Q10. What is SIP / STP?
- Q11. What are the advantages of investing in mutual funds?
What is a mutual fund?
A Mutual Fund is an intermediary that pools money from a number of investors and invests the same in a variety of different financial instruments. The income earned through these investments and the capital appreciation realized by the scheme is shared by the investors or Unit Holders, in proportion to the number of units owned by them. Mutual funds can thus be considered as financial intermediaries that collect funds from investors and invest it on their behalf. The losses and gains accrue to the investors only.
What are Open-end and Close-end schemes?
Open-end schemes are funds where the investors are free to buy and sell their units at the applicable NAV, on any given business day. Close-end schemes are those which have a fixed tenure from the time of their issue. After expiry of the term, the scheme can cease to exist (i.e. wound up) or get converted into an open-ended scheme or roll over for another term as a close-ended scheme.
What are Equity, Debt and Hybrid funds?
Equity funds are those which invest primarily in stocks. Within equity funds, the structure of a particular fund may differ from that of another. Equity funds include diversified funds, market capitalization based funds, sector specific funds, theme based funds and tax saving funds. Equity funds are generally aimed at providing comparatively high returns within the mutual finds family, but with a relatively higher degree of risk.
Debt funds - invest a majority of their assets into fixed income bearing instruments such as bonds, debentures, government securities, certificates of deposit, commercial papers and other money market instruments. Debt funds are also called income funds as they normally provide a stable income to the investors, while minimizing the element of risk.
Balanced or hybrid funds - Balanced or hybrid funds invest both in equity and fixed income based securities. They aim to reduce the risk component, while providing a steady return. In these funds, the equity portion provides growth and the debt portion provides income.
What is NAV?
Net Asset Value (NAV) of a fund is the total market value of all the investments of the fund (minus its expenses) divided by the number of units outstanding, on that given day. Buying and selling of mutual funds, as well as its performance is based on its NAV.
The way the NAV gets calculated on a daily basis is represented by the following formula:
How can a fund’s performance be tracked?
A fund’s performance can be tracked by tracking its NAV. The NAVs are calculated usually on a daily basis and the fund’s performance can either be measured against various benchmarks such as a stock market index like the Sensex, Nifty, BSE 200, etc., or against mutual funds from other fund houses which have a similar investment objective.
What do the terms growth, dividend payout and dividend reinvestment mean?
Mutual funds offer investors three options for distributing returns. It also depends on their appetite for risk. They are as follows:
Growth
In the growth option, an investor’s returns on his investment would carry on working in the market and would be considered as an appreciation in the NAV of the fund. Investors would not receive a dividend from their units, but may receive a high capital gain after the sale of the mutual fund. The growth or appreciation option is a good option for those who do not urgently require a regular and steady payout or liquidity.
Dividend Payout
In Mutual Fund parlance, dividend is the distribution of profits made by the fund. In the dividend payout option the profits thus accumulated on the investment are distributed among the unit holders from time-to-time. This type of fund is suitable for those who require a more regular inflow of income. Dividend income is tax free in the hands of the investor.
Dividend Reinvestment
In the dividend reinvestment option the dividend amount is used to buy more units of the same fund the investor has chosen. Returns from this option are generally similar to that of the growth option. In case an investor has the need for liquidity, he can sell a few units of his portfolio at the applicable NAV, leaving his principal amount untouched.
Are mutual funds completely risk free?
Every investment has some sort of risk associated with it. The risk spectrum ranges from bank deposits and government securities (low risk, low return) to equity (high risk, high return). Mutual funds are not risk free and the level of risk involved depends on the type of mutual fund it is (growth, income, hybrid, etc.).
What happens to my money if a scheme is closed?
In case a mutual fund ceases or closes, investors are paid an amount after the expenses are adjusted. This amount depends on the NAV of the fund as on the date of closure and the quantum of units that the investor holds as on that date.
What are the disadvantages of investing in mutual funds?
Costs
Mutual funds charge costs in the form of entry and exit loads, which are used for sales & marketing or operational expenses, during the time of purchase. Investors need to know what exactly they are paying for and whether it makes sense in the long run.
Over diversification
Some funds have tiny holdings spread across a huge number of companies. Because of this, high returns from a single security doesn’t have too much of an impact on your investment.
Varied returns
Like most investments, mutual funds offer no guarantee on returns. As the value of stocks in the fund keeps varying, so does the collective price of your fund; this could cause the value of your fund to dip or rise based on the value of the underlying asset.
What is SIP / STP?
A Systematic Investment Plan (SIP) is great for first time investors or salaried individuals. It allows you to begin investing with a modest sum in a disciplined format. In SIP, money is invested in any particular mutual fund scheme at regular intervals (for e.g. monthly or quarterly); this works out best for people with a periodic cash inflow. In case an investor has a lump sum and doesn’t want to risk the whole amount with equities, a certain amount can be transferred from debt to an equity scheme or vice versa in regular intervals. This is known as Systematic Transfer Plan (STP).
Both SIP and STP are relatively hassle free procedures and can be set up by just filling up one form. They may be very profitable in the long run, thanks to the power of Compounding and rupee cost averaging.
What are the advantages of investing in mutual funds?
Professional Management
The basic advantage of mutual funds is that, they are professionally managed by well qualified fund managers. Investors purchase funds because they do not have the time or the expertise to manage their own portfolio.
Diversification
Purchasing units in a mutual fund instead of buying individual stocks or bonds, reduces, spreads and minimizes investment risk to a certain extent. The idea behind diversification is to invest in a large number of diversified assets, so that a loss in any particular investment is minimized by gains in others.
Economies of scale
Mutual funds buy and sell large amounts of securities at a time and reduce transaction costs, thereby helping to bring down the average cost of the unit for individual investors.
Simplicity
The process of investing in a mutual fund is simpler than investing in individual stocks. Also, minimum investment in a mutual fund is significantly lower than in any other investment vehicle. It is possible to purchase mutual fund schemes at any given time or in simple instalments through systematic investment planning.
Regulated Entity
Mutual Funds come under the purview of the market regulator SEBI and are regularly inspected by their authorities. Since these regulations provide for a high degree of transparency, it is simpler for investors to follow what’s going on with their investments.
Accessibility
The presence of numerous registrars, transfer agents and distributors working with fund houses has made mutual fund investing extremely accessible. These intermediaries provide necessary reach for investors far and wide and allow them to participate in the markets through mutual funds.
Prompt Service
Mutual fund investors have access to a wide range of transaction points like branches, service centers and internet facilities. There are skilled professionals who are specifically trained to service investors, making it a far more efficient and pleasurable experience.
Tax Benefits
Investments in Mutual Funds attract a variety of tax benefits. For instance, all investments in equity funds are akin to investing in stocks and do not attract capital gains tax on any investment beyond one year. Even on fixed income investments, mutual funds provide facilities where the tax on returns is far lesser than the tax in traditional investment vehicles like Fixed Deposits.
Tax benefits are also offered in particular schemes like Equity Linked Savings Schemes (ELSS). As per the Income Tax Act (Section 80c) up to Rs. 1,00,000 invested in ELSS is deductible from the annual gross total income, considered for taxation.
