In this article we are going to discuss what is Mutual fund, what is open and close ended mutual fund, what is NAV, what is SIP and what is expense ratio along with the advantages and disadvantages of mutual fund and how to invest in mutual funds in India. Before we understand what is mutual fund, it’s very important to know the area in which mutual fund works, the basic understanding of stocks and bonds. To understand the basics of stocks and stock market please go through The Basic Terms of Stock Market, Basic Terms of Investment and Trading, Basic FAQs for the beginners in stock markets, Few preliminary basic terms of Trading.
What is Mutual Fund?
As the term itself might suggest, mutual refers to a group of people and fund refers to pooling of money. Therefore, a mutual fund is where Asset Management Company (AMC) creates a pool of money from investments made by individuals. Once investors invest in that fund, the AMC invests the money in various securities like stocks, bonds, Index Funds such as Nifty & Sensex, Commodities such as gold & silver or debt.
Mostly an AMC diversifies funds to reduce the risk of loss. In other words, the AMC invests its funds in various stocks and shares to reduce loss and gives part of ownership of that fund to its investors which are called units. When an invetor invests in any scheme, they are allocated units. The value of each unit is called NAV. The NAV price is the current market value of the fund’s holdings. When an investor invests in an unit of a fund they buy it at its NAV price.
Mutual funds are operated by professional money managers to earn the highest possible returns for fund investors. It is like a fixed deposit (FD) where one can deposit their money and get returns. Since, the fund invests in stocks and bonds, unlike a FD it entails a certain amount of risk.
There are many stocks or indices available in a stock market which have higher price tags and are difficult for an individual or small investor to invest in. For example if an investor wishes to buy a Sensex Index fund it will cost them around Rs. 40K to buy one share of Sensex. However the investor might not have that much money available. Once that same investor invests in a mutual fund, their and other investors money is pooled together and can be used to buy a Sensex share. So, that investor will now own a small portion of the stock of Sensex by investing in a mutual fund. Therefore, mutual funds give small or individual investors access to equity portfolios, bonds and other securities. The primary structure of a mutual fund includes open-ended funds and closed-ended funds.
What is Open Ended fund?
Open-ended mutual fund refers to the continuous buying and selling of the units. An investor can easily enter or exit as per their convenience at any point of time as these funds do not have any lock-in period and can be traded even after New Fund Offer (NFO). The NAV value can be changed every time an investor enters or exits that mutual fund. Sometimes if an AMC decides that they cannot manage large fund they can stop accepting new subscription request of mutual fund. However an AMC cannot stop an investor from selling their units. On the basis of purchase and sale of units the NAV value gets changed on a daily basis.
What is Close Ended Fund?
Close-end fund is complete opposite of Open Ended fund. An investor cannot enter or exit in accordance with their wishes at any point of time as these funds have lock-in period and cannot be traded after New Fund Offer (NFO). Unlike Open Ended Funds an AMC cannot increase the number of units in a Close Ended Fund. That means the number of units will always stay the same. Many times Close Ended Mutual funds do not offer SIP options.
What is NAV value?
Net Asset Value shows a mutual fund’s market value per unit. In order to calculate NAV value we must deduct a mutual fund’s liabilities from its assets, then divide it by the unit quantity. For example if Mutual Fund X has invested in shares of Rs.100 and the fund has liabilities of Rs. 20 then the fund value would become Rs.80. Now if the fund has 10 investors then the NAV value would become Rs.8 per unit.
(Mutual Fund Assets – Mutual Fund Liabilities)/Numbers of Units
What is SIP?
The full form of SIP is Systematic Investment Plan. It is like a recurring deposit in a Post Office or bank where one can decide a on investing a certain amount of money in a mutual fund every month or quarter depending on their capabilities. An SIP is an ideal way of investing in the mutual funds. It is highly popular among investors. On a specific date chosen by the investor, a specified amount gets debited directly from the investor’s bank account weekly, monthly or quarterly. This plan is flexible which means that an investor can increase/decease/discontinue the amount which is being debited from the bank account. This method of investment can help investors reach their financial goals by investing small amounts of money every month without worrying about the payment as it gets debited automatically.
What is Expense Ratio?
Expense ratio of a mutual fund scheme refers to the annual fee charged by an AMC to the investors for managing the fund. This is calculated by dividing the fund’s total expenses by its assets under management. It is the opposite of AUM (Asset Under Management) of the fund. When the value of a funds’ assets is small, the expense ratio would become higher such that the management needs to meet the fund expenses ,example fund managing expenses (Fund manager, Analytics’s salaries etc) from a smaller asset base. But when the asset value of a fund is large, the expense ratio is comparatively lower as the expenses get distributed across a wider asset base.
What is AUM?
An AUM (Asset Under Management) means how much asset a mutual fund has under its portfolio. It is also called Funds Under Management (FUM). An AUM can be used to understand success and size of a mutual fund. An AUM might increase or decrease time to time. It might increase when investment performance is positive and can decrease when the performance of investment is negative. An AUM also includes the returns which a mutual fund earns.
What are the advantages of Mutual Fund?
1. It is easier to invest in a Mutual fund as it is easier to enter and exit a mutual fund scheme. Investors can sell their units at any time as per their choice.
2. It can hold hundreds or thousands of different securities among different companies, sectors and regions which allows investors to reduce the risk of a particular stock or sector & this process is called diversification.
3. It doesn’t require the investors to research before investing in each stock, bonds etc, as a fund manager takes care of it all and makes decisions about which stocks needs to be purchased or sold. A fund manager also decides whether to invest in equities or debt or to hold them or not and for how long.
4. Some investors who are aware of stock market know how price drops with increased volume when investors buy a share. If investors buy multiple units at a time, the processing fees and other commission charges will be less compared to when they buy one unit at a time.
5. Investors can start with one mutual fund and slowly diversify in several mutual funds. Nowadays, it is easy to identify and hand-pick fund which is most suitable for them. Maintaining and regulating the portfolio will take no extra effort by the investor.
6. Mutual fund is regulated primarily by Securities and Exchange Board of India (SEBI) which is a government body. So, one can easily verify the credentials of the AMC and the asset manager from SEBI. SEBI also has an investor complaint handling system that works in the interest of investors. All mutual fund managers are required to report the same information to investors, which makes them easier to compare with each other.
What are the disadvantages of Mutual Fund?
1. Often AMCs get greedy and they invest more time and money advertising and promoting their mutual funds, since AMCs earn from numbers of investors are investing in mutual fund through expense ratio. And AMCs do not put much effort to maximize the return as they do not get any percentage of the profit.
2. Many times mutual fund managers hesitate to pick risky portfolios in order to safeguard their reputation, and status as mutual fund manager to save their job and salary. Therefore investors get less return than they could have.
3. It costs more to manage but higher management fees do not guarantee better fund performance.
4. It has a long-term lock-in period which may be extended from five to eight years, also investors must pay the specific exit fee if they want to exit from the fund.
5. While diversification reduces investors’ risks of loss, it can reduce their profit as well. Hence, investors should not invest in more than seven to nine mutual funds at a time.
What are the categories of Mutual Fund?
Mutual fund is divided into four categories. These are Equity fund, Debt fund, Commodity fund & Hybrid fund.
Equity Fund: An equity fund is a type of private investment fund that invests principally in stocks of companies. It can be actively or passively managed. It aims to generate high returns and quick growth by investing in the shares of companies of different market capitalization.
Debt Fund: Debt Mutual Fund which is known as a fixed income fund, mainly invests in fixed income securities like treasury bills, government securities, corporate bonds. Generally, debt securities have a fixed maturity date & pay a fixed rate of interest. It can be considered high risk investment as it invests in debts.
Commodity Fund: Commodity funds invests in gold, silver, natural gas, oil etc. Investing in commodity mutual fund has its own risks and advantages. It is very important for early investors to have a clear concept of functioning of the commodities markets and the risks and benefits of investing in the commodity.
Hybrid Fund: Hybrid or balanced mutual funds invest in more than one asset class - typically a combination of equity and debt assets. These funds typically invest in a mix of stocks and bonds. They serve as a good entry point for new investors in the stock market and also can be used for saving for individual goals.
How to invest in Mutual Fund?
Now days investors are few clicks away from their computers, phones to invest in Mutual fund. Even if someone does not have a DEMAT account, that person can invest in Mutual Funds through their internet banking or various other websites available in the internet including SIP.
If an investor has DEMAT account they can also start investing in Mutual Funds through their registered broker online.
A person can also seek assistance of a mutual fund advisor locally and invest through him. The advisor would help investors with the formalities and advice on mutual fund schemes. This is the preferable method if a person is new to mutual funds or not very clear about the concepts related to mutual funds and investments. Experts basically recommend a fund for first-time investors as per their requirement and risk taking capabilities.
All funds carry some level of risk. With mutual funds, investors may lose some or all of the money they invest because the securities held by a fund can decrease in value. Payment of dividend and interest may also change as market conditions. By law, each mutual fund is required to file a prospectus and regular shareholder reports with the SEBI. An investor must be sure to read the prospectus and the required shareholder reports before investing.