Basics of Mutual Funds- Part Two

AMFI

Association of Mutual Funds in India is the industry association for Mutual Funds. It was established in 1995. They promote the interest of Mutual Funds, educate investors, represent the industry in interactions with regulators like SEBI/RBI.

What is a SIP?

This is a term we have often hear during our interactions with financial agents. Systematic Investment Plan(SIP) is a mode of investment. It is not a scheme. It is not a specific investment product. In SIP, investors are encouraged to invest small amount in a regular interval for a particular time duration. In other words, usually we think of buying a Mutual Fund by investing a lump sum amount(Say 10,000 INR). If we instead opt for SIP, we can invest small amount(1000 INR) regularly(Every Month) for a year. This reduces investors burden of parting with a big amount at one shot. More importantly, in a volatile market SIP helps in averaging your investment thereby reducing your exposure to loss.

What is a STP?

If an investor opts for SIP, his money usually moves out of his savings account on a particular day of the month. For example, if I decide to start a SIP of 5000/month and declare my SIP date to be 25th of each month, the amount is deducted on 25th from my account. This leads to a situation that the 5k earns the savings account interest from 1-24th day. Usually that interest is around 3.5%. The investor can instead put this amount in a Liquid Mutual fund and for the same period earn higher interests. Liquid funds do not have any entry/exit loads. They have minimal risk. This efficient switch from a Liquid fund to a SIP plan thereby making your money work more effectively is known as Systematic Transfer Plan(STP).

Please note that the recent changes allowing banks to have flexible savings account interest might reduce the ROI gap between Liquid funds and Savings bank account.

What is SWP?

A Systematic Withdrawal Plan works a bit differently. Here the investors invests a lump sum amount in the beginning and withdraws some money regularly over a period of time. For example, an investor puts in 20,00,000 INR. He is aged 60 yrs. He wants to withdraw 1 lac per annum which is around 8.3K per month. In SWP, he gets the provision to do that. In addition to that, it is expected that his initial principal amount will grow over time and hence he also gets the option to either get that extra amount on a monthly basis or withdraw the same amount(8.3K) for a longer duration.

Different Options of Investing in a Mutual Fund

An investor can choose primarily three different options to invest in a Mutual fund. It can be decided by the objective of the investment, the age of the investor etc.

a) Growth Option: In this option, the interest gained on the principal amount is not withdrawn. Instead it is reinvested. For example, if an investor has invested 10k and the scheme delivers a return of 10%. The 1K in interest is not taken out by the investor. It is reinvested.

b) Dividend Payout Option: In this case, 1k is paid to the investor as dividend. Assuming NAV at the time of purchasing was 10. A 10% return meant a NAV increase to 11. However, as the dividend is paid out, the NAV falls back to 10.

c) Dividend Reinvestment Option: In this case, the Dividend is invested back and the investor gets additional units (1000/10=100 units).

Is is important to note that all three options will end up giving the same amount of returns.

Taxation

Equity Mutual Funds have various advantages when it comes to Taxation. If a Mutual Fund is held for a period of more than 1 year, no tax is charged on the income amount. There is no tax on dividend distributed by equity mutual funds. ELSS funds allows an investor to get tax exemption under Sec 80C at the time of investment. However, any redemption of equity funds before one year is taxable. For Debt Funds, the tax structure is different.

The world of Mutual Fund is interesting and vast. There are lots of concepts and there is a lot of room for innovation. Its a thriving industry. It is also true that Equity Funds in particular are risky as they are very closely linked with the stock markets.

To summarize, Mutual Funds are a must for every investor. A young working professional should be having a majority of his/her portfolio in MF while a middle aged person can have a balanced outlook. SWPs are a good option for people who retire from their jobs. ELSS is a good way to claim tax exemption. A lot of good sites are available where one can learn as well as compare funds.

Happy Investing!

Basics of Mutual Funds- Part One

The Mutual Fund industry is growing at a spectacular rate ever since its inception. All of us have heard about this investment instrument and have exposure to it at different levels. I have tried to present a brief overview of my understanding of Mutual funds here.

To begin with, Mutual Fund(s) are just another mode of investment. An investor chooses to put his hard earned money in them with the expectation of getting a good return on investment(ROI). As a concept it is nothing different form other investment avenues and works on the same principles.

Mutual Fund structure in India

MF primarily follows a 3 tier structure. The Sponsor(1st Tier) is the one who decides to launch a fund. In order to do that he needs to set up a Trust(2nd Tier). A group of members called the Trustees are authorized to act on behalf of the Trust.Once the Trust is registered with SEBI(Securities and Exchange Board of India), it is known as the Mutual Fund. The AMC(Asset Management Company-3rd Tier) manages investors money and looks after the mutual fund.

What is the primary source of information about a Mutual Fund?

At the time of creation of a new Mutual Fund, the AMC present a Draft Offer document to SEBI. Upon approval, this document becomes the Offer Document(OD). It is the most comprehensive source of information. An investor has the right to get this document. He can always ask for it. The Key Information Memorandum(KIM) is another document which is provided to investors by default.

What is a NFO?

We have often come across this term. A New Fund Offering is nothing but the launch of a new mutual fund. During a NFO, the AMC invites investors to put their money into the scheme by subscribing to units. There can be close ended funds or open ended funds. In case of a close ended fund, an investor can only put his money during the NFO. For an open ended fund, an investor can enter the scheme at any given point of time.

What are Equity Funds?

Every company listed on the stock exchange issues shares which investors can buy. These shares are known as Equity shares. Equity Funds are a class of Mutual Funds which primarily invests in equity shares of companies. 40% of the MF industry is composed of certain funds. They are often termed as High Risk,High Return funds. It must be kept in mind that a high return is not guaranteed. Since they have maximum exposure to the stock market, there is no guarantee of positive returns. There are various sub groups of Equity funds:

a) Index Funds : They invest in stocks comprising indices like BSE 30,Nifty 50. Their target is to mirror their respective index movement. They never try to beat the index returns.Amongst equity funds, they are considered to be the safest.

b)Diversified Large Cap Funds: Funds which invests only in large cap stocks. A stock with a high market capitalization is usually termed as a Large cap stock. These funds invest in such stocks across sectors(industries)and hence called Diversified.

On similar lines, there are Mid Cap funds and Sectoral Funds.

What is P/E ratio?

It is one of the fundamental formula to analyze a stock. Price to earning ratio is nothing but Current Market Price(CMP) of the stock to its earning per share(EPS). If a company A issues 100 shares and its profit is 1000 crores, then the EPS is 1000/100=10. Let's say A's CMP is 150. It's P/E ratio will come out to be 150/10=15X(15 times). Hence we can say that the price of the company is 15 times its earning per share. It is usually said that a lower P/E ratio indicates that the stock has good upside potential.

What are ELSS funds?

Equity Linked Saving Schemes are another class of Mutual Funds. It is particularly beneficial for salaried professionals like us who can invest in these schemes and get tax exemption under Sec 80C. They come with a lock in period of 3 years which means an investor can't exit from the fund before 3 years.

What is Entry Load and Exit Load?

They are expenses linked with a mutual fund. An entry load is usually charged to an investor at the time of entering a fund. An exit load is charged during redemption of units. As per new regulations, entry loads are not relevant anymore. If an investor redeems after holding mutual fund units for over a year, no exit load is charged.

What is an Expense Ratio?

It is a very important ratio to determine the expenses of the mutual fund. It is defined as the ratio of expenses incurred to average weekly net assets. A low expense ratio indicates a better managed mutual fund.

To Be Contd....