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....