23 frequently asked questions on mutual funds
1. What is an NFO?
A new fund offer (NFO) is the first time subscription offer for a new scheme launched by the asset management companies (AMCs). An NFO is launched in the market to raise capital from the public in order to buy securities like shares, government bonds etc from the market.
NFOs are offered for a stipulated period. This means that the investors opting to invest in these schemes at the offer price (in most cases the offer price is fixed at Rs10) can do so in this stipulated period only. After the NFO period, investors can take exposure in these funds only at the prevailing net asset value.
2. What is a mutual fund?
A mutual fund pools the money of people with similar investment goals. This money is then managed by a professional fund manager, who uses his investment management skills to invest it in various financial instruments.
3. What is a balanced mutual fund?
A balanced mutual fund offers the best of both worlds: Equity and Debt. A balanced mutual fund portfolio’s exposure to both equity and debt instruments enables investors to get optimised returns with relatively lower volatility compared to pure equity mutual funds. Pure equity mutual funds offer superior returns over the long term but are more volatile and suited for aggressive investors. On the other hand, the returns in debt mutual funds are stable but tend to be lower compared with the balanced mutual funds over the long term.
A balanced fund brings in the required stability in its portfolio by having a partial exposure to the fixed income instruments. Also, depending on the macro-economic outlook, the fund manager periodically reviews the portion of debt and equity, and makes adjustments accordingly to maximise the returns and minimise the risk. A balanced fund is suited for conservative investors looking for returns that are superior to bank term deposits/debt mutual funds and carry relatively lower risk compared to pure equity mutual funds.
4. What are the benefits of investing in balanced funds?
The benefits of investing in balanced mutual funds are many.
- Exposure to two asset classes: A majority of the investment in a balanced mutual fund is in equity which acts as a wealth building vehicle in the long term. Investors also benefit from diversification by way of requisite exposure to debt instruments, thereby reducing the volatility in returns vis-a-vis the pure equity mutual funds.
- Auto re-balancing: It is imperative that an investor follows proper asset allocation according to his/her risk profile and investment objectives. At the same time, an investor must review and rebalance his/her portfolio periodically. The rebalancing happens automatically in a balanced mutual fund. The fund manager adjusts the portfolio as per the prevailing trend and outlook of the equity and debt markets (from equity to debt when the stock market is over-heated and from debt to equity when the stock market is down).
- The tax angle: A balanced mutual fund invests around 70-80% of its funds in equity and the balance in debt. Since a balance mutual fund invests more than 65% in equity, the tax rules of equity mutual funds are applicable to these (ie dividends are tax-free and capital gains after one year are exempt from taxes).
- Tax-free debt: If an investor invests in a pure debt mutual fund then short-term tax is applicable if redemption is done before three years. An investor will get the indexation benefit if redemption happens after three years of the purchase. As a balanced mutual fund falls under the Equity mutual fund category, the returns generated from their debt portfolios also enjoy tax exemption where redemptions after one year are tax-free.
5. So how does a mutual fund make money?
In two ways: by earning dividends or interest on its investments and by selling investments that have appreciated in price. The fund pays out, or distributes, its profits (less fees and expenses) to its shareholders. That's how you make money. Most funds offer investors the option of reinvesting their distributions in the fund by buying more shares.
6. How do mutual funds work?
Your money is invested in various securities depending on the objectives of the scheme you choose like stocks, bonds and money market.
Each fund's investments are chosen and monitored by qualified professionals who use this money to create a portfolio. That portfolio could consist of stocks, bonds, money market instruments or a combination of these.
As an investor, you own shares of the mutual fund, not the individual securities. Mutual funds permit you to invest small amounts of money, however much you like, but even so, you can benefit from being involved in a large pool of cash invested by other people. All shareholders share in the fund's gains and losses on an equal basis, proportionately to the amount they've invested.
7. What are the benefits of investing in mutual funds?
- Professional management of your money
- Instant diversification
- Potential to give higher returns compared with other instruments
- Low cost
- Well regulated
- Tax benefits
8. How do mutual funds help me diversify my investments?
A mutual fund is well diversified. It spreads your money among many different companies and industries as it owns hundred different securities. This effectively reduces your risk, ie it reduces the possibility that you may lose money if some constituents of the fund do not perform. This diversification is one of the biggest advantages of mutual funds.
For most of us, the amount of income and investment knowledge required to accomplish similar diversification would be impossible to obtain. Also, sharing expenses with millions of like-minded investors, through a mutual fund, significantly reduces your investment cost. That's because a mutual fund is an "institutional trader" and can therefore buy securities at wholesale prices.
9. What are bluechip companies?
These are companies with market capitalisation equal to or more than the least market capitalised stock of BSE 100 Index. These companies have large business presence, good reputation and are possibly market leaders in their industries.
10. What all to keep in mind while choosing a mutual fund?
Before you buy units in any mutual fund, it is important that you know exactly how much it is going to cost. All mutual funds charge a management fee. It doesn't matter if you buy from a bank or a broker, you will pay a management fee. In addition, some mutual funds charge a "load" when you buy or sell your mutual fund units. If you are charged a fee when you buy your units, it is known as front-load and if the fee is charged at the time of redemption, it is known as a back-load.
11. What are open-ended schemes?
Based on the accessibility these provide investors, mutual fund schemes can be classified into “open-ended” and “closed-ended”. Open-ended schemes don’t have a fixed tenure and are always open for investment or withdrawal. That is, there is continuous purchase and repurchase, after the initial issue, which is open for a limited period. You can invest or withdraw at any time. This ease of entry and exit makes them a popular choice among investors.
In open-ended mutual funds, the size of the fund changes as investors enter or exit. The purchase and repurchase are generally done at a price linked to the net asset value (NAV) of the scheme.
12. What are closed-ended schemes?
Closed-ended schemes are of fixed tenure, which is stated at the time of the initial issue itself. These invite subscriptions only once during their lifetime, at the time of the launch. That is, units are sold only during the new fund offer. The size of the fund is kept constant as there is generally no exit till the redemption date.
Some closed-ended schemes are listed on stock exchanges and hence investors can sell or buy their units in the market. However, these mostly trade at a discount to the NAV and have low liquidity. A few closed-ended funds have started offering limited exits to investors (say once every six months).
13. What is corpus?
The total money available with a scheme including the value of its investments, at any point in time, is referred to as the “corpus” or “assets under management”. A mutual fund invests its corpus in various securities in line with its stated objectives.
14. What is unit?
A mutual fund issues “units” to investors against their investment. A unit is the currency of a fund. What a share is to a company, a unit is to a fund.
15. What is meant by NAV?
NAV when expanded reads “net asset value”. A scheme’s NAV is its net assets, that is the market value of the securities and other assets it owns minus its liabilities, divided by the number of units it has issued.
A scheme’s NAV is a dynamic figure. The market value of a scheme’s portfolio changes from day to day, as prices of shares and bonds move up or down. The number of units outstanding also changes, as new investors come into the scheme and old ones leave.
16. What is the significance of NAV?
The NAV of a scheme tells how much each unit is worth at any point in time and is, therefore, the simplest measure of how a scheme is performing. If the NAV of a scheme rises from Rs10 to Rs11 over time, the scheme is said to have generated a return of 10%. Similarly, if its NAV falls from Rs10 to Rs9, it is said to have lost 10%.
A mutual fund is generally bought and sold at its NAV. If, for example, you were to invest Rs10,000 in a scheme when its NAV is Rs10, you will be allotted 1,000 units (10,000/10) roughly (the fund charges a processing fee, ie the load).
Fund houses have to calculate and disclose the NAVs of their schemes daily.
17. Is the NAV of a scheme the exact price at which an investor enters or exists the scheme?
Although the NAV represents a scheme’s current market value, it is not the exact price at which an investor enters or exits the scheme. Fund houses levy a nominal charge on most of their schemes to meet their processing costs and to discourage investors from leaving. This charge is referred to as “load” and it is the price you pay over and above the fund’s NAV when you buy or sell units.
18. What are entry and exit loads?
If you pay load at the time of buying units it is called entry load and if you pay load at the time of selling units it is called exit load. Load is expressed as a percentage of the NAV and has the effect of reducing your return. An entry load increases the sale price, which places fewer units in your hands. An exit load reduces the repurchase price, which reduces your sale proceeds. For example, a scheme has an NAV of Rs10, and levies an entry and exit load of 1% (or 10 paise) each. So when you buy units you pay Rs10.1 per unit and if you sell, you get Rs9.9 per unit, not Rs10.
Loads are subject to regulations of the Securities and Exchange Board of India (Sebi) and vary depending on industry practice. Under Sebi rules, the sum of entry and exit loads charged by a scheme cannot exceed 7%.
19. What is CDSC?
Contingent deferred sales charge (CDSC) is a variable exit load, charged depending on the duration of the stay in the fund.
20. Will I have to pay any other charges for investing in a mutual fund?
Another entry that eats into an investor’s returns is “expenses”. This is what the fund charges for managing an investor’s money. Fund managers have to be paid a fee, as do the other constituents involved in managing the money. All this entails costs which a scheme recovers from investors, within limits.
Every year, a fund charges some amount to the scheme’s NAV, reducing the investor’s returns by that amount. Sebi rules allow equity schemes to charge a maximum of 2.5% of corpus as expenses every year; the corresponding limit for debt schemes is 2.25%. Sebi also decides what kind of expenses a fund can charge its unit holders and what it cannot. For example, the cost of running an advertisement campaign about a fund having won an award cannot be charged to investors.
21. How can I know where a mutual fund has deployed the funds of investors?
Under Sebi rules, fund houses have to send annual reports to all unit holders, disclosing the complete portfolio of all their schemes, and publish half-yearly results in newspapers. These documents shed light on a scheme’s performance over various time periods and how it stands up, given the existing market conditions.
Some fund houses go beyond such mandatory information sharing. They send relevant information to investors on a quarterly or even monthly basis, through fact sheets and newsletters. Most fund houses update their scheme portfolios on their websites even faster, the norm being on a monthly basis. This information can be used by investors to make informed investment decisions.
22. What is sale price?
Sale price is the price you pay when you invest in a scheme. It is also called “offer price”. It may include a sales load.
23. What is redemption/repurchase price?
Redemption price or Repurchase price is the price at which open-ended schemes repurchase their units and close-ended schemes redeem their units on maturity. Such prices are NAV related (exit load may be deducted wherever applicable).