What is a Mutual Fund? | How are mutual funds set up?
What is a Mutual Fund?
A mutual fund is a trust that pools the savings of a number of investors who share a common financial goal. This pooled money is invested by the Asset Management Company (AMC) into different asset classes like equity, debt, money market instruments and other securities as defined by the investment objective. The funds add value to the investment in two ways – income earned and capital appreciation realised through sale. This is shared by the unit holders in proportion to the number of units owned by them. For example, an equity fund would invest in equity and equity-related instruments and a debt fund would invest in bonds, money market instruments etc.
How are mutual funds set up?
A mutual fund is set up in the form of a trust, which has a Sponsor, Trustees, Asset Management Company (AMC) and custodian. The trust is formed by the sponsor or more than one sponsor who is like a promoter of the company and is registered with Securities and Exchange Board of India (SEBI). The trustees hold the fund’s property for the benefit of unit holders. An Asset Management Company approved by SEBI manages the fund by making investments in various types of securities.
A custodian who is registered with SEBI holds the securities of various schemes in its custody. The trustees are vested with the power of superintendence and direction over the AMC. They monitor the mutual fund’s performance and its compliance with SEBI regulations.
The regulations by SEBI require that at least two-third of the directors of the trustee company or board of trustees must be independent i.e., they should not be associated with the sponsors. Also, 50% of the directors of an AMC must be independent.
Know about the various types of mutual funds available to you
Classification based on maturity period
Open-ended funds can be purchased or redeemed at any point of time at Net Asset Value (NAV) based prices. They are available for subscription throughout the year. These funds do not have a fixed maturity date. Liquidity is the key feature of open-ended funds.
Close-ended funds have a defined maturity period, usually between five to seven years. The units of closed-ended funds can be bought only during a specified period at the time of the initial launch. SEBI insists that all close-ended funds should provide a liquidity window to its investors. These funds are required to be either listed on a recognised stock exchange or provide periodic repurchase facility to investors.
Interval funds combine the features of open-ended and close-ended funds. These funds might trade on stock exchanges or be open for sale or redemption at predetermined intervals on the prevailing Net Asset Value (NAV).
Classification based on investment objectives
The aim of Equity/Growth funds is to provide capital appreciation over the medium to long term. These funds invest a major part of their corpus in equity securities. These types of funds are suitable for investors with a long term outlook and higher risk appetite. They provide different options like growth option, dividend option etc. to investors.
The main objective of debt/income funds is to provide regular and steady income to investors. These funds invest in fixed income securities such as bonds, corporate debentures, government securities (G-Secs), money market instruments, etc. Debt funds are suitable for investors whose main objective is safety of capital with moderate growth. These funds are not affected by fluctuation in equity markets. However, the funds’ NAVs are affected because of change in the interest rate.
The aim of balanced funds is to provide both, regular income and capital appreciation to investors. This type of fund invests in equity and fixed income securities as per the proportion indicated in the fund’s offer document. Balanced funds are suitable for investors looking for moderate growth. They generally invest 40-60% in equity and debt instruments. These funds’ NAVs are also affected by fluctuations in share prices but are less volatile than those of the pure equity funds.
Money Market/ Liquid Funds
The aim of money market funds is to provide liquidity, preservation of capital and moderate income to investors. These funds invest in short-term maturity instruments such as treasury bills, certificate of deposit, commercial paper and call money market-based instruments. These funds are ideal for investors looking for moderate returns on their surplus funds. The returns on these funds do not fluctuate much with the changes in prevailing interest rate in the market.
Gilt funds invest exclusively in government securities. Although these funds carry no credit risk, changes in interest rates and other major macro-economic factors of a country have a significant impact on the NAV of these funds.
Index schemes replicate the performance of a particular index such as the BSE Sensex
or the S&P CNX Nifty. The portfolio of these schemes consists of only those stocks
that constitute the index and the weightage assigned to each stock is identical
to the stock’s weightage on the index. Hence, the returns from these funds are more
or less similar to those generated by the index and variations, if any, in the percentage
change in NAV of the index fund to that of the Index, is measured by tracking error.
Exchange traded index funds are a variation of index funds. They trade on the stock exchanges just like equity securities and can be purchased or sold on the exchange at a quoted price just like any other equity security.
Sector funds invest in the securities of only those sectors or industries as specified in the offer document. The returns in these funds are dependent on the performance of the respective sector/industries. Sector funds are riskier as their performance is dependent on one or two particular sectors though the same is also responsible for higher returns generated by these funds.
Fund of Funds
Fund of funds (FoF) invest in other mutual funds. These schemes offer the investor an opportunity to diversify risk by distributing investments across assets. The underlying investments for FoF are the units of other mutual fund schemes either from the same mutual fund or other mutual fund houses.
Classification of Plans
Under the growth option, dividends are not paid to unit holders. Under this option, the income continues to remain invested in the scheme and is reflected in the NAV of the units. Investors can realise capital appreciation through an increase in NAV of their units by redeeming them.
Dividend Payout Option
Under this option, dividends are paid out to the unit holders. However, the NAV of the unit falls to the extent of the dividend paid out.
Dividend Reinvestment Option
The dividends that accrue on funds are re-invested back into the fund and the investor is issued additional units proportional to the dividend amount.
Know about the 7 benefits that mutual fund offer
Advantages of investing in mutual funds
Mutual funds provide the benefit of professional management as the investors money is managed by qualified fund managers. Investors who do not have the time or expertise to manage their own portfolio invest in mutual funds.
Mutual funds provide the benefit of diversification across different sectors and companies. They widen investments across various industries and asset classes. Thus, by investing in mutual funds, you can avail of the benefits of diversification and asset allocation without investing the large amount of money that would be required to create an individual portfolio.
Mutual funds are usually liquid investments. Unless they have a pre-specified lock-in, your money will be available to you anytime you want. Normally, funds take a few days to return your money. Since they are well integrated with the banking system, most funds can send money directly to your bank account.
Mutual funds offer a range of plans, such as regular investments, regular withdrawal and dividend reinvestment plans. Depending upon one’s preferences and expediency one can invest or withdraw funds, accordingly.
Since mutual funds have a number of investors, the fund’s transaction costs, commissions and other fees get reduced to a considerable extent. Thus, owing to the benefits of a larger scale, mutual funds are comparatively less expensive than direct investment in the capital markets.
Mutual Funds provide investors with updated information pertaining to the markets and schemes through fact-sheets, offer documents and annual reports.
Mutual funds in India are regulated and monitored by the Securities and Exchange Board of India (SEBI), which endeavours to protect the interests of investors. Mutual funds are required to provide investors with regular information about their investments, in addition to other disclosures like specific investments made by the scheme and the proportion of investment in each asset class.
Mutual fund - a tax efficient investment avenue
A to Z about mutual funds
A statement issued by the mutual fund house, giving details of transactions and holdings of an investor in different mutual fund schemes.
A yearly report containing the annual record of a mutual fund's performance. The report informs the investor about the fund's earnings and operations as well.
The percentage change in net asset value (NAV) over a year's time, assuming reinvestment of distributed income such as dividend payment and bonuses back into the fund.
The increase in the value of an investment. For example, an equity share whose price rises from Rs. 20/- to Rs. 25/- has appreciated by Rs. 5/-.
A form through which investors can make an application to subscribe to the units of a fund.
The practice of buying and selling a listed stock on different exchanges in order to profit from minute differences in price between the two markets.
Property and resources, such as cash and investments, comprise a person's assets; i.e., anything that has value and can be traded. Examples include stocks, bonds, real estate, bank accounts, and jewellery.
Allocation of the portfolio of a mutual fund in various categories of assets such as equity, debt and others on the basis of the investment objective of the scheme. It is the process of diversifying investments among different types of assets like stocks, bonds and cash to optimise risk / return trade-off based on a person's financial situation and goals.
Asset Management Company (AMC)
The trustee delegates the task of floating schemes and managing the collected money to a company of professionals, usually experts who are known for smart stock picks. This company is called an asset management company (AMC). An AMC charges a fee for the services it renders to the Mutual Fund trust. Thus the AMC acts as the investment manager of the trust under the broad supervision and direction of the trustees. The AMC must have a net worth of at least Rs. 10 crore at all times and it cannot act as a trustee of any other mutual fund.
Automatic Investment Plan
A plan under which, the investor mandates the mutual fund to allot fresh units at specified intervals (monthly, quarterly, etc.) against which the investor provides post-dated cheques. On the specified dates, the cheques are realised by the mutual fund and on realisation, additional units are allotted to the investor at the prevailing NAV.
Automatic Reinvestment Plan
A plan under which a unit holder makes periodic investment of a fixed amount, either directly from his bank account or by issuing post-dated cheques into his or her mutual fund account. On the specified dates, the cheques are realised by the mutual fund and on realisation; additional units are allotted to the investor at the prevailing NAV.
Automatic Withdrawal plan
A plan that allows an investor to receive periodic payments of fixed amount or units from his investment in a mutual fund scheme. Retirees who want a regular income supplement often choose this plan.
A service offered by most mutual funds whereby income, dividends and capital gain distributions are automatically invested into the fund by buying additional shares and thus building up holdings through the effects of compounding.
Absolute returns over a period (which could be larger or smaller than a year) aggregated to a period of one year.
Average Cost Method
A method of finding out the cost per unit by adding up all the costs involved in purchasing all the units of investment and then dividing the sum by the total number of units.
A financial statement showing the nature and amount of a company's assets, liabilities and shareholders' equity.
A mutual fund scheme with an investment objective of both long-term growth and income, through investment in stocks and bonds. Generally, 60% is invested in stocks and 40% in bonds, in order to obtain the highest returns consistent with a low-risk strategy.
The smallest measure used in quoting yields on fixed income securities. 100 basis points are equal to one percentage point.
The period during which investors are on a selling spree and the share prices in general are going down.
A standard used for comparison. The investment performance of the scheme needs to be compared in relative terms against some indicator, which is called the benchmark for the scheme. The common benchmarks for equity-oriented funds are the BSE 200 index or the BSE Sensex.
A measure of a fund's volatility in relation to the stock market is measured by a stated index. By definition, the beta of the stated index is 1; a fund with a higher beta is more volatile than the market, and a fund with a lower beta is less volatile than the market. Based on past historical records, a beta higher than 1.0 indicates that when the market rises, the stock will rise to a greater extent than that of the market; likewise, when the market falls, the stock will fall to a greater extent. A beta of lower than one indicates that the stock will usually change to a lesser extent with respect to the market. The higher the beta, the greater the investment risk.
Bid or Sell Price
The price at which a mutual fund's units are redeemed (bought back) by the fund house. The bid or redemption price means the current net asset value per unit, less any redemption fee or back-end load.
A debt instrument issued by a company, state or the central government (or its agencies), with a promise to pay a stated rate of interest at regular intervals and return the principal amount on a specified date. Unlike stockholders, bondholders do not have corporate ownership privileges.
Period during which the prices of stocks in the stock market keep continuously rising for a significant period on the back of sustained demand for the stocks.
A bond in which the issuer is permitted or required to redeem before the stated maturity date at a specified price, usually at or above par, by giving notice of redemption in a manner specified in the bond contract.
Capital Gains /Losses
Net profit or losses arising from the sale of securities in the fund's portfolio. Short-term gains or losses are generated on securities held for one year or less; long-term gains or losses pertain to securities held for more than one year.
Certificate of Deposit
Short-term debt instrument issued by scheduled commercial banks excluding regional rural banks. They are unsecured instruments that mature between three months to one year.
An extra security provided by a borrower to back up his/her intention to repay a loan.
Short-term unsecured instruments issued by a company that needs to raise money and is willing to pay an interest rate. These are included in portfolios of some mutual funds. Such instruments have maturities ranging from 3 months to 1 year.
The broker's or agent's fee for buying or selling securities for a client. The fee is usually based as a percentage of the transaction's market value.
Interest earned not only on the initially invested principal but also on the accumulated interest during the period.
The total amount of money invested by all investors in a scheme.
A colloquial term that refers to a security's interest rate.
The annual rate of interest payable on a debt security expressed as a percentage of the principal amount.
Changes in the value of a currency in relationship to other major currencies. Currency fluctuations can have a significant effect on the value of international mutual funds.
The possibility that fluctuating currency exchange rates will affect the rupee value of an investment.
The organisation (usually a bank) that keeps and safeguards the custody of securities and other assets of a fund.
Date of Redemption
The date specified for the redemption of a scheme. No such date is specified for an open-ended scheme.
Debt /Income Funds
Funds that invest predominantly in fixed income bearing instruments such as corporate debentures, PSU bonds, gilts, treasury bills, certificates of deposit and commercial papers. Although these funds are less volatile, the underlying investments carry a credit risk. Comparatively, these funds are the least risky and are preferred by risk-averse investors.
A debt obligation that is not backed by collateral, but usually rated by a credit rating agency.
The difference between the lower price paid for a security and the security's face amount at issue.
An investment strategy that spreads investments among securities in different industries, with different risk levels, and in different companies, potentially lowering risk by reducing the impact of any one security. Mutual funds are the best method of diversification because their portfolios consist of a variety of securities, unless otherwise noted. Mutual funds are a diversified investment by nature.
Portion of profits that a company or a mutual fund distributes to its shareholders or unit holders.
Dividend Distribution Tax
A tax payable by a debt oriented mutual fund (a mutual fund that invests more than 50% of its portfolio in the debt market) before dividend is distributed to the unit holders. The DDT rate for different category of funds is different, and investors must check for the same.
An estimate of how much a bond's price will fluctuate with a change in comparable interest rates; always measured in ‘years’. For e.g., if interest rates rise by 100 basis points, a fund with five year duration is likely to lose about 5% of its value.
Earnings Per Share (EPS)
A company's net income or net profit per share. Mathematically it is arrived by dividing a company’s total earnings by the number of outstanding common shares.
The load charged by the fund when one invests into it. Entry Load increases the price of a unit i.e. NAV and is expressed as a percentage of the NAV. For example, a 1 % entry load will increase the NAV from Rs. 10 to Rs. 11 and therefore the number of units allotted will be lesser to that extent.
Funds where more than 65% of the corpus is invested in equity shares of various companies.
The annual percentage of fund's assets that is paid out in expenses. These include management fees and all the fees associated with the fund's daily operations.
The load charged by the fund when one redeems the units from the fund. Exit Load reduces the price of a unit i.e., NAV and is usually expressed as a percentage of NAV.
The value printed on the face of a stock, bond or other financial instrument or document.
A person appointed by the AMC to make all the final decisions regarding investments of a scheme.
Securities created and issued by the Central Government that are sold to the public.
The rate at which the general level of prices for goods and services are rising.
The chance that the value of assets or income will be diminished as inflation shrinks the value of a currency.
The amount paid by a borrower as compensation for the use of borrowed money.
The annual rate, expressed as a percentage of principal, payable for use of borrowed money.
A speculative bond with higher credit risk
An acronym for “Know Your Customer” or “Know Your Client”, a term commonly used for Client Identification Process. Pursuant to PMLA, SEBI has prescribed the certain requirements relating to KYC norms for Financial Institutions and Financial Intermediaries (such as Mutual Funds) to 'know' their clients. This could be in the form of personal meetings or verification of identity and address, financial status, occupation and such other personal information.
Liabilities simply refer to any money or service that is currently owed to another party. One form of liability would be the property taxes that a homeowner owes to the municipal government.
Libor (London Interbank Offer Rate)
The rate of interest at which banks borrow funds from other banks, in a marketable size, in the London interbank market.
A type of security instrument (i.e., a tax lien), placed against property, making it security for the payment of a debt, judgment, mortgage, or taxes. If the lien is not paid, the lien holder has the right to confiscate the property in order to recover the money that was loaned.
A term used for the cash and cash equivalent assets available with a fund to meet expenses and immediate redemption requirements of the investors. It also refers to the ability to buy or sell an asset quickly or the ability to convert to cash quickly.
Liquid Funds /Money Market Funds
Funds investing only in short-term money market instruments including treasury bills, commercial paper and certificates of deposit. The objective is to provide liquidity and preserve the capital.
A charge that may be levied as a percentage of NAV at the time of entry into the Scheme/Plans or at the time of exiting from the Scheme/Plans.
The period, after investment, during which the investor cannot redeem his units.
The date upon which the principal of a security becomes due and payable to the security holder.
Mibor (Mumbai Interbank Offer Rate)
This is the rate of interest at which banks borrow funds from other banks, in marketable size, in the Mumbai interbank market.
Money Market funds
Mutual funds that aim to pay money market interest rates are generally called as money market funds. The objective of these funds is accomplished by investments in safe, liquid securities, including certificates of deposit, commercial paper, and Government securities.
Money Market Instruments
Refers to Commercial Papers, Treasury Bills, GOI Securities, etc. with an unexpired maturity of less than or up to one year, Call Money, Certificates of Deposit and any other instrument specified by the Reserve Bank of India.
A legal instrument given by a borrower to the lender entitling the lender to take over pledged property if conditions of the loan are not met.
Net Asset Value (NAV)
The price at which a mutual fund investment is valued. Mathematically it is the value of fund's portfolio at market value less current liabilities divided by the number of units outstanding. Net asset value is normally computed daily or weekly and can be found in the financial section of the daily newspaper.
Market / Fair Value of Scheme's investments (+) Receivables (+) Accrued Income (+) Other Assets (-) AccruedExpenses (-) Payables (-) Other Liabilities ----------------------------------------------------------------------------------------------------------------------------- ------ Number of Units Outstanding
A person's total value of all possessions, such as a house, stocks, bonds, and other securities, minus all outstanding debts, such as mortgage and revolving credit lines.
New Fund Offer
An offer that is floated when a mutual fund is launched, allowing the firm to raise capital for purchasing securities. A new fund offer is similar to an initial public offering; however, unlike an initial public offering (IPO), the price paid for shares or units is often close to a fair value. This is because the net asset value of the mutual fund prevails.
Offer Document or Prospectus
The official document issued by mutual funds prior to the launch of a fund describing the characteristics of the proposed fund to all its prospective investors. It contains information required by SEBI pertaining to issues such as investment objective and policies, services, and fees.
The lowest price that a seller is willing to accept from a prospective buyer. In the case of a mutual fund with a sales charge, this price is the net asset value (NAV) plus the sales charge. In the case of no-load funds, it is the NAV.
PortfolioA term used to represent a pool of individual investments owned by an investor or mutual fund. Portfolios may include a combination of stocks, bonds, and money market instruments.
The amount by which a bond/ or a stock sells above its par (face) value.
A valuation ratio of a company's current share price compared to its per-share earnings.
The price at which a mutual fund's units are purchased. The purchase price for a mutual fund is made up of the current net asset value plus sales charge, if any.
Rate of Return
The percentage that an investor achieves from his investment in any asset class. To calculate the rate of return, total proceeds derived from the investment are divided by the investment made and then the resultant figure is multiplied by 100to arrive at the percentage.
Buy back/cancellation of the units by a fund on an on-going basis or on maturity of a scheme. The investor is paid a consideration linked to the NAV of the scheme.
The act of returning money to an investor by the fund. This could be on account of rejection of an application to subscribe units or in response to an application made by the investor to the fund to redeem units held by him.
Registrar or Transfer Agent
The institution that maintains a registry of unit holders of a fund and their unit ownership. Normally the registrar also distributes dividends and provides periodic statements to unit holders.
The date on which a fund's dividend and/or capital gains are reinvested back into the fund and additional fund units are issued.
Rupee Cost Averaging
An investment strategy based on investing equal amount of money in a fund at regular intervals. As more units are bought at lower prices and fewer units at higher prices, eventually the average cost of the total units turns out to be lower than the higher price over the period. In this way investors in bearish times save themselves from higher losses on high prices and in bullish times get higher profit on average prices.
Buying back/ cancellation of the units by a fund on an ongoing basis or for a specified period or on maturity of a fund. The investor is paid a consideration linked to the NAV of the scheme
The price at which open-ended funds repurchase their units and close-ended funds redeem their units on maturity. Such prices are NAV related.
Risk Adjusted Returns
The expected returns from an investment depend upon the risk involved in the investment. A standard measure is required for comparing returns from different investments classes and this is where risk adjusted returns work. These returns standardize the absolute returns generated, by an investment class, with the risk involved in achieving these returns. So, a single number is achieved which can be used for ranking of mutual funds.
It is the same as the purchase price as the mutual funds are outside the effects of demand and supply, there isn’t any difference between purchase and sale price.
The fee charged on the purchase of new units of a mutual fund; it is also called load.
Mutual funds that are established to focus and invest in the stocks of specific sectors of the economy, such as pharmaceuticals, chemicals, or information technology.
A risk-adjusted returns measure, which is used to standardise absolute returns generated by a fund.Mathematically, the ratio is measured by dividing the access returns generated by a fund, arrived by subtracting risk free return from the fund’s absolute return, with the volatility i.e. standard deviation, of the fund.
The difference between the rates at which money is deposited and the rate at which it is borrower from a financial institution. Spread in context of capital markets relates to the difference between the sale price and the buy price for a security.
Systematic Investment Plan (SIP)
A programme that allows an investor to provide post-dated cheques to the mutual fund to allot fresh units at specified intervals (usually monthly or quarterly). On the specified dates, the cheques are realised by the mutual fund and additional units at the prevailing NAV are allotted to the investor. This enables him or her to invest as little as Rs 1,000 per month and take advantage of rupee cost averaging
Systematic Withdrawal Plans (SWP)
A plan offered by some funds under which post-dated cheques of fixed amounts (as may be fixed by the fund) are issued to the investors for monthly, bi-monthly or quarterly withdrawals. The withdrawals are as per the requirements of the investor specified by him or her at the time of investment.
Systematic Transfer Program (STP)
A plan that allows the investor to give a mandate to the fund to periodically and systematically transfer a certain amount from one fund to another.
A risk measure, which is used to understand the degree to which a fund's return fluctuates around its mean returns. It is also referred to for the volatility of the fund and is the most common risk measure used in arriving at risk-adjusted returns.
The aggregate return on an investment arrived at after summing capital appreciation, dividends, interest, bonus and other distributed income.
The divergence between the price behaviour of a position or portfolio and the price behaviour of a benchmark. It is generally used to measure risk on an index fund, since index funds mirror their respective benchmark any substantial deviation in the returns of the two defeats the purpose of having an index fund.
A person or a group of persons having an overall supervisory authority over the fund managers. They ensure that the managers keep to the trust deed that the unit prices are calculated correctly and the assets of the funds are held safely.
A term used in lieu of the buying and selling activity of a fund manager during an year.
An organisation or any legal entity that acts as a distributor of an initial public offering of any security to brokers, dealers or investors; underwriter also undertakes to subscribe any under-subscription of the offer.
One undivided share in the assets of a fund.
A person who holds the unit(s) of any mutual fund.
The process of determining the current worth of an asset or a company. There are many techniques that can be used to determine this worth, some are subjective and others are objective.
The date on which a foreign exchange transaction or a cash movement takes place. It can be used interchangeably with settlement date.
A risk measure used to gauge the fluctuation in the price or returns or any other parameter of an asset class.
The annual rate of return based on the purchase price of an investment, it is usually expressed in percentage.
A graph depicting yield on a bond vis-à-vis the maturity of the bond. It indicates the interest rates levels of any interest bearing asset class and helps investor understand the applicable returns for different time horizons.
Yield to Maturity
An instrument used to determine the rate of return an investor will receive if a long-term, interest-bearing investment, such as a bond is held to its maturity date. It takes into account purchase price, redemption value, time to maturity, coupon yield and the time between interest payments.
Bonds that do not pay regular coupon to the investors. These bonds are issued at discount to their maturity value. Therefore, an investor in these bonds realises value of his investment only at the end of the maturity term or by selling these bonds in the secondary market, if any exists.