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Mutual Funds Handbook


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Mutual Funds Handbook

  1. 1. Mutual Funds Handbook
  2. 2. What is Mutual Fund? Mutual Fund is defined as trust that pools the savings of investors who share common financial objective. Collected money then invested by professional Fund Manager in different type of securities such as Equity, Debt, Gold according to investment objective. Income earned through these investments & capital appreciation realized by the schemes then shared by its unit holders in proportion to number of units owned by them. So, to simply put, a mutual fund is the money pooled in by a large number of investors and offers an opportunity to invest in a diversified and professionally managed basket of securities at a relatively lower cost.
  3. 3. How Mutual Fund Works?
  4. 4. How do you make money from Mutual Funds 1. Capital appreciation: As the value of securities in the fund increases, the fund's unit price will also increase. You can make a profit by selling the units at a price higher than at which you bought 2. Coupon / Dividend Income: Fund will earn interest income from the bonds it holds or will have dividend income from the shares 3. Income Distribution: The fund passes on the profits it has earned in the form of dividends
  5. 5. Advantages of Mutual Funds 1. Professional Management: Investing is hard work. There are hundreds of companies to track & their prospects could change without warning. Mutual fund appoint skilled professionals whose job is to continuously research & monitor companies in mutual fund portfolio & take appropriate actions for the benefits of the investor. 2. Diversification: By putting your money in just a few shares, you are subject to considerable risk. Major decline in any single share can have adverse impact on investment. Mutual fund spreads the money across large no. of shares. This spread is balanced across different companies, sectors thus providing optimum safety. 3. Liquidity: The best feature any Investment can offer is the access to your money when you needed the most. Mutual fund offer the much required liquidity while investing.
  6. 6. Advantages of Mutual Funds 4. Transparent & Well Regulated: Mutual funds are obligated by law to release comprehensive data about their operations & investments. All funds release NAVs daily & most release their complete portfolio every month. SEBI regulates the fund industry very tightly to protect investor better. 5. Tax Efficiency: When you sell mutual fund units you have to pay capital gain tax (depending upon tenure of your holding) which is lesser than personal tax you have to pay. If you invest in ELSS or RGESS, it is permissible investments under Section 80 which will help you to reduce your tax liability. 6. Low Entry Level: In the case of mutual funds, minimum investment required is as low as Rs.5,000/- . Since there are not many quality shares which you can buy with Rs.5,000/- in hand, it is encouraging for investors who start small & at the same time take exposure to 25 to 30 stocks.
  7. 7. Mutual Fund Unit Mutual Fund units represent your extent of ownership in a mutual fund. So if NAV of Mutual Fund is Rs.10/- & you invest Rs. 1000/- then you will receive 100 units. NAV NAV is mutual fund's price per unit. The per-unit amount of the fund is calculated by dividing the total value of all the securities in its portfolio, less any liabilities, by the number of units outstanding. All mutual funds' buy and sell orders are processed at the NAV of the trade date. Asset Management Company (AMC) A company part of Mutual Fund, which takes investment decisions for the mutual fund , & manages the assets of the mutual fund. NFO When Mutual Fund launched for the first time it is called New Fund Offer. A NFO is similar to Initial Public Offering or IPOs of Company. Benchmark An unmanaged group of securities whose performance is used as a standard to measure investment performance. Commonly known as a market index. Some well-known benchmarks are the BSE Sensex and NSE Nifty. Technical Terms used in Mutual Funds
  8. 8. Equity Stock or share representing an ownership interest in the company. Debt A debt investment with which the investor loans money to an entity (company or government) that borrows the funds for a defined period of time at a specified interest rate. For e.g. Bank Fixed Deposits, Company Fixed Deposits, Government Bonds etc. Asset Allocation The process of diversifying the investments in different kinds of assets such as stocks, bonds, real estate, cash in order to reduce risk. Redemption When you sell your mutual fund units, it is called redemption. Market Capitalization Market Capitalization is simply multiplying the issued and outstanding shares of the company by its current market price. Technical Terms used in Mutual Funds
  9. 9. Types of Mutual Funds Mutual Funds are classified mainly on the basis of tenor 1. Open- Ended Mutual Funds: These funds available for buying & selling on all business days throughout the year. These funds do not have fixed tenure i.e. it won’t mature after fixed time period. Investors have the flexibility to buy & sell any part of their investments at any time at prevailing price i.e. NAV. 2. Close Ended Mutual Funds: These mutual funds are available for buying in specific period only ; generally NFO period. You can not buy units of these mutual fund after NFO period. One can not sell these mutual funds before its maturity. These mutual funds matures at fixed pre decided maturity date & amount is directly credited to investors bank account. Fixed Maturity Plan or FMPs is example of Close Ended Mutual Fund.
  10. 10. Investor can invest their money in different asset classes such as Equity, Debt, Gold, Real Estate. Mutual Funds provide an opportunity to invest in such asset classes. On the basis of asset classes Mutual Fund further classified as 1. Equity Funds Equity Funds invest money in equity i.e. Shares/ Stocks, Rights, Warrants etc. Equity funds invest money in companies across sectors & market capitalization. Suitability -: Equity Funds are suitable for investors with an appetite & tolerance for high risk & looking for better real rate of return. 2. Debt Funds Debt funds invest money in Government Securities, Corporate bonds, Debentures & all kind of different Fixed Income instruments. Suitability -: Debt Funds are suitable for investors who are risk averse & do not mind compromising on real returns & generally have near or short term financial goals. Types of Mutual Funds
  11. 11. 3. Hybrid Funds Hybrid Funds invest in multiple asset classes which could invest in Equity, Debt or even Gold. They are mandated to invest certain portion of their AUM in the respective asset classes. Depending upon their dominant exposure to equity or debt they are classified as equity-oriented hybrid funds and debt-oriented hybrid funds. Balanced Fund is an example of equity-oriented hybrid fund while Monthly Income Plans (MIPs) is example of debt-oriented hybrid funds . Suitability -: Hybrid funds can be suitable for investors who want to tactically allocate their assets; but the selection therein should be done as per their risk appetite and tolerance 4. Gold Funds Gold Funds invest money exclusively in Gold or companies which involved in activities related with Gold such as Mining, Trading or Safe Vault the Gold. Suitability -: Gold Funds are suitable for investors who looks to diversify their portfolio assuming high risk thereto. Types of Mutual Funds
  12. 12. Equity Mutual Funds further classified on the basis of market Capitalization 1. Large Cap Mutual Funds These funds are usually mandated to invest a predominant portion of their assets in large cap companies which have the market capitalization over Rs.1000 Crores. These are companies with well established business & stable profits. Their performance is more predictable & have ability to weather unfavorable economic conditions. Suitability-: Large cap funds are an indispensable part of the equity portfolio, irrespective of the risk appetite of the equity investor. 2. Mid Cap Mutual Funds These funds are usually mandated to invest a predominant portion into mid cap companies which have the market capitalization between 200 to 1000 Crores. They are well established but have potential to grow as they are yet in growth stage of their business cycle. They are more volatile as they tend to show fluctuations in profits & at times even struggle to sustain in challenging circumstances. Suitability-: Mid caps show a tendency to do well during the upside of the market, they also tend to plunge during the downside of equity markets. Hence although one could invest as permitted by risk appetite, it is imperative to stay invested for the long-term to strike a better risk-return trade-off. Types of Mutual Funds
  13. 13. 3. Small Cap Mutual Funds These funds usually mandated to invest predominant portion into small companies which fall below the market capitalization of Rs 200 Crores. Small caps carries highest risk as not many of these companies have capacity to sustain any adverse economic condition. But they all have potential to generate super normal returns if they found way to sustain any economic condition. Suitability-: Small cap funds are suitable for those who are willing to assume very high risk in their endeavor to clock super-normal returns. 4. Multi Cap Mutual Funds These funds are facilitated by their mandate to invest across market capitalization, i.e. large caps, mid caps and small caps. Thus by doing so they spread their risk across market capitalization and even capture investment opportunities across segments. Suitability-: Multi cap funds are appropriate if you are willing and / or want to take exposure across market capitalization to tap opportunities, and at the same time want to diversify risk. 5. Sector / Thematic Funds These funds focus to invest in particular sector or invest following theme like Infrastructure or Consumption. Suitability -: Investors who are willing to take very high risk and are adequately diversified but yet wish to follow their conviction of investing in sectors / themes may consider such funds. Types of Mutual Funds
  14. 14. Debt Funds are further classified on the basis of maturity profile of the securities they hold. One should carefully choose debt funds according to time period they wish to remain invested. 1. Liquid Funds These funds mainly invest in very short term money market instruments with maturity up to 91 days. 2. Ultra Short Term Funds These funds invest in Portfolio comprises a mix of certificate of deposits, commercial paper, call money and other money market instruments with slightly higher maturity than the instruments held in liquid funds but maturity less than 1 yr. 3. Short Term Funds These funds have exposure to short-term bonds, deposits and NCDs. They may also invest in T-bills and Government securities with maturity of less than 3 years. 4. Long Term Income Funds These Funds invest in bonds and debentures with maturity of more than 5 years. They can also invest in Government securities with maturity profile of 5 to 10 years. Types of Mutual Funds
  15. 15. 5. Dynamic Bond Funds These funds invest in short-term as well as long-term bonds and NCDs according to the interest rate cycle. They may also invest in Government securities with maturity of up to 5 years . But these funds carry highest risk among debt funds as its returns depends upon fund manager’s ability to predict the trend of interest rate cycle . 6. Gilt Funds or G-Sec Funds These funds invest exclusively in securities issued by Central or State Governments. Since Government Securities are highly traded market instruments they are generally over sensitive to any movement in the interest rates. Fiscal deficit & Current Account Deficit also have adverse impact on the market price of Government securities. 7. Fixed Maturity Plans or FMPs FMPs are close-ended schemes with fixed tenure that cease to exist thereafter. They invest in debt & money market instruments of similar maturity as the stated maturity of the plan which means a 90 day FMP will invest in debt & money market instruments that mature within 90 days like 3- month Certificate of Deposits (CDs), 3-month Commercial Papers (CPs). FMPs do not provide investors with an option to exit before Maturity. FMPs are suitable to those who wish to clock better post-tax returns as against bank or corporate FDs; but who are willing to take slightly high risk & do not require money before Maturity . Types of Mutual Funds
  16. 16. 1. Lump Sum or One Time Investments Lump Sum Mode helps Invest all your Investible surplus at one go. You should invest in lump sum only if you have an appetite for higher risk as chances are high that, you may see your investments in the negative for some time. Ideally while investing in lump sum, you should have a longer time horizon. Or, on a cautious note, if you have a short term horizon, then you should invest your lump sum money in less risky options like liquid funds. This mode is more suitable if you are ready to take High Risk in anticipation of High Return 2. Systematic Investment Plan (SIP) This is most popular mode of investment in Mutual Funds. SIP is a disciplined Mode of Investment, through SIP you can invest a fixed sum of money on a regular basis, in a mutual fund scheme. SIPs provide you the benefit of Rupee Cost Averaging . Through SIP, you invest a fixed amount every month, irrespective of the market movements. As the investment happens on a regular basis, you get an opportunity to invest at various market levels. So when the markets fall, you buy more units with the same amount; while if the market trends higher, you buy less units and simultaneously the value of your existing units grow. So in the long run your cost of buying is averaged out and your Average Cost per Unit may work out to be lesser than the Average Price per Unit. It is suitable for person who can invest fixed amount on regular basis i.e. monthly or Quarterly & looking to reduce the risk of market volatility in the long term. How to invest in Mutual Funds?
  17. 17. 3. Systematic Transfer Plan ( STP) Though less popular, STP is an advanced version of SIP, which functions with a similar objective . In STP mode you make lump sum investment in one mutual fund scheme then periodically transfer certain amount from this scheme to another. Generally in STP the investor initially invests in less risky liquid funds that may offer better returns, and over time gradually or systematically transfer a certain amount from the scheme to another scheme which may be an equity fund from the same fund house. STP is a relatively safer investment method than lump sum investment with the benefit of Rupee Cost Averaging like SIP. As all your money is not invested directly in risky asset class, STP may turn out to be a relatively safe investment strategy. It is Suitable for Investor who have large savings but do not wish to take high risk of lump sum investing. Investors who can not set aside fixed amount regularly but wish to reduce risk of market volatiltiy, can also look for this option. 4. Systematic Withdrawal Plan (SWP) SWP is a smart way to plan for your future needs by withdrawing amounts systematically . SWP helps Systematically Withdraw an amount of money from the invested mutual fund scheme on a regular basis . SWP offers Fixed Withdrawal as well as Appreciation Withdrawal facility. Through fixed withdrawal, you as an Investor can specify the amount you wish to withdraw from your investment on a monthly or quarterly basis, while under Appreciation Withdrawal you can withdraw the appreciated amount on a monthly or quarterly basis. It is suitable for person who wish to manage regular expenses without keeping the savings idle How to invest in Mutual Funds?
  18. 18. Dividend Option This option facilitates investors to book profits in the form of dividend and provides further sub-options: i. Dividend Payout This option proposes to timely pay distributable surplus / profits to investors in the form of dividends either through cheques or ECS credits, thereby facilitating them to book profits. Suitability -: This option can be selected by those who are in need of cash flows during the investment horizon . ii. Dividend Re-investment Under this option instead of paying dividend cheques or providing ECS credits…) The dividend amount declared by a mutual fund scheme, goes in to buy additional units of the same scheme Suitability -: This option is suitable for investors who are not in need for cash flows in the form of dividend during the investment horizon; but instead would prefer to add additional units to the same scheme It should be noted that selecting the dividend option in no way makes it mandatory for the fund house to declare dividends. It is solely subject to the performance of the respective mutual fund scheme, availability of distributable surplus and discretion of the Trustees. Growth Option This option facilitates compounded growth in value of your mutual fund scheme, subject to the investment bets taken by the fund manager. Suitability -: This option is suitable for those investors who are not in need for cash flows in the form of dividend during the investment horizon; but would instead prefer to invest their hard earned money for compounding their wealth. Investment Options in Mutual Funds?
  19. 19. Risk is an inherent aspect of every form of investment. For Mutual Fund investments, risks would include variability, or period-by-period fluctuations in total return. Market Risk Mutual Fund investments are subject to market risk, as the underlying investments where mutual funds invest – such as stocks and bonds - show uncertain movement. Do not forget the prices of these underlying instruments are driven by market sentiment and over a time period it may lead to volatility in the performance of the funds. Interest Rate Risk Interest rates and bond prices are inversely related. Any upside movement in interest rates may lead to downside movement in bond prices and thus impact its portfolio valuation, especially of debt mutual funds. However the impact of this risk may fade over time. Fund Manager Risk Fund manager risk can be experienced when the fund manager fails to execute the fund's investment strategy or meet its investment objective. Also a frequent change in fund managers may lead to such risk. However process driven fund houses are well placed to avoid such risk for its investors. Currency Risk A swift upside or downside movement in currency may impact one's investment in offshore instruments. An Indian investor investing in a U.S. focused fund may earn high return in a scenario where the Indian Rupee suffers a huge depreciation against the U.S. dollar and vice versa. Types of risks associated with Mutual Fund Investment
  20. 20. Standard Deviation (SD) It is the measure of risk taken or volatility born by the mutual fund. SD measures by how much the investor could diverge from the average return either upwards or downwards. It highlights the element of risk associated with the fund. Higher SD indicates the scheme carries higher risk. So if 2 schemes generated identical returns then you should choose scheme with lower SD as it has managed to deliver returns at relatively lower risk. Beta It is measure of the volatility of the scheme in comparison to the market indices. A beta of less than 1.0 will indicate that the scheme is less volatile than the benchmark index; while beta of more than 1.0 will indicate that the scheme is more volatile than the benchmark index. Duration It measures a bond's sensitivity to changes in interest rates . Duration shows the change in value of fixed income instrument that will result from a 1% change in interest rate. Longer the duration of a bond, higher the sensitivity and vice versa. . If you have a low risk appetite, debt funds with higher duration may not be suitable for you. You can find all these indicators in Mutual Fund Fact Sheets which are readily available on Mutual Fund websites. Indicators for Mutual Fund Risk
  21. 21. Sharpe Ratio A measure developed to calculate risk-adjusted returns. Sharpe Ratio measures how much return you can expect over and above a certain risk-free rate (for example, the bank deposit rate), for every unit of risk i.e. Standard Deviation of the scheme. Sharpe Ratio = (Portfolio Return – Risk Free Return) Standard Deviation of the Portfolio If 2 schemes have delivered similar returns, you should choose the one with the higher Sharpe Ratio, as it has shown its ability to deliver better risk adjusted returns. Treynor Ratio It measures risk-adjusted return based on systematic risk. It is similar to the Sharpe ratio, with the difference being that the Treynor ratio uses Beta as the measurement of volatility, while the Sharpe ratio uses Standard Deviation. Treynor Ratio = (Portfolio Return – Risk Free Return) Beta of the Portfolio A scheme with a higher Treynor Ratio should be preferred as it indicates the scheme has excess return per unit of systematic risk or Beta. Alpha It represents the difference between actual returns of the scheme vis-à-vis the expected returns of the scheme, over a period of time . Alpha indicates the ability of the fund manager to generate additional returns for investors. So one should choose fund with positive Alpha. You can find these ratios available with Mutual Fund Research & Analytics websites such as Value Research, CRISIL, CARE Ratings, Morning Star Indicators for Measuring Mutual Fund Performance on Risk Return Parameters
  22. 22. Absolute Return or Simple Return It is return that asset achieves from day of its purchase to the day of its sale regardless how much time has elapsed in between . Absolute Return = (END value – Initial Value) X 100 Initial Value Generally Mutual Fund Returns for period less than 1 year are expressed in absolute returns form. Compounded Annual Growth Rate (CAGR) CAGR show you year on year growth rate of your investment over period of time,. It is calculated as Mutual Fund Returns for period more than 1 year are expressed in CAGR. CAGR returns are superior to Absolute returns because it accurately measures uniform growth over the years. CAGR & Absolute returns are incomparable since CAGR returns includes compounding effect. For e.g. Asset A & B purchased at 100. If asset A delivers 10% CAGR return over 2 years & Asset B delivers 10% Absolute return over same period , then value of both Assets are not the same at the end of 2 years. Value of Asset B at the end of 2 years is 110 only; while because of compounding effect value of Asset A increased to 121. Mutual fund helps in compounding of your investments which creates Wealth in the long term. Calculating Mutual Fund Returns
  23. 23. Mutual Fund invest money only in share market Mutual fund make their investments according to investment objective set for mutual fund. So if objective of mutual fund is growth & capital appreciation in long term, then it will invest money in equity or ‘Share Market’. If objective set for mutual fund is generating regular income, then it will invest money in debt or fixed income instruments like deposits, bonds. Mutual Fund with low NAV is ‘Great Buy’ or you should buy Mutual Fund in NFO because they are cheap This fallacy is due to the fact that investors perceive the NAV of a mutual fund (MF) as similar to the price of equity shares. NAV per se does NOT tell you anything about a fund's performance. Instead, it is the change in NAV over a time period (i.e. the returns) that you should be measuring. For E.g. fund with NAV of Rs. 10 increased to Rs. 11 in 1 year has produced equal returns like fund with NAV of Rs. 100 increased to Rs. 110 in a year. Selling a Rs10 NAV NFO as a 'cheap' one was a common fraud perpetrated by agents till the regulator cracked down on them. NFO’s are more risky than the existing mutual funds as they don’t have track record to compare. There is no advantage with NFO when it comes to investments unless they have very strong strategy and unique and strong idea. Still NFO should not be more than 5% of entire portfolio. One should buy Mutual Funds of reputed banks or Government Companies Investors Often make mistake of assuming mutual fund scheme belongs to renowned companies are worth investing in. Mutual fund companies are independent entities & as per regulation do not give guarantees on the performance of your investment. So mutual fund scheme from SBI Mutual fund is not the one offered by SBI bank & its performance will be totally dependent on securities it has invested in & Fund manager’s ability to make necessary changes to portfolio for the benefit of investors. Myths About Mutual Funds
  24. 24. SIP Mutual Fund Schemes are different from Lump sum Mutual Fund Schemes The fact is SIP is just the mode of investing. There are no special mutual fund schemes for SIP investments. I’ll be penalized if I Miss one or two SIP dates Since an ECS mandate is usually signed, the question of missing SIP dates doesn’t arise. Also on the SIP date if you do not have sufficient funds in your bank account, you aren’t penalized by the AMC (but your bank will charge you for missing ECS); you will simply miss that SIP instalment, but your account will remain active. However if you miss 3 consecutive SIP installments then your SIP will be terminated. You won’t be charged for SIP termination neither AMC nor your bank will penalized you for the same. In case of SIP in ELSS, Entire Money can be Withdrawn after 3 Years The fact is, your every instalment of SIP should have completed the lock-in tenure of 3 years for you to be in a position to withdraw. So say if you put in Rs 5,000 through SIP in the month of Jun 2014, the lock-in period for this instalment will get over or free in Jun 2017. So if you have started SIP in ELSS from Jun 2014 to May 2015, then you can withdraw entire money on May 2018 & not on Jun 2017 . Because on Jun 2017 ,only your first SIP installment get lock free & you can redeem only those units. Myths About Mutual Funds
  25. 25. After completion of SIP period, amount will automatically get credited with bank You only allowed to do SIP in open ended mutual funds since they are available for purchase on all business days. Open Ended Mutual funds do not have fixed maturity period. They are perpetual in nature. So even if SIP period ends your money remained invested & continue to grow. But if you wish to withdraw your money, you have to give separate redemption request. I should not put all my money into one fund. I should hold a diverse basket This is true of stocks, not of funds. A mutual fund already does the diversification for you, by holding several stocks. You can get little additional benefit by diversifying into several funds. In fact, you risk making your portfolio fragmented and difficult to manage. Ideally you should invest in5-6 different mutual funds across asset classes & market capitalization according to your risk appetite & financial goals. I should check & review my fund portfolio daily Generally people invest their money in Mutual Fund as they don’t have time to track the markets & take investment decisions. So it is very ironic when you invest your money in mutual fund & review it on daily basis. It is unnecessary & counterproductive in general. This has nothing to do with improving the returns prospects of your portfolio. Review of mutual fund portfolio once or twice in year is just sufficient to check whether your mutual performance aligned with market performance & more importantly in line with your financial goal. Myths About Mutual Funds
  26. 26. To Summarize, Mutual Fund is professionally managed pool of money which invest across all the asset classes such as Equity, Debt, Gold etc; according to its investment objective. Mutual Fund is very unique financial product since it is capable to serve your all financial goals like saving money for your child education or saving for down payment of your home. Mutual funds are market linked & carries risk but all the data from portfolio disclosures to risk parameters periodically made available by mutual funds itself , helps investors to take informed decision & mitigate risk. Each Mutual Fund Scheme is unique & caters to certain risk profile & investment objective. So always decide what are your financial goals & your risk appetite before investing in mutual funds. Do not rely heavily on star ratings. Most star ratings are on principles of “one size fits all” which is not the case in reality. Take your financial advisor help to select mutual fund scheme that fits your requirement. SUMMARY