Introduction to Mutual Funds

This is a super quick introduction to mutual funds.

Mutual funds are institutions which collect money from people and invest them in the stock market. There are also mutual funds investing in gold or other things but let me write everything in the context of mutual funds investing in stock markets and the concepts will be the same for other mutual funds.

FAQ

Q) Why should one invest in a mutual fund ?
A) There are two main reasons. The first reason is that investment in mutual funds have the potential to earn more returns than standard investments like fixed deposits in a bank. For example when the Indian economy was doing good from 2003 to 2007, mutual funds have given an average returns of over 30% per anum. This is much more than any bank would have given. However, this performance cannot always guaranteed and hence it is best not to put all your money in the stock market but also keep some in the safe fixed deposits which are not subject to market risks. The second reason is tax benefit. Certain mutual funds in India qualify for tax exemption under section 80 C. However note that not all mutual funds are eligible for such a deduction. A mutual fund usually mentions if its investments qualify for deductions under 80C. It is important to remember that currently all mutual funds which qualify for deductions under 80C have a lock-in period of three years. That is if you invest your money today, you wont be able to liquidate your investment only after three years.

Q) What is NAV ?
A) NAV is an acronym for Net Asset Value. The total assets , (i.e. money or cash and current value of investments) of the mutual fund is divided into small imaginary units. The price of one such unit is called Net asset value or NAV. For example when you invest say Rs. 10,000 in a mutual fund whose price of one unit, or NAV is Rs. 100, you actually buy 100 units of that mutual fund. When the mutual fund makes profit, the price of each of its units goes up. Thus suppose it makes 50% profit, then the number of units you hold will still remain to be 100, but the NAV, or price of each unit will increase from 100 to 150. Note that mutual funds also deal with fractional parts of the units.

Q) What is SIP ?
A) SIP is an acronym for Systematic Investment Plan. This is an investment plan where you invest a fixed amount of money every month instead of investing a lumpsome amount. The obvious advantage of an SIP is that you do not have to have a lumpsome amount to invest and can plan to keep aside a fixed portion of your salary every month. But the main advantage of investing in an SIP is that it is less risky than investing a lumpsome amount. Lets take an example. Suppose you want to invest rupees 50,000. Currently the market index is at , say 4000. If you invest all money today, and if the market goes down, then you will end up making a loss. You would have done better by investing when the market goes down. On the other hand, if you invest a fixed amount periodically, you will invest a portion today, and also a portion when the market goes down. Thus you will 'average out' the market risk to some extent. Thus SIP is a way of minimizing risk. It may not necessarily be a way of maximising returns, however. For people who do not have a thorough understanding of the market and the economy , SIP is highly recommended.

Q) What is Entry Load ?
A) When you invest in a mutual fund, the mutual fund charges you a fee as soon as you invest. Currently the typical value is around 2.25% of your initial investment. This fee is called as an entry load.

Q) What is Exit Load ?
A) Exit Load is a fee which some mutual funds charge when you liquidate your investment. Typically tax-saving mutual funds do not charge exit loads. So if you are investing partly for tax saving reasons, look for a mutual fund which does not charge an exit load.

Q) What is an Open ended mutual fund or an open ended scheme ?
A) Mutual Funds in which you can liquidate your investments, i.e. sell your units any time you wish are called open ended mutual funds. As mentioned above, mutual funds which qualify for tax-saving purpose are not open ended. Moreover Open ended mutual funds often charge an exit load if you sell your units before a specified time (for example they have a typical exit load of 2.25% if you exit before 6 months).

Q) What is a Closed ended mutual fund or a closed ended scheme ?
A) These are mutual funds which have a lock-in period, typically 3 years for tax saving mutual funds. If you invest today in a closed ended mutual fund, you will not be able to sell your units and get your money back before the expiry of the lock-in period.

Q) How to exit or stop an SIP ?
A) Suppose you start an SIP in a mutual fund which has a lock in period of 3 years and after a couple of months you want to stop investing. Ofcourse since the lock-in period is 3 years you wont be able to liquidate the investment that you have already made before the end of 3rd year. But you can stop your SIP, i.e. stop putting more money provided (in some cases after you have completed 6 months) by simply giving a one month notice to the respective mutual fund office.


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Aug 26, 2008

1 comments:

Sushil Girdher December 25, 2008 at 12:02 AM  

For a more informed investor who has the time to research, I would recommend selecting mutual fund schemes to invest in based on the following criteria.

1. Longterm Performance , consistency in Returns
2. Short Term Performance (though a fund has performed well in the past, is there a let down in short to mid term performance)
3. Performance across market cycles, like during bullish and bearish phases (how well did the fund perform during the bearish phases)
4. Fund Corpus (When selecting midcap funds, the corpus size is very important)
5. Fund Managers performance with the scheme(If a fund just got a new fund manager, I would observe the performance under this new manager before I select the fund)
6. For equity mutual funds, one will also need to evaluate risk. (Exposure to midcaps, Standard Deviation of the fund)
7. For debt mutual funds, apart from risk one also need to examine entry/exit loads and expense ratio are very important.

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