A mutual fund is a professionally managed collective investment vehicle that pools money from a number of investors with a view to making profit for the group as a whole. The funds are managed by a professional fund manager(s) who purchase and sell various securities such as stocks, bonds, and/ or any other assets on behalf of the investors and to that extent, it is like betting on a jockey rather than the horse.
Before you invest in any mutual fund you must understand some basic things about the different types of mutual funds, which will help you select a fund based on your investment objective and risk appetite. Every mutual fund scheme has the features we list out below:
“Capital appreciation scheme”: indicating that their primary goal is to accumulate long term wealth by investing in shares of companies which are likely to do well in the medium to long term as the business of the company matures.
“Dividend income scheme”: indicating that the primary goal of the scheme is to invest in shares of companies which pay regular dividends, oftentimes retaining little of the profits in their reserve and surplus account and returning most of the profits as dividends to the shareholders.
“Interest income”: indicating that the scheme aims to invest the funds in safe government or private debt (i.e. bonds or other fixed interest income bearing instruments).
► An investment strategy: Just like the investment objective, the investment strategy specifies approach or criteria to select investment for the fund. For Example, a scheme may generally be focusing on sound fundamental companies or high dividend paying stocks or small cap stock or any other stock based on particular criteria.
► An investment pattern : A Mutual fund scheme also specifies how much investment will be made in particular asset classes such as equity scheme or debt scheme. For example, a typical asset allocation clause in a mutual fund scheme is as under:
Remember that every mutual fund operating in the Indian mutual fund industry will mandatorily have a scheme information document which will provide all this information.
The scheme information document would further describe how it classifies medium to high risk equities, low risk debt instruments etc. It is important to read the scheme information document fully before investing. Additionally, there are, shemes which invest in other asset classes. For example gold schemes for funds that invest in gold, their returns fluctuate with the prices of gold. Similarly there are commodity funds, real estate funds etc.
Tip: While everyone’s intention in buying mutual fund schemes is to make profits, their goals differ. It is therefore extremely important to set out your goal before you start investing.
When selecting from the different types of mutual funds, ask yourself these questions:
- How much time can you give yourself (i.e. how long would you like to stay invested in the scheme?); and
- Are you looking for regular income or capital growth over a period of time? or
- Are you looking for a combination of the two?
► Open vs close ended schemes: Schemes are also divided bases on the frequency at which the investors can buy and sell their units.
- “Open – ended Schemes”: Such schemes are open for investors to enter and exit at any time. They don’t have a fixed maturity. The main advantage of investing in an open ended scheme is that Investors can conveniently buy and sell units at NAV related prices at any time and have liquidity whenever they want.
- “Close – ended Schemes”: Unlike open-ended scheme, close-ended schemes have a pre-defined maturity period, (for example 5 years). Under the SEBI regulations, all close-ended schemes need to be compulsorily listed on a stock exchange. An existing investor has two options to exit a closed-ended scheme. 1) By selling the units in the stock exchange or 2) Alternatively some close-ended schemes provide an additional option of selling the units directly to the mutual fund company through periodic repurchase at the schemes NAV.
Note: In practice, the investor has liquidity in case of both (i.e. open or close ended schemes) and the NAV of a close ended scheme (which is listed on a stock exchange) is not very different from the trading prices of the underlying asset value.
► Net Asset Value (NAV): The profit and loss of mutual fund investment depends on the NAV of the units. This NAV is determined by assessing the closing market price of the securities which constitute the fund. Typically, NAV is calculated at the end of the day’s trading session but in some cases it may be calculated several times during the day.
For example, if at the close of trading on a given day, a fund has assets of Rs. 500 Cr (such as stocks, bonds etc) and liabilities (such as management fees to be paid, borrowed money to purchase securities etc.) of Rs. 100 Cr, its NAV will be Rs. 400 Cr.
By dividing the NAV of a fund by the number of outstanding units, we get the price per unit. In our example, if the fund had 40 million units outstanding, the price-per-unit will be Rs. 400 Cr divided by 40 million, which equals to Rs. 10 per unit. Of course the value of your investment will be calculated by multiplying the units you hold by the price per unit.
It is most important to understand how mutual fund industry operates. Whether you decide in favor of or against buying mutual funds, the probability of success depends largely on your understanding of the product and more importantly on understanding your own personal goals and risk profile.