BEGIN INVESTING WITH MUTUAL FUNDS

I hope you’ve read the post on how to get started with ETFs. The advantage of starting with ETFs is that you don’t waste time in trying to select the right mutual fund.

Having said that, it’s a good idea to understand mutual funds as you may want to add a few to your core ETF portfolio. So let’s get started.

Remember the basic terms such as debt/equity, market indices etc were covered in the Fast Finance series. Now let’s get a bit more technical to understand how this works in practice.

How does a mutual fund work?

It starts with a person or company called sponsor that decides has to apply for a license from the regulator. Once approved, the sponsor sets up an asset management company or AMC and hires teams for investments, operations, marketing etc. Then the mutual fund is set up…which is basically a trust structure… the AMC is appointed to manage while a separate board of trustees is appointed to oversee the management on behalf of investors.

Now the AMC starts marketing in newspapers, television, radio. everywhere to retail investors – people like you and me – with promises that they will invest our small savings to earn higher returns than bank deposits.

In the meantime, the investment team has a bunch of analysts coming up with investment ideas and researching them, who then pitch to the fund manager who makes the final call on how to invest.

What is the mutual fund NAV?

Say you decide to invest 100 rupees when a new fund starts. Your cheque gets deposited into the bank account of fund along with the investments from hundreds of investors that day, totaling say 10,000 rupees. Now fund has to be give you ..and all other investors some kind of receipt for your respective investment to indicate your proportionate share of the fund.

To standardize reporting, they issue 10,000 ‘units’ say at 1 rupee each so you get allotted 100 units. This unit price is also called ‘net asset value’ or NAV.

The next day the fund manager starts investing in a diversified portfolio of shares or bonds, or both. By the time the stock exchange closes at 3:30pm, the fund now owns say 9,500 rupees worth of shares. They leave 500 in the bank account which is shown as ‘cash’. Now there were some expenses for that day – the brokerage paid to the stock broker to buy the shares, the stamp duty on those trades…these get charged directly to the fund. Then the fees due to the AMC and trustee companies, investor education expenses etc which add up to the expense ratio.

The AMC now has to update the unit price or NAV after adjusting all these expenses which is why if you look up the NAV online the next day, it is likely to be slightly lower than the 1 rupee.

The next day, some share prices might rise, some might fall. So the NAV not only has to reflect the expenses for that day but also the market prices for all the portfolio holdings. That’s why the disclaimer about mutual funds being subject to market risks.

In summary, you now understand that mutual funds have unit prices or NAVs declared daily which reflect the market value of portfolio holdings; the absolute value of NAV doesn’t matter but they need to check that the NAV increases over time

What is the difference between open-ended and closed ended mutual funds?

Most mutual funds are open-ended, which means investors can redeem their unit holdings any day the market is open.

If they put in their request by a certain time, the AMC gives them the value of the units based on the market value as at the end of that day…and cancels the units in their books, reducing the number of units. If the request comes after the cut-off time, they get the market value as at the end of the next day.

Since there are units being issued and canceled all the time, the number of units is changing and hence, the unit price or NAV in itself has no meaning.

Some mutual funds are closed-ended, which means investors cannot get out by putting in requests to the AMC. They need to stay in. If they are really keen to get the money, they have to find other investors to buy their units off them, either through the AMC or in the market. Note in this case, the number of units in the fund does not change, so the price can fluctuate either at a discount or premium to the NAV depending on demand and supply.

What are the various options for income from mutual funds?

A mutual fund can invest in shares, bonds and cash, so can receive dividends from the shares and interest from bank deposits..and coupon interest from bonds. This constitutes income for the fund.

The fund is also buying and selling shares all the time, generating some realised gains. All this income and realised gains have to be given to investors somehow.

In India, the mutual funds give three income options –

1. Pay out all the dividends, interest and realised capital gains as distributions – this will correspondingly reduce the unit price or NAV – called divided payout, recently renamed to distribution payout
2. Declare the distributions but instead of paying out, reinvest in new units – the NAV will reduce but the number of units increase locking in the gain – called dividend or distribution reinvested
3. Not declare the distributions, but instead increase the NAV – the number of units remain the same – called growth option

Investors need to consider their income needs as well as tax implications.

What is the difference between regular and direct mutual funds?

The world over, mutual funds have an ‘expense ratio’ built into the unit pricing structure which reflect the asset management fee, trustee fee and a few other small things, adding up to about 1.5 to 2.5% per annum. The AMC is then free to pay out a trail commission, also called retrocession, to the intermediary who sold the fund to investors – out of their annual management fee. This practice has a range of issues from administrative to conflicts of interests.

In some markets, the AMC has the choice of offering ‘wholesale’ versions to institutional investors – with higher minimum investment amounts and lower fees because there are no trail commissions built in. Retail investors can access these funds via platforms, fee-charging advisers or directly if they know what they are doing.

In India, the AMCs don’t have a choice but are mandated to offer these with low minimum investment amount and lower fees versions ‘directly’ via their website. These are called ‘direct’ funds – they are basically a separate unit price calculation – and are available to retail investors.

Why are there so many different mutual funds?

A mutual fund is a type of legal structure – a trust. By itself, mutual funds are not an ‘asset class’ and therefore not risky. What makes them risky, or not, is what they invest in. So what do they invest in? MFs invest mostly in different types of debt and equity. Some invest in both. Some include a third asset class such as gold. So broadly, mutual funds can be classified as following asset classes and sub asset classes –

Type of securities invested in	Equity	Debt	Gold
Size	Large, mid, small Multi/diversified
Time horizon		Long, mid, short Dynamic
Risk	Single sector (bank, infra, health etc)	Govt, Corporate, Credit
Style characeristics	Value, growth, dividend yield
Selection method	Thematic		Physical, F&O

Then there are ‘multi-asset class’ funds which invest in two or three asset classes. Some are pre-packaged ‘solutions’ to common goals such as retirement, childrens’ education etc.

When the disclaimer talks about risks in mutual funds, it is referring to ‘market risks’ which is basically the fact that the fund unit price (NAV) has to reflect what the underlying securities would sell for that day. More here –

Now let’s address the most frequently asked questions (FAQ) –