Mutual Funds
What are Mutual Funds?
Fundamentally, mutual funds are collectively pooled monies from various investors. The funds are invested into a wide range of stocks, bonds, money-market instrument, short-term debt etc.
In simple terms, a mutual fund is a flexible investment option that has the potential to generate big corpus of wealth over a period of time.
How does it work?
Investors have various investment objectives. For each investment objectivewe typically have a category designed. For instance, Tax Saving – we have ELSS schemes. Today, we have more than 8 categories of Mutual Funds to meet different investment objectives such as Retirement Planning, Wealth Creation, Meeting expenses for a wedding, planning a foreign vacation, buying your dream home / car.
Framework
Assume a mutual fund pools in Rs 1 crore from 100 investors. Each investor invested Rs 1 lac.
Now the fund house issues mutual fund units at a Net asset Value (NAV) Rs 10.
Total number of units would be 10 lacs (1crore/10) (Funds pooled / NAV).
Since each investor contributed 1 lac so proportionate units allotted to each investor would be 10,000 units (1 lac / 10).
The pooled funds are invested into stocks, debt, gold, commodities etc as per the investment objective.
Let us say the value of stocks in the mutual fund moves up and assuming no change in investor’s holding, the AUM now stands at Rs. 1.5 crore. So, the revised NAV would be Rs. 15 (1.5 crores / 10 lac units).
Holding of each investor will be 10,000 units x current NAV of Rs. 15 = Rs. 1,50,000.
Further assume that 10 investors withdraw their complete holdings at NAV Rs. 15. So units after redemption would now stand at 9 lacs. AUM would fall to 1.35 crores. NAV after redemption will be 1.35 crores / 9 lac units = Rs. 15.
We can see that NAV does not change if investors redeem their monies.
Assume now that the stock values fall in the portfolio and consequently the value of portfolio (AUM) decreases from 1.35 crores to 1.17 crores. Revised NAV would now stand at Rs. 13 per unit (Rs. 1.17 crores / 9 lac units).
Suppose a new investor invests 1 lac rupees @ NAV of Rs 13. So, he will get Rs. 1 lac / 13 = 7692.3077 units.
This process continues – the NAV keeps on changing on a daily basis (calculated at the end of the day considering all changes)
Features of Mutual Funds
- Diversification – AUM (pooled funds) is invested across different asset classes like domestic equity, corporate bonds, T-Bills, G-SEC, gold, commodities, foreign equity. etc. The performance is not dependant on a single asset class.
- Fund Manager – Professional and experienced personnel is appointed to manage the monies. Fund managers have years of experience managing large corpus of monies. The fund manager is responsible for the overall performance of the particular fund he/she manages. From stock selection to capital allocation, everything is managed by the fund manager.
- Expense Ratio – AMC charges fee towards fund management expenses. According to SEBI guidelines, the total expense ratio cannot exceed 2.25%.
- Lock in Period – Open ended mutual funds do not have any lock in period. Investors can buy and sell units whenever they want. However, tax saving ELSS schemes comes with a lock in period of 3 years, which is amongst the least when considering tax saving options u/s 80C of Income Tax Act, 1961.
- Liquidity – MF offers high liquidity when compared with other investment options such as Real Estate, PPF, FDs., NSC, etc. One can place a redemption request and the proceeds would automatically get credited to ones designated bank account within 3-7 working days. Mutual funds also provide flexibility to switch funds from one scheme to another – reallocation of funds to better performing schemes.
- SIP option–Mutual funds offer flexibility with regard to the amount of investment and frequency. One can start SIP with an amount as low as 500 rupees. The frequency can be weekly, monthly etc.