Mutual Funds Concept

What Is Mutual Fund?

Mutual Fund is a vehicle that enables a collective group of individuals to:

a.) Pool their investible surplus funds and collectively invest in instruments / assets for a common investment objective.

b.) Optimize the knowledge and experience of a fund manager, a capacity that individually they may not have

c.) Benefit from the economies of scale which size enables and is not available on an individual basis

Investing in a mutual fund is like an investment made by a collective. An individual as a single investor is likely to have lesser amount of money at disposal than say, a group of friends put together. Now, let’s assume that this group of individuals is a novice in investing and so the group turns over the pooled funds to an expert to make their money work for them. This is what a professional Asset Management Company does for mutual funds. The AMC invests the investors’ money on their behalf into various assets towards a common investment objective.

Hence, technically speaking, a mutual fund is an investment vehicle which pools investors’ money and invests the same for and on behalf of investors, into stocks, bonds, money market instruments and other assets. The money is received by the AMC with a promise that it will be invested in a particular manner by a professional manager (commonly known as fund managers). The fund managers are expected to honour this promise. The SEBI and the Board of Trustees ensure that this actually happens.

Typical classification of mutual fund schemes on various basis:

Tenor refers to the ‘time’. Mutual funds can be classified on the basis of time as under:

1.Open ended funds

These funds are available for subscription throughout the year. These funds do not have a fixed maturity. Investors have the flexibility to buy or sell any part of their investment at any time, at the prevailing price (Net Asset Value – NAV) at that time.

2.Close Ended funds

These funds begin with a fixed corpus and operate for a fixed duration. These funds are open for subscription only during a specified period. When the period terminates, investors can redeem their units at the prevailing NAV.

Asset classes

1.Equity funds

These funds invest in shares. These funds may invest money in growth stocks, momentum stocks, value stocks or income stocks depending on the investment objective of the fund. .

2.Debt funds or Income funds

These funds invest money in bonds and money market instruments. These funds may invest into long-term and/or short-term maturity bonds.

3.Hybrid funds

These funds invest in a mix of both equity and debt. In order to retain their equity status for tax purposes, they generally invest at least 65% of their assets in equities and roughly 35% in debt instruments, failing which they will be classified as debt oriented schemes and be taxed accordingly. (Please see our Tax Section on Page 39 for more information.) Monthly Income Plans (MIPs) fall within the category of hybrid funds. MIPs invest up to 25% into equities and the balance into debt.

4.Real asset funds

These funds invest in physical assets such as gold, platinum, silver, oil, commodities and real estate. Gold Exchange Traded Funds (ETFs) and Real Estate Investment Trusts (REITs) fall within the category of real asset funds.

Investment Philosophy

1.Diversified Equity Funds

These funds diversify the equity component of their Asset Under Management (AUM), across various sectors. Such funds avoid taking sectoral bets i.e. investing more of their assets towards a particular sector such as oil & gas, construction, metals etc. Thus, they use the diversification strategy to reduce their overall portfolio risk. .

2.Sector Funds

These funds are expected to invest predominantly in a specific sector. For instance, a banking fund will invest only in banking stocks. Generally, such funds invest 65% of their total assets in a respective sector.

3.Index Funds

These funds seek to have a position which replicates the index, say BSE Sensex or NSE Nifty. They maintain an investment portfolio that replicates the composition of the chosen index, thus following a passive style of investing.

4.Exchange Traded Funds (ETFs)

These funds are open-ended funds which are traded on the exchange (BSE / NSE). These funds are benchmarked against the stock exchange index. For example, funds traded on the NSE are benchmarked against the Nifty. The Benchmark Nifty BeES is an example of an ETF which links to the stocks in the Nifty. Unlike an index fund where the units are traded at the day’s NAV, in ETFs (since they are traded on the exchange) the price keeps on changing during the trading hours of the exchange. If you as an investor want to buy or sell ETF units, you can do so by placing orders with your broker, who will in-turn offer a two-way real time quote at all times. The AMC does not offer sale and re-purchase for the units. Today, ETFs are available for pre-specified indices. We also have Gold ETFs. Silver ETFs are not yet available.

5.Fund of Funds (FOF)

These funds invest their money in other funds of the same mutual fund house or other mutual fund houses. They are not allowed to invest in any other FOF and they are not entitled to invest their assets other than in mutual fund schemes/funds, except to such an extent where the fund requires liquidity to meet its redemption requirements, as disclosed in the offer document of the FOF scheme.

6.Fixed Maturity Plan (FMP)

These funds are basically income/debt schemes like Bonds, Debentures and Money market instruments. They give a fixed return over a period of time. FMPs are similar to close ended schemes which are open only for a fixed period of time during the initial offer. However, unlike closed ended schemes where your money is locked for a particular period, FMPs give you an option to exit. Remember though, that this is subject to an exit load as per the funds regulations. FMPs, if listed on the exchange, provide you with an opportunity to liquidate by selling your units at the prevailing price on the exchange. FMPs are launched in the form of series, having different maturity profiles. The maturity period varies from 3 months to one year.

Geographic Regions

1.Country or Region Funds

These funds invest in securities (equity and/or debt) of a specific country or region with an underlying belief that the chosen country or region is expected to deliver superior performance, which in turn will be favourable for the securities of that country. The returns on country fund are affected not only by the performance of the market where they are invested, but also by changes in the currency exchange rates.

2.Offshore Funds

These funds mobilise money from investors for the purpose of investment within as well as outside their home country. so we have seen that funds can be categorised based on tenor, investment philosophy, asset class, or geographic region. Now, let’s get down to simplifying some jargon with the help of a few definitions, before getting into understanding the nitty-gritty of investing in mutual funds.

Definition

Net Asset Value (NAV)

NAV is the sum total of all the assets of the mutual fund (at market price) less the liabilities (fund manager fees, audit fees, registration fees among others); divide this by the number of units and you get the NAV per unit of the mutual fund.

Compounded Annual Growth Rate (CAGR)

These funds invest in physical assets such as gold, platinum, silver, oil, commodities and real estate. Gold Exchange Traded Funds (ETFs) and Real Estate Investment Trusts (REITs) fall within the category of real asset funds.

Absolute Returns

These are the simple returns, i.e. the returns that an asset achieves, from the day of its purchase to the day of its sale, regardless of how much time has elapsed in between. This measure looks at the appreciation or depreciation that an asset – usually a stock or a mutual fund – achieves over the given period of time. Mathematically it is calculated as under: Ending Value – Beginning Value x 100

Beginning Value
Generally returns for a period less than 1 year are expressed in an absolute form.

How To Read Fund Performance Scorecard?

Quartile:  Performance for the period is differentiated in four quartiles. First quartile represents best performing schemes (top 25%  schemes),  while last or fourth quartile represents relatively worst performing schemes for the period. If a scheme remains in first or second quartile for all the given periods, then the performance of the scheme is considered as consistent & above average. For further filteration, risk ratio should be considered.

Standard Deviation (SD) :Standard Deviation is absolute measure of volatility. It suggests the deviation of returns from its mean. SD is the measure of risk taken by, or volatility borne by, the mutual fund.  Mathematically speaking, SD tells us how much the values have deviated from the mean (average) of the values. 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.

Beta : It is the measure of the volatility of a security or a portfolio as compared to the market as a whole. Beta signifies the risk or volatility relative to the Benchmark Indices. By definition, benchmark index holds Beta of 1. For example – If a fund’s Beta is 1.2, it simply means that the fund is 1.2 times more volatile than the benchmark index.

Sharpe Ratio (SR) : The Sharpe ratio, also known as Reward to Risk Ratio, measures the risk-adjusted performance. It indicates the excess return per unit of risk associated with the excess return. To calculate Sharpe ratio, risk free rate is subtracted from portfolio returns and dividing the result by the standard deviation of the portfolio returns. The higher the Sharpe Ratio, the better the performance. A negative Sharpe indicates that a rational investor would choose risk-less asset over the risky investment under analysis. SR is a measure developed to calculate risk-adjusted returns. It 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. Statistically, the Sharpe Ratio is the difference between the annualised return (Ri) and the risk-free return (Rf) divided by the Standard Deviation (SD) during the specified period. Sharpe Ratio = (Ri-Rf)/SD. Higher the magnitude of the Sharpe Ratio, higher is the performance rating of the scheme.

Treynor Ratio : The Treynor ratio, also known as the Reward to Volatility ratio, measures returns earned in excess of that whichcould have been earned on a risk-less investment per each unit of market risk. To calculate Treynor ratio, risk free rate is subtracted from portfolio returns and dividing the result by the Beta of the portfolio returns. Treynor ratio is a risk-adjusted measure of return based on systematic risk. It is similar to the Sharpe ratio, but the Treynor ratio uses beta as the measurement of volatility whereas Sharpe ratio uses Standard Deviation. The higher Treynor Ratio score means better the fund.

Alpha :  The excess return of the fund relative to the return of the benchmark index is a fund’s alpha. Alpha is the actual return in excess to what was predicted using the CAPM model. Alpha is often considered to represent the value that a portfolio manager adds to or subtracts from a fund’s return. The higher Alpha score means better the fund.

Diversification – A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this  technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio. Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, the benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated (ideally perfectly negatively correlated).

Risk Adjusted Returns – We should know that how much risk is involved in producing an investment’s return. The return generated in excess of risk is known as Risk Adjusted Return and is generally expressed as a number or rating. Risk-adjusted returns are applied to individual securities and investment funds and portfolios. There are five principal risk measures: Alpha, Beta, R-squared, Standard Deviation and the Sharpe ratio. Each risk measure is unique in how it measures risk.

What is Mutual Fund?

How does a Mutual Fund work?

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