Mutual Fund Investment - Basic Guidelines

Terms:

Open Ended Schemes

Buy or Sell units at any point in time; No fixed maturity date.
  • Money Market/Liquid: Short-term debt instruments.
    • For parking surplus funds for short-term (1 day to 3-4 months) while awaiting better options.
 
  • Debt/Income:
    • Debt Instruments: Invests in Debentures, Government Securities, Treasury Bills (T-bills), Commercial Papers(CPs), Certificates of Deposit (CDs).
    • Low Risk, Low Return. For Steady income.
    • Suitable for 1-3yr.
    • Others: Gilt, Flexible Bond, Long Term/Short Term/Ultra Short Term Bond

  • Equity/Growth: Equities. High-risk investment in short term, but ideal investment for capital appreciation in the long run (5-8 years).
    • Index: Replicate the movements of benchmark indices like Nifty, Sensex. Lower expenses than actively managed schemes. Unlike NAV, one can buy and sell at real-time prices.
    • Arbitrage: Leverages the price differential  by buying in Cash market and Selling in Future market. NOTE: NO option to Short Sell in Cash market and Buy in Future market.
    • Sectorial: Investments in specific sectors (IT, Pharma). High Risk-High Return within the equity space.
    • Tax Saving (ELSS): Investments are Tax exempted (Equity Linked Savings Schemes), 3-year lock-in period. Long-term growth.
    • LargeCap (Market Capital >10cr. top 50?), MidCap 2-10Cr (50-200), SmallCap <2Cr (200-rest)
    • Balanced:  Growth and income at regular intervals with predetermined proportions in Equities and Fixed income securities. "Cautiously aggressive". Meets challenges like inflation, interest rates, market volatility.
    • Others: Diversified, Commodity
 

Close Ended

Possible to Buy only during NFO (New Fund Offer) period, for a stipulated maturity period. 
  • Capital Protection: High-quality fixed income securities with marginal exposure to equities. Safeguard principal amount while trying to deliver reasonable returns. (1, 3 & 5 years)
  • Fixed Maturity Plans (FMPs): Debt Instruments. Indexation benefits & Long-term Capital Gains Tax when held for more than 3 years.
  • No active trading of debt instruments, hence lower expenses than actively managed schemes.
  • Interval: Combination of open and closed ended schemes, allowing investors to trade units at pre-defined intervals.
  

NAV (Net Asset Value)

NAV = Net Assets / Outstanding Units
Net Asset Value or NAV is the sum total of the market value of all the shares held in the portfolio including cashless the liabilities, divided by the total number of units outstanding. Thus, NAV of a mutual fund unit is similar to the "Book Value" of a stock/share.
 
  • NAV decreases proportionately to dividend pay-outs. Dividends are paid from your own holdings (so, Growth plans are better for long-term capital appreciation)
  • The absolute value of NAV does not say much about the future performance of the mutual fund.
  • A 20% growth with NAV of 20 is the same as 20% growth with NAV of 200.
 
  • Growth option
    • The profits you make are reinvested along with your capital.
    • Assets up; Units remain same ==> NAV up. (1000+50) / 100 ==> 10.5.
  • Dividend Payout option
    • A part of profits (an amount that the fund decides to give out) is stripped from your NAV and given to you in cash.
    • Hence, your NAV falls to the extent of dividends. This is why the NAV of growth and dividend option are not the same.
    • Assets up, less Dividend; Units remain same => NAV down. (1000+50 - 50) / 100 ==> 10
  • Dividend Reinvestment option
    • A part of profits (an amount that the fund decides to give out) is stripped and they are allotted to you as units at the prevailing NAV.
    • Hence, by adding more units, you simply stay invested in the fund, earn dividend on reinvested units too. Conceptually, the dividend reinvestment option is the same as the Growth option for all Equity funds.
    • Assets up, less Dividend, plus Reinvestment; Units up ==> NAV down. (1000+50 - 50 + 50) / (100+5) ==> 10.
 
  • Expense Ratio:
    • Expense ratio is the recurring cost per unit incurred to operate a scheme. This charge is made on the total assets of the scheme. NAV per unit is arrived at after deducting such a charge.
    • Ideally, 1% towards management fees and 0.6% towards other annual expenses should be acceptable. But Expense Ratios could be in 2.5-2.7% range.
    • Funds having larger asset base size *should* have lower Expense Ratio.
    • Debt funds have lower returns, so carefully watch the Expense Ratio (and Asset Size).
    • Passively managed funds (Index) have lower Expense Ratio than Actively managed funds (Equity).
       
  • "Direct" plans: When the investor directly approach Mutual Fund house / AMC to make their investments, the Expense Ratio do not include charges such as distributor expenses / trail fees / transaction charges. Thus Direct plans have lower Expense Ratio as compared to "Regular" plans.
  
 

Tax Implications

  • Liquid/Debt/Income/FMP Funds:
    • Taxed as per income tax slab of the taxpayer, if held for less than three years.
    • 20% tax is charged (with indexation) if held for more than 36 months (3 years)
    • 25% Dividend Distribution Tax (plus surcharge & cess)
  •  Arbitrage/Equity Funds:
    • Short-term Capital Gain Tax (15%) up to 1 year.
    • Long-term Capital Gain Tax (0%) after 1 year
    • No Dividend Distribution Tax
 
 

Performance Parameters

  • Alpha: A positive Alpha of 1.0 means the fund has outperformed its benchmark index by 1%.
  • Beta: A Beta of less than 1.0 indicates that the investment will be less volatile than the market, and, correspondingly, a beta of more than 1.0 indicates that the investment's price will be more volatile than the market. So, if a fund portfolio's beta is 1.2, it's theoretically 20% more volatile than the market.
  • Standard Deviation: The Standard Deviation tells how much the return on a fund is deviating from the expected returns based on Mutual Fund's historical performance.
  • Sharpe ratio: The greater an investment's Sharpe ratio, the better its risk-adjusted performance. It is calculated by subtracting the risk-free rate of return (Treasury Bond) from the rate of return for an investment and dividing the result by the investment's standard deviation of its return.
  • R-squared: The R-squared value between 85 and 100 has a performance record that is closely correlated to the index, which indicates that fund management is not very effective. If an actively managed fund delivers returns (percent change in NAV) in-line with (its respective) benchmark index, it should be considered as under-performance.

  • Performance track record, fund management and volatility determine the portfolio return.
  • Performance of other funds in the same category and target funds standing in there.
  • A fund's ability to consistently outperform its benchmark over 1 year, 3 year, 5 year and even 10 year returns is a highly desirable trait.
  • But, past performance does not guarantee future returns :)
 
  • Equity funds: If you put a lump sum amount of money, you could either gain a lot or lose a lot. So invest small amounts (SIP) regularly to average out your total cost of acquisition.
  • Debt markets are relatively quite stable. So, investing lump sum in a debt fund may be acceptable as you are not likely to lose.
 
  • Dollar Cost Averaging: The technique of buying a fixed dollar amount of a particular investment on a regular schedule, regardless of the share price.  
  • Systematic Investment Plan (SIP)
  •  Systematic Withdrawal Plan (SWP)
 
 
 

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