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ABCs of Mutual Funds

Know the basics of mutual funds.

What is a mutual fund?

A mutual fund is an instrument that pools the money of several investors and invests in various securities such as stocks, bonds, money market instruments and gold.  Mutual funds are managed by the professional fund managers who make sure that fund is aligned to its investment objective.

Net Asset Value (NAV)

NAV is in a way similar to the share price of stocks. Just as a share price reflects the investor’s demand and overall market sentiment, the NAV is based on underlying assets of the fund which is further influenced by the market value of the various securities and inflows in the mutual fund.

Net Asset Value is the current value of total assets minus the total value of all liabilities, divided by the total number of outstanding units. NAV of the fund is disclosed on every business day, and it lets an investor track the performance of the fund.

For example, the market value of the total securities of a mutual fund is Rs.200 lakh, and the mutual fund has 20 lakh units, then the NAV of the fund is Rs.10.

Assets under management (AUM):

The asset under management is the total market value of the entire underlying assets managed by the fund house or the particular fund. The AUM of a fund depends on the current market price of the securities and inflows. In case of an equity fund, when the market is moving up, and investors are investing in the fund, the AUM of the fund goes up. On the other hand, during a dip in the market, the AUM of the mutual fund decreases. Typically, higher AUM is a success parameter in the industry. Before investing in a fund, it is essential to look at the AUM of the fund. Although the AUM does not influence the return potential, it is always better to avoid funds with low AUM such as Rs.50 crore as the risk associated with a fund with low AUM is higher.

What is sip investment?

Systematic investment plan or SIP is a way to invest in mutual funds. SIP allows investors to invest a certain sum of money at regular intervals. Investors can opt for daily SIP, monthly SIP, and quarterly SIP etc. After the SIP is set up, investors are allotted units regularly irrespective of the market level. As the investment amount remains the same, investors are given fewer units when the markets are up and more units when the market is down. Thus, it averages out the investment cost.  Investors can start a SIP with as little as Rs.100.

Minimum investment amount

The minimum investment amount varies from fund to fund. The minimum lump sum is higher than the minimum SIP amount.  There is a minimum initial investment applicable only for the first lump sum investment after which investors have to pay the minimum additional investment amount. Few fund houses have a minimum initial investment amount of Rs.5,000 while the additional investment amount is Rs.1,000. The minimum SIP amount in a few funds starts from Rs.100 per month. Typically, the SIP amount in the majority of mutual funds is Rs.500.  

Types of mutual funds

Mutual funds come in various shapes and sizes. There is at least one type of mutual fund for every investor. Mutual funds can be classified on multiple parameters, such as options and asset classes. Based on the asset class, funds can be broadly classified into three types: equity mutual fund, hybrid funds and debt mutual funds.

Equity mutual funds invest a significant part of their portfolio in stocks and other equity instruments. The objective of these funds is long term wealth creation. Investors with an investment horizon of more than 7 years can look at equity funds. 

Debt funds invest in debt instruments issued by the central, state governments and companies. These securities come with different maturity periods. Debt funds are considered safer than equity funds as it is less volatile. It is a good investment option for short term investment goals.

Hybrid funds invest in a mix of debt and equity instruments.  There are different types of hybrid funds. While few hybrid funds have around 20% exposure in equities while in some funds, more than 65% of their portfolio allocation is invested in equities.

Mutual funds come with growth and dividend option. In case of growth options, the returns are reinvested in the fund, which helps to increase your wealth substantially over time. Choose growth option if your goals are a few years away.

Close-ended and open-ended funds

Close-ended funds are open for subscription only during a specific period, mostly during the launch period. Investors can’t also redeem easily from a close-ended fund after it is closed for subscription. It has a fixed maturity period. Close-ended funds can be both debt funds and equity funds. On the other hand, open-ended funds are open for subscription throughout the year. Investors can also redeem their mutual fund units from the open-ended funds with ease.  

Expense Ratio

Fund houses charge expense ratio that covers administrative expenses, salaries, marketing expenses, distributor fees etc. It is a percentage of your investment that you pay every year to manage your money. For example, if you invest Rs 10,000 in a fund with an expense ratio of 1%, you are paying the fund Rs.100 per year to the fund house to manage your investment. It is calculated by dividing the total cost of the fund by the fund’s total assets. The market regulator SEBI sets the maximum expense ratio for the different categories of mutual funds.

These were some of the basics that you should know about mutual funds. Talk to your financial advisor to know more about mutual funds and start your investment journey today with mutual funds.

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