“Mutual fund investments are subject to market risks. Please read the offer document carefully before investing.” The statement is frowned upon in every invest and get rich mutual fund commercial, despite the fact that many of us don’t even know what mutual funds are and how one can benefit by investing in mutual funds to build their wealth. It is prudent that we understand the basics of mutual funds before jumping on to any conclusions because of the clichéd commercial. In layman’s language mutual fund is the money pooled in by numerous investors which is then invested into different class of assets like stocks, bonds and even real estate. Investors need to first understand ‘What is a Mutual Fund?’ and the nuances of this product. This article will do just that. It will help you comprehend different aspects that are integral to understanding the funds.
As an investor one should not form a pessimist opinion about investing in mutual funds each time you hear the commercial warning you to read the offer document carefully before investing. One must understand that mutual funds are managed by qualified professionals who operate in accordance with a research team that works continuously to get higher return on your investments. They are more affordable as compared to shares and provide liquidity. Besides providing the tax benefit, the investor is also protected since all mutual funds are required to register with SEBI and follow strict regulations. Mutual funds were created to make investing easy so customers wouldn’t have to be burdened with picking individual stocks.
Now that we know what mutual funds are and the benefits attached to them we must also understand certain concepts associated with mutual funds.
- WHAT IS NET ASSET VALUE (NAV)?
In simple terms,NAV is the price at which the units of a mutual fund are bought and sold. It is calculated on a daily basis using the formula:
NAV=(Market value of all securities held by fund + Cash & equivalent holdings – Fund liabilities)/Total fund shares outstanding
Example: At the close of trading Mutual Funds held 1,000,000 worth of securities, ₹200,000 cash and ₹ 500,000 liabilities. Fund had ₹ 100,000 outstanding shares. In this case yesterday’s NAV would be:
NAV = (1,000,000+200,000-500,000)/100,000 = 7
NAV helps an investor in measuring the performance of a particular scheme over time. It also assists in calculating redemption amount and profit.
- WHAT IS SHARPE RATIO?
Sharpe Ratio is a measure for calculating risk-adjusted return. In easier terms it is a ratio of return versus risk.Sharpe Ratio = (rx-Rf)/StdDev(x)Where, x = Investmentrx = Average rate of return of x
Rf= Best available rate of return of a risk-free securityi.e treasury notes
StdDev = Standard Deviation of rx.
Example- Your portfolio is expected to generate a return of 12%. Returns on risk free treasury notes are 5 % and standard deviation that the portfolio carries is 6%, then the Sharpe Ratio for the portfolio will be :
Sharpe Ratio = (0.12-0.05)/0.06 = 1.17
It is used to compare the change in portfolio’s overall risk-return characteristics when a new asset or asset class is added to it. The greater a portfolio’s Sharpe Ratio, the more attractive the risk-adjusted return.
- WHAT IS EXIT LOAD?
Exit load is a fee charged by companies from investors upon exiting or leaving a scheme as an investor. The main aim of collecting this fee at the time the investor exits is to compensate for all the distribution costs of the scheme. It also is kept so that the AMC can discourage investors from hopping in and out of different schemes (which never is good habit for the investor). Let’s see how it looks in practicality:Suppose you hold 300 units of a particular fund. The scheme charges an exit load of 1%. At the time of exit or redemption if the NAV of the fund was 50, then the 1% would be applied on INR 15,000. So the money that the AMC would receive as the exit load in this case would be INR 150 and INR 14850 would be credited to the bank account of the investor.
- WHAT IS AN EXPENSE RATIO?
Simply putting an expense ratio is the annual cost to operate a mutual fund. This involves fund management fee, agent commissions, registrar fees and selling and promotion expenses. While investing in mutual funds one must analyze this ratio since this is charged annually, a higher ratio over the long-term may eat into your returns through power of compounding.Example- 100,000 invested over 10 years @15%. Expense ratio associated is 1.5%. Return at the end of 10 years should be. 4.05 lacs, but actual return because of the expense ratio will be 3.55 lacs.
- TAXATION OF EQUITY AND DEBT MUTUAL FUNDS
An equity mutual fund is one which invests atleast 65% of the total corpus in equity and equity related instruments. Returns from equity mutual fund are treated as long term capital gains if investments are held for more than a year and are exempt from income tax. But if investments are held for one year or less, the returns are taxed under short term capital gains @15%.Mutual funds that invest less than 65% of corpus in equity are considered as non-equity funds and debt mutual funds fall in this category. Returns from such funds are treated as long term capital gains if investments are held for more than three years and taxable @20% with the indexation benefit. If investments are held for three years or less, the returns are treated as short term capital gain and added to the income of the investor and taxed as per the income tax rate.
- IMPORTANCE OF PROFESSIONAL GUIDANCE
With a variety of investment options available in the present times and risk that each investment entails, an experienced professional is always advisable. An advisor can help you invest in a right fund that caters to your needs. Internet and other software may come handy but they cannot replicate the personal attention and experience of an expert.
DOCUMENTS REQUIRED FOR INVESTMENT
- Application Form
- KYC and PAN Card
- Blank Cheque (Cancelled)
- In case of minors a third party declaration form ( Only parents or legal guardian are allowed to invest on behalf of their children)
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