Buying shares in mutual funds can be intimidating for beginning investors. There is a huge amount of funds available, all with different investment strategies and asset groups. Trading shares in mutual funds is different than trading shares in stocks or exchange-traded funds (ETFs). The fees charged for mutual funds can be complicated. Understanding these fees is important since they have a large impact on the performance of investments in a fund. The following is a guide to help get a new investor up to speed on the basics of trading mutual funds.
What Are Mutual Funds?
A mutual fund is an investment company that takes money from many investors and pools it together in one large pot. The professional manager for the fund invests the money in different types of assets including stocks, bonds, commodities and even real estate. An investor buys shares in the mutual fund. These shares represent an ownership interest in a portion of the assets owned by the fund. Mutual funds are designed for longer-term investors and are not meant to be traded frequently due to their fee structures.
Mutual funds are often attractive to investors because they are widely diversified. Diversification helps to minimize risk to an investment. Rather than having to research and make an individual decision as to each type of asset to include in a portfolio, mutual funds offer a single comprehensive investment vehicle. Some mutual funds can have thousands of different holdings. Mutual funds are also very liquid. It is easy to buy and redeem shares in mutual funds.
There is a wide variety of mutual funds to consider. A few of the major fund types are bond funds, stock funds, balanced funds and index funds. Bond funds hold fixed-income securities as assets. These bonds pay regular interest to their holders. The mutual fund makes distributions to mutual fund holders of this interest.
Stock funds make investments in the shares of different companies. Stock funds seek to profit mainly by the appreciation of the shares over time, as well as dividend payments. Stock funds often have a strategy of investing in companies based on their market capitalization. Market capitalization is the total dollar value of a company’s outstanding shares. For example, large-cap stocks are defined as those with market caps over $10 billion. Stock funds may specialize in large-, mid-or small-cap stocks. Small-cap funds tend to have higher volatility than large-cap funds.
Balanced funds hold a mix of bonds and stocks. The distribution among stocks and bonds in these funds varies depending on the fund’s strategy. Index funds track the performance of an index such as the S&P 500. These funds are passively managed. They hold similar assets to the index being tracked. Fees for these types of funds are lower due to infrequent turnover in assets and passive management.
Some popular objectives of a mutual fund are –
| Fund Objective | What the fund will invest in |
|---|---|
| Equity (Growth) | Only in stocks |
| Debt (Income) | Only in fixed-income securities |
| Money Market (including Gilt) | In short-term money market instruments (including government securities) |
| Balanced | Partly in stocks and partly in fixed-income securities, in order to maintain a ‘balance’ in returns and risk |
Managed by an Asset Management Company (AMC)
The company that puts together a mutual fund is called an AMC. An AMC may have several mutual fund schemes with similar or varied investment objectives.
The AMC hires a professional money manager, who buys and sells securities in line with the fund’s stated objective.
All AMCs Regulated by SEBI, Funds governed by Board of Directors
The Securities and Exchange Board of India (SEBI) mutual fund regulations require that the fund’s objectives are clearly spelt out in the prospectus.
In addition, every mutual fund has a board of directors that is supposed to represent the shareholders’ interests, rather than the AMC’s.
Basic of MF
Net Asset Value or NAV
NAV is the total asset value (net of expenses) per unit of the fund and is calculated by the AMC at the end of every business day.
How is NAV calculated?
The value of all the securities in the portfolio in calculated daily. From this, all expenses are deducted and the resultant value divided by the number of units in the fund is the fund’s NAV.
Expense Ratio
AMCs charge an annual fee, or expense ratio that covers administrative expenses, salaries, advertising expenses, brokerage fee, etc. A 1.5% expense ratio means the AMC charges Rs1.50 for every Rs100 in assets under management.
A fund’s expense ratio is typically to the size of the funds under management and not to the returns earned. Normally, the costs of running a fund grow slower than the growth in the fund size – so, the more assets in the fund, the lower should be its expense ratio.
Load
Some AMCs have sales charges, or loads, on their funds (entry load and/or exit load) to compensate for distribution costs. Funds that can be purchased without a sales charge are called no-load funds.
Open- and Close-Ended Funds
1) Open-Ended Funds
At any time during the scheme period, investors can enter and exit the fund scheme (by buying/ selling fund units) at its NAV (net of any load charge). Increasingly, AMCs are issuing mostly open-ended funds.
2) Close-Ended Funds
Redemption can take place only after the period of the scheme is over. However, close-ended funds are listed on the stock exchanges and investors can buy/ sell units in the secondary market (there is no load).
Important documents
Two key documents that highlight the fund’s strategy and performance are 1) the prospectus (legal document) and the shareholder reports (normally quarterly).
Why invest through Mutual Funds?
Professional Money Management
Fund managers are responsible for implementing a consistent investment strategy that reflects the goals of the fund. Fund managers monitor market and economic trends and analyze securities in order to make informed investment decisions.
Diversification
Diversification is one of the best ways to reduce risk (to understand why, read The need to Diversify). Mutual funds offer investors an opportunity to diversify across assets depending on their investment needs.
Liquidity
Investors can sell their mutual fund units on any business day and receive the current market value on their investments within a short time period (normally three- to five-days).
Affordability
The minimum initial investment for a mutual fund is fairly low for most funds (as low as Rs500 for some schemes).
Convenience
Most private sector funds provide you the convenience of periodic purchase plans, automatic withdrawal plans and the automatic reinvestment of interest and dividends.
Mutual funds also provide you with detailed reports and statements that make record-keeping simple. You can easily monitor the performance of your mutual funds simply by reviewing the business pages of most newspapers or by using our Mutual Funds section.
Flexibility and variety
You can pick from conservative, blue-chip stock funds, sectoral funds, funds that aim to provide income with modest growth or those that take big risks in the search for returns. You can even buy balanced funds, or those that combine stocks and bonds in the same fund.
Tax benefits on Investment in Mutual Funds
1) 100% Income Tax exemption on all Mutual Fund dividends
2) Equity Funds – Short term capital gains is taxed at 15%. Long term capital gains is not applicable.
Debt Funds – Short term capital gains is taxed as per the slab rates applicable to you. Long term capital gains tax to be lower of – 10% on the capital gains without factoring indexation benefit and 20% on the capital gains after factoring indexation benefit.
3) Open-end funds with equity exposure of more than 65% (Revised from 50% to 65% in Budget 2006) are exempt from the payment of dividend tax for a period of 3 years from 1999-2000.
Note: Equity Funds are those where the investible funds are invested in equity shares in domestic companies to the extent of more than 65% of the total proceeds of such funds.