Mutual Fund Knowledge Centre
A mutual fund is a trust. It pools money from like-minded shareholders and invests in diversified portfolio of securities, through various schemes that address different needs of investors. The pool of money thus collected is then invested by the Asset Management Company (AMC) in different types of securities. These could include shares, debentures, convertibles, bonds, money market instruments or other securities, based on the investment objective of a particular scheme. Such objective is clearly laid down in the offer document for that scheme. The fund adds value to the investment in two ways: income earned and any capital appreciation realised through sale. This is shared by unit holders in proportion to the number of units they own.
An AMC is involved in the daily administration and also acts as investment advisor for the fund. An asset management company is promoted by a sponsor which usually is a reputed corporate entity with sound record of profits. An AMC typically has three departments:
Mutual fund schemes can be classified as follows:
By Investment Objective
Open ended funds can issue and redeem units any time during the life of the scheme. Close ended funds cannot issue new units except through a bonus or rights issue. Hence, unit capital of open ended funds can fluctuate daily. Further, new investors to an open ended fund can join the scheme by directly applying to the mutual fund at applicable Net Asset Value-related prices. In the case of close ended schemes, new investors can buy units only from the secondary market.
It is a document which an open-end fund, or newly issued closed-end fund, is required to provide to investors. Funds say that investors should read it carefully before investing or sending money. A prospectus contains descriptions of:
The net asset value (NAV) is the market value of the fund's underlying securities. It is calculated at the end of the trading day. Any open-end fund buy or sell order received on that day is traded based on the net asset value calculated at the end of the day. The NAV per units is such Net Asset Value divided by the number of outstanding units.
A mutual fund may receive dividend or interest income from the securities it owns; it is required to pay out this income to its investors. Most open-end funds offer an option to purchase additional shares with the dividends. Dividends are often made monthly or quarterly, though many funds make distributions only yearly.
No stock market related investments can be termed safe with certainty; they are inherently risky. However, different funds have different risk profile, which is stated in its objective. Funds which categorize themselves as low risk, invest generally in debt which is less risky than equity. Anyway, as mutual funds have access to services of expert fund managers, they are always safer than direct investment in the stock markets.
Equity Funds are open to market risk i.e. there is a possibility that the price of the stocks in which the Fund has invested may decrease. Of course, the prices may also go up, making it possible for the Fund to earn profits.
Debts Funds are open to two main risks - Credit Risk and Interest Rate Risk. Credit Risk refers to the possibility that the company that has issued the bond or debenture in which the Fund has invested may default on interest or on principal payments. Debt Fund managers take care of this by investing in bonds which have good credit rating.
Interest Rate Risk refers to the possibility that the price of the bond in which the Fund has invested may go down because of an increase in the interest rates in the economy. In general, it is useful to remember that this is a "see-saw" relationship - bond prices (and therefore, NAV) goes up when interest rates drop and drops when interest rates rise.
Some mutual funds have floated "assured" return schemes that guarantee a certain annual return. At present, there are very few funds who assure returns as they have realized that it is not possible to assure returns in a volatile market.
There are three ways in which you can make money in a mutual fund.
First you can earn a dividend from the Mutual Fund. Most Debt Funds declare dividends around once in six months in their Dividend Option. If you do not want the dividend, you can choose to be in the Cumulative Option. When a dividend is declared, the NAV of the units will fall, since dividend is paid out of the appreciation in the value of the unit.
Next, you can make a profit by selling the mutual fund units at a price higher than that at which you bought them. This is capital gain. (If you sell the units at a lower price, you make a capital loss.)
Finally, the value of the units you hold can appreciate. This is unrealised capital gain. Dividends and capital gains are treated differently.
Mutual funds can meet the investment objectives of almost all types of investors. Younger investors who can take some risk while aiming for substantial growth of capital in the long term will find growth schemes (i.e. funds which invest in stocks) an ideal option.
Mutual funds are meant for small investors. The prime reason is that successful investments in stock markets require careful analysis which is not possible for a small investor. Mutual funds are usually equipped to carry out thorough analysis and can provide superior returns.
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