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Mutual Funds: A Beginner’s Guide

We all have different financial goals at different points of time. It could be the education of your child, retirement plans or the marriage of your child. We all look at ways of making our money work and grow faster, not unlike a plant. Taking the analogy further, while we can look after our garden, a gardener does a much better job. The plants benefit with the care and experience of the gardener and free us to do other things. A mutual fund works on this principle. There are many securities available and we do not usually know how the market works. Furthermore we may have small amounts of money available at a given time to invest.

What if a pool of such saved amounts with a common financial goal was done by a group of fund managers? That is the underlying concept of a mutual fund. This pool is invested in shares, securities etc. The income generated by investing in these instruments is then divided in the ratio of investment. Investors benefit without putting in large sums of money, having an experienced fund manager to tend to their fund.

According to AMFI, the advantages of investing in a mutual fund are:

  • Professional Management
  • Diversification
  • Convenient Administration
  • Return Potential
  • Low Costs
  • Liquidity
  • Transparency
  • Flexibility
  • Choice of schemes
  • Tax benefits
  • Well regulated

Some disadvantages of mutual funds include:

  • Hidden fees
  • Low liquidity
  • Trade execution only at end of day
  • Attracts Capital gains tax
  • Information about fund not always available

Mutual funds can be categorised according to structure or investment. By structure we mean open ended, close ended or interval schemes.

In open ended schemes the investor can redeem the scheme or buy as many units at any time.

Close ended schemes refer to a limited number of units, therefore buying or selling is restricted by demand and supply of the same.

In an interval scheme, the redemption can happen at pre-determined intervals. It is a mix of the open ended and close ended schemes.

If mutual funds were to be categorised by financial objectives, there are growth schemes, balanced schemes, money market schemes and income schemes.

Growth funds generally invest in equities. This fund will look at high growth opportunities in the medium to long term.

In balanced schemes as the name suggests, investment takes place in securities, preference shares and fixed income securities. The aim is not merely growth but income as well in the long term.

Income schemes see investment in fixed income instruments issued by the government, banks, financial institutions and private companies. The objective of this scheme is to preserve capital and to provide fixed income over the medium to long term.

Money market schemes invest in short term instruments with high liquidity and high interest.

Some other noteworthy schemes include tax saving schemes, index schemes, sector specific schemes, exchange traded funds , sector specific funds and capital protection funds.

Tax saving schemes offer tax rebates to investors. Index schemes reflect the performance of indices of various stock markets. Sector specific funds invest in a certain sector. Exchange traded funds invest in a wide array of stocks and are listed and traded in the market as such. Their USP seems to be easy liquidity. Capital protection funds aim at protecting the invested capital by investing in low risk securities.

Some commonly used terms with regards to mutual funds are:

  • Net Asset Value is the market value of the assets of the scheme minus its liabilities. The per unit NAV is the net asset value of the scheme divided by the number of units outstanding on the Valuation Date.
  • Sale Price is the price you pay when you invest in a scheme. Also called Offer Price. It may include a sales load.
  • Repurchase Price is the price at which units under open-ended schemes are repurchased by the Mutual Fund. Such prices are NAV related.
  • Redemption Price is the price at which close-ended schemes redeem their units on maturity. Such prices are NAV related.
  • Sales Load is a charge collected by a scheme when it sells the units. Also called, ‘Front-end’ load. Schemes that do not charge a load are called ‘No Load’ schemes.
  • The repurchase or back-end load is a charge collected by a scheme when it buys back the units from the unit holders

Once you decide what kind of scheme you want to invest in go to a reliable distributor, who will further help you zero in on the kind of fund you want. Clearly ask about all fees associated with investing. Note if he is pushing a scheme because he might be getting a higher commission on it.

Post this a Know Your Client registration, also known as KYC will take place. At this stage you will have to submit a proof of identity and address. Once this is done, you can fill up the application and make the payment in the name of the scheme. Do not give a cheque in the name of the distributor or individual agent. Do write the application number on the cheque and vice-versa. Contact the customer support cell of the fund in case of doubts or queries.

If at any time you get information that the fund house is changing its objective that is not suitable for you be sure to switch your investment. Always undertake a review from time to time as to whether the fund is helping you realise your financial objectives. You can do this by looking at the statements you get for your investments.

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