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FAQ for Investors

WHAT ARE MUTUAL FUNDS?

A mutual fund is a pool of money managed by a professional Fund Manager.

It is a trust that collects money from a number of investors who share a common investment objective and invests the same in equities, bonds, money market instruments and/or other securities. And the income / gains generated from this collective investment is distributed proportionately amongst the investors after deducting applicable expenses and levies, by calculating a scheme's "Net Asset Value" or NAV. Simply put, the money pooled in by a large number of investors is what makes up a Mutual Fund.

Here's a simple way to understand the concept of a Mutual Fund Unit. Let's say that there is a box of 12 chocolates costing 40. Four friends decide to buy the same, but they have only 10 each and the shopkeeper only sells by the box. So the friends then decide to pool in 10 each and buy the box of 12 chocolates. Now based on their contribution, they each receive 3 chocolates or 3 units, if equated with Mutual Funds. .

And how do you calculate the cost of one unit? Simply divide the total amount with the total number of chocolates: 40/12 = 3.33.

So if you were to multiply the number of units (3) with the cost per unit (3.33), you get the initial investment of 10.

This results in each friend being a unit holder in the box of chocolates that is collectively owned by all of them, with each person being a part owner of the box.

Next, let us understand what is "Net Asset Value" or NAV. Just like an equity share has a traded price, a mutual fund unit has Net Asset Value per Unit. The NAV is the combined market value of the shares, bonds and securities held by a fund on any particular day (as reduced by permitted expenses and charges). NAV per Unit represents the market value of all the Units in a mutual fund scheme on a given day, net of all expenses and liabilities plus income accrued, divided by the outstanding number of Units in the scheme.

Mutual funds are ideal for investors who either lack large sums for investment, or for those who neither have the inclination nor the time to research the market, yet want to grow their wealth. The money collected in mutual funds is invested by professional fund managers in line with the scheme's stated objective. In return, the fund house charges a small fee which is deducted from the investment. The fees charged by mutual funds are regulated and are subject to certain limits specified by the Securities and Exchange Board of India (SEBI).

India has one of the highest savings rate globally. This penchant for wealth creation makes it necessary for Indian investors to look beyond the traditionally favoured bank FDs and gold towards mutual funds. However, lack of awareness has made mutual funds a less preferred investment avenue.

Mutual funds offer multiple product choices for investment across the financial spectrum. As investment goals vary - post-retirement expenses, money for children's education or marriage, house purchase, etc. - the products required to achieve these goals vary too. The Indian mutual fund industry offers a plethora of schemes and caters to all types of investor needs.

Mutual funds offer an excellent avenue for retail investors to participate and benefit from the uptrends in capital markets. While investing in mutual funds can be beneficial, selecting the right fund can be challenging. Hence, investors should do proper due diligence of the fund and take into consideration the risk-return trade-off and time horizon or consult a professional investment adviser. Further, in order to reap maximum benefit from mutual fund investments, it is important for investors to diversify across different categories of funds such as equity, debt and gold.

While investors of all categories can invest in securities market on their own, a mutual fund is a better choice for the only reason that all benefits come in a package.

A PLETHORA OF SCHEMES TO CHOOSE FROM

Mutual funds are favoured globally for the variety of investment options they offer. There is something for every profile and preference.

Chart 1: Risk/Return trade-off by mutual fund category

chart1

TYPE OF MUTUAL FUND SCHEMES

Mutual Fund schemes could be 'open ended' or close-ended' and actively managed or passively managed.

OPEN-ENDED AND CLOSED-END FUNDS

An open-end fund is a mutual fund scheme that is available for subscription and redemption on every business throughout the year, (akin to a savings bank account, wherein one may deposit and withdraw money every day). An open ended scheme is perpetual and does not have any maturity date.

A closed-end fund is open for subscription only during the initial offer period and has a specified tenor and fixed maturity date (akin to a fixed term deposit). Units of Closed-end funds can be redeemed only on maturity (i.e., pre-mature redemption is not permitted). Hence, the Units of a closed-end fund are compulsorily listed on a stock exchange after the new fund offer, and are traded on the stock exchange just like other stocks, so that investors seeking to exit the scheme before maturity may sell their Units on the exchange.

ACTIVELY MANAGED AND PASSIVELY MANAGED FUNDS

An actively managed fund is a mutual fund scheme in which the fund manager "actively" manages the portfolio and continuously monitors the fund's portfolio , deciding on which stocks to buy/sell/hold and when, using his professional judgement, backed by analytical research. In an active fund, the fund manager's aim is to generate maximum returns and out-perform the scheme's bench mark.

A passively managed fund, by contrast, simply follows a market index, i.e., in a passive fund , the fund manager remains inactive or passive inasmuch as, she does not use her judgement or discretion to decide as to which stocks to buy/sell/hold , but simply replicates / tracks the scheme's benchmark index in exactly the same proportion. Examples of Index funds are an Index Fund and all Exchange Traded Funds. In a passive fund, the fund manager's task is to simply replicate the scheme's benchmark index i.e., generate the same returns as the index, and not to out-perform the scheme's bench mark.

UNDERSTANDING RETURNS FROM MUTUAL FUNDS

MEASURING PERFORMANCE

While looking at a mutual fund scheme's performance, one must not be led by the scheme's return in isolation. A scheme may have generated 10% annualised return in the last couple of years. But then, even the market indices would have gone up in similar way during the same period. Under-performance in a falling market, i.e. when the NAV of the scheme falls more than its benchmark (or the market), is the time when you must review your investment.

One must compare the scheme's return as against its benchmark return. It is better to be rid of investment in a scheme that consistently under-performs as compared to its benchmark over a period of time, from one's portfolio. It is important to identify under-performers over the longer time horizon (as also out-performers).

In addition, one may also consider evaluating the 'category average returns' as well. Even if a scheme has outperformed its benchmark by a decent margin, there could be better performers in the peer group. The category average returns will reveal how good (or bad) is one's investment is against its peers which help in deciding whether it is time shift the investment to better performers.

One may be holding a too little or too much-diversified portfolio. Even the expense ratio of some of the schemes that one could be holding may be high compared to others within the same category.

Most importantly, the review helps an investor validate if the investments are aligned to his/her goals.

HOW OFTEN SHOULD ONE REVIEW

One should avoid the temptation to review the fund's performance each time the market falls or jumps up significantly. For an actively-managed equity scheme, one must have patience and allow reasonable time - between 18 and 24 months - for the fund to generate returns in the portfolio.

The review may become more pronounced in case of thematic or sectoral schemes as they are more prone to the changing economic environment.

It is advisable for common investors to make a separate watch list of funds that are found to be underperforming their benchmark or their comparable peers. From this list, one should look for improvement in performance over the subsequent 2-3 quarters. A consistent under-performance over 3-4 quarters may warrant shifting the investment to other better options. One needs to even check the reason for the under-performance, which may be expressed in the fund manager's commentary. The underlying stocks in the portfolio of an MF scheme keep changing and along with it change the associated risks. An important factor is the risk metrics. If the risk profile of the fund has skewed further towards "High" risk while the returns remain the same or do down, it may be advisable to exit the fund.

Therefore, a review of the fund's risk-adjusted return, i.e., a measure to find how much return an investment will generate given the level of risk associated with it, could be more helpful.

As an investor, high return at low risk is always preferable. Hence, MF schemes with high risk-adjusted returns are most sought-after. Risk-adjusted returns are well captured by several rating agencies.

The winners of today may not continue with the winning streak year after year. In other words, reviewing the performance as mentioned above may not always be fruitful. Moreover, tracking and reviewing of a scheme's portfolio is quite different from reviewing one's own portfolio. A mutual fund investor should not worry themselves about the portfolio of a fund. That's the fund manager's job.

WATCH OUT

Be mindful not to disrupt your overall portfolio allocation, while redeeming units from equity mutual fund schemes, as the redemption proceeds would have to be re-deployed in another equity scheme which will require undergoing the entire process of choosing the right scheme to invest in. Try to maintain the original levels of exposure to equities, unless your allocation needs a change.

Frequent review and tracking of mutual fund returns may tempt you into taking unwarranted impulsive decisions. Do not let an fall in NAVs tempt you to discontinue SIPs or redeeming units from a fund. When there are market falls steeply, try to invest lump-sum amount. An annual review comparing the fund with the benchmark as well as with the category peers will certainly help and advisable.

CALCULATING RETURNS ON MUTUAL FUND UNITS

There are many ways to calculate returns from mutual fund investments. Two of the most popular methods are Absolute returns and Annualised returns.

Absolute returns

Absolute return is the simple increase (or decrease) in your investment in terms of percentage. It does not take into account the time taken for this change.

So if an investment's current market value is Rs. 5,25,000 and your invested amount was Rs. 2,75,000 then your absolute return will be: [(5,25,000-2,75,000)/2,75,000] = 90.9%

Notice how irrelevant the date of investment or date of redemption is. Ideally, you should use the absolute returns method if the tenure of your investment is less than 1 year.

For periods of more than 1 year, you need to annualise returns; which means you need to find out what the rate of return is per annum.

Annualised returns

A Compound Annual Growth Rate (CAGR) measures the rate of return over an investment period. It is a smoothened rate because it measures the growth of an investment as if it had grown at a steady rate, on an annually compounded basis.

CAGR = [(Current Value / Beginning Value) ^ (1/# of Years)]-1

How can I find the CAGR using the computer?

To calculate a CAGR, use the XIRR function in MS Excel.

8-Jan-06 1,00,000 Enter the date and the investment value
31-Dec-12 2,00,000 Enter the current value and the current date
XIRR formula 10.43%

Please remember to put a negative sign as the XIRR formula calculates the return on cash flows. Thus to find returns there has to be a cash inflow and cash outflow, which should be indicated with the use of positive and negative signs.

ACTIVELY MANAGED FUNDS AND PASSIVELY MANAGED FUNDS

Actively managed funds are those where the fund manager actively manages these funds and buys or sells stocks of companies as per the broad guidelines that have been enumerated in the scheme information document sells stocks. These funds don't mimic the index but buy and sell on basis of the research of the fund manager.

Passive funds on the other hand look at offering returns by mimicking an index like a BSE or Nifty. The whole point of Index fund is to follow a certain benchmark, and therefore they are called passively managed funds.

UNDERSTANDING ALPHA. HOW DOES IT MEASURE THE FUND MANAGER'S CONTRIBUTION?

But how can I measure the fund manager's contribution to performance?

This brings us to the question, how exactly can you measure a fund manager's contribution to performance? Alpha measures the performance due to stock selection. It is the difference between the return you would expect from a fund, given its beta and the return it actually produced. If the fund returns more than its beta would predict, it has a positive alpha and if it returns less than the amount predicted by the beta, that would mean that the fund has a negative alpha.

A positive alpha is the extra return would be awarded to you for taking a risk, instead of accepting the market return.

UNDERSTANDING BETA

Beta measures the volatility of a security relative to something, usually a benchmark index. A beta greater than one means the fund or stock is more volatile than the benchmark index, while a beta of less than one means the security is less volatile than the index.

If the market goes up by 10%, a fund with a beta of 1.0 should go up 10% and vice versa. While standard deviation determines the volatility of a fund according to the disparity of its returns over a period of time, beta, determines the volatility, or risk, of a fund in comparison to that of its index or benchmark.

Beta is based on the capital assets pricing model which states that there are two kinds of risk in investing in equities- systematic risk and non-systematic risk. Systematic risk is integral to investing in the market and cannot be avoided. Eg. risk arising out of inflation and interest rates. Non-systematic risk is unique to a company - can be mimimised by diversification across companies. Since non-systematic risk can be diversified, investors need to be compensated for systematic risk which is measured by Beta.

UNDERSTANDING STANDARD DEVIATION

Usually denoted with the letter σ, Standard Deviation is defined as the square root of the variance.

It basically serves as a measure of uncertainty. Volatile securities that have a higher standard deviation are also considered a higher risk because their performance may change quickly, in either direction and at any moment.

So the standard deviation of a fund measures this risk by measuring the degree to which the fund fluctuates in relation to its mean return i.e. the average return of a fund over a period.

For example, a fund that has a consistent four year return of 3%, would have a mean, or average of 3%. The standard deviation for this fund would then be zero because the fund's return in any given year does not differ from its four year mean of 3%.

The standard deviation of a set of data measures how "spread out" the data set is. In other words, it tells you whether all the data items bunch around close to the mean or if they are "all over the place."

What you need to take out of this is that the fund with the lower standard deviation would be more optimal because it is maximizing the return received, for risk acquired.

Imagine you have a choice between two stocks: Stock A historically returns 5% with a standard deviation of 10%, while Stock B returns 6% and carries a standard deviation of 20%, which one do you think is more risky?

Stock A has the potential to earn 10% more than the expected return, but is equally likely to earn 10% less than the expected return. Likewise Stock B can vary by up to 20%.

So on a risk and return perspective, Stock A is less risky than Stock B.