Understanding Mutual Funds

Bharat Kalluri / 2020-07-20

What are mutual funds?

Not everyone has the time, energy and the context to invest and trade stocks. Also since the markets can be highly volatile, it is not advised to trade without understanding the markets.

Another approach is to pay someone who deeply understands the markets a small fee and seek their expertise to manage a fund. This is exactly what mutual funds are. In mutual fund, a fund manager pools in money and invests/trades. The job of the fund manager is to bag high returns. And customers pay a small fee on the mutual fund (called as expense ratio) to the manager for the service they are offering.

Regular vs Direct Funds

Regular funds are the funds where you pay a higher expense ratio since you go via a broker. Direct meaning there is no broker, and you will directly go to the AMC (Asset management Company).

Types of funds

  • Debt: These funds are maintained by Banks. When someone like the government, or a private sector organization takes money from a bank, they take it at a fixed interest rate over a period of time. So, what is basically happening is that banks pool money through mutual funds and lend it to various gov/private org. and the return on the fund is the interest rate the org pays the bank back. This is usually a safe bet since most of the companies don't completely default. But if they do, then the fund loses money, which means you lose on your returns/money.
  • Equity: These funds just straight up invest in stocks, there are a couple of types here like
    • Large Cap
    • Small Cap
    • Mid Cap
    • Multi Cap
  • ELSS (Equity linked savings scheme) , it is mandatory that 80% of the investments are in equity. The simple reason why people prefer equity is that the returns are usually higher. But also it means risk is higher.
  • Growth funds have stocks which are high in terms of their growth but less in terms of the amount of dividend (money paid occasionally by the company to the shareholder). You might find companies you might have never heard of, but the manager of the fund thinks are a good growth investment.
  • Index Funds: They invest in the index they refer to (SENSEX / NIFTY). No manager since they just track the index, so no expense.
  • Hybrid: They do both Equity and debt funds

Terms to understand

NAV (Net asset value)

Mutual funds have assets and liabilities. Assets would be the stocks they possess, the gains they realize on the trades etc. Liabilities would mean the losses they realize on the trades, the taxes etc. The value of the entire mutual fund can be summarized as (assets-liabilities). This will be usually a large amount. The mutual fund manager now decides to break this into small pieces called units and then sells these units to the customer. So NAV is (assets-liabilities)/total unit count. NAV is the price at which units of mutual funds can be bought.

Exit Load

The amount of the fund you have to pay to the fund management organization if you exit the fund before the stipulated time.

Expense ratio

measures how much of a fund's assets are used for administrative and other operating expenses. One thing to note is that expense ratio's generally tend to be stable. A fund with low expense ratio stays low for a good amount of time.

CAGR (Compound Annual Growth Rate)

Compound annual growth rate (CAGR) is the rate of return that would be required for an investment to grow from its beginning balance to its ending balance, assuming the profits were reinvested at the end of each year of the investment’s lifespan. (I need to fully understand this yet)

Tracking error

Between multiple index funds tracking the same index, there can be found differences in returns over time. For example, Tarus nifty fund can have a return of 15% over the last year but DSP nifty fund may have 18%. Since they track the same index, there should ideally be no difference in return. But since the fund managers need to react and buy stocks when the index is changed and adjust accordingly, there can be a scope for difference. This difference is called the tracking error. The error which occurs due to not tracking the fund as it is. If the tracking error is very high for a fund, it means the management behind the fund is not paying attention to the index and should be avoided.

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