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8 Key Mutual Fund Terms

Anmol Gupta

Welcome to part 2 of our Mutual Fund journey. So, you seem to be interested in Mutual Funds and you understand why mutual funds exist! And you couldn’t wait and started to find best schemes as per your goals? But, you found out that those boring scheme documents talked in some alien language! So, here we present you the eight key terms which will help you decode the mutual fund documents up to a great extent.

1. ‘Investment Objective’, the most important thing to consider while investing in a mutual fund! 

This is the most important thing which you should look while reading details of a mutual fund. This is the first thing which you should be finding about the mutual fund, everything else comes later! Okay, so let’s see why is it so important. We know that you very well understand the importance of defining financial goals in financial planning by now :) So, these investment objectives helps you determine whether the scheme is suitable for your goals or not. For example, if you are planning for your retirement which is after 30 years, then you are looking for an investment option which will give you returns in long term. So, the mutual fund whose investment objective is to generate regular income in short term won’t be suitable for your goal. Rather, you will need to look at a scheme which states its investment objectives as to generate return in long term! 

The point is, the investment objectives drive the decision taken by fund managers to select various kinds of investment options to invest. For instance, if the objective is to generate return in long term, then fund managers will be leaned towards investing in equity related instruments. On the other hand, if the investment objective is to generate income in short term (say 3 years), then the fund managers will keep themselves away from the equity market. Majority of their portfolio will consist of debt instruments, which can generate some income with certainty. So, you see if you invest in a mutual fund with investment objective as long term, while your goal is a short term goal, you are dragging yourself in trouble. No mutual fund forces you to invest in them. No matter how good a fund is performing, if its investment objectives doesn’t suit your goal, it’s not worth your money. And you need to take special care! You might get persuaded by various kinds of agents to invest in some scheme stating that it’s performing really well. In those cases, you have to use your brain and firmly decline their offer if the scheme doesn’t suit your goals. Some agents might sell you schemes just because they earn commissions on selling them, but you have to take care of yourself.

2. You don’t invest in mutual funds in kilograms, you invest in ‘Units’ 

It’s quite simple. Just like you invest by purchasing certain number of shares of a company, like purchasing 100 shares of ABC Company, you purchase ‘Units’ of mutual funds to invest in them. Suppose, a mutual fund decides to sell one unit at a price of Rs. 10 and you want to invest Rs. 10,000 in that mutual fund, you will need to buy Rs. 10,000/10 = 1000 units. And, you might sell some of your units in future or buy some more units. Basically, you trade in units of mutual fund. Yes, it’s as simple as that.

3. The total value of your fund or investment – ‘Net Assets’ 

Suppose, when the mutual fund starts (New Fund Offer), the total number of existing units are 10 Lakh each worth Rs. 10, then the total value of this mutual fund is Rs 1 Crore. Now, if the costs of managing this fund amounts to Rs. 2 Lakh, then the net value of your fund will be Rs. 1 Crore – Rs. 2 Lakh = Rs. 98 Lakh. The expenses include things like fund manager’s fee, regulatory expenses, advertising expenses etc. 

Now, your Net Assets may go up or down in following cases. If new investors buy additional units. Suppose, in the above example some new investors buy additional 1 Lakh units in your mutual fund, then Net Assets of your mutual fund will increase by Rs. 10 Lakh. On the other hand, if some of the investors sell their units back to mutual fund and take back their investment amount, then the Net Assets will decrease. And, the desired situation is when the value of your investment will go up due to profits, leading to Net Assets going up. But, obviously the Net Assets will go down when your fund makes a loss. So, the Net Assets keep changing with change in any of the above factors.

4. The important performance measure of your investment – ‘Net Asset Value (NAV)’ 

NAV is the number which you will hear and care when you have invested in a mutual fund. It’s just like share price. Net Asset Value is the value of each single unit in a mutual fund. It’s calculated as Net Assets divided by the number of units outstanding in that mutual fund. Suppose a mutual fund which has Net Assets of Rs. 10 Crore with 1 Crore units, the NAV is calculated as Rs. 10 Crore/ 1 Crore = Rs. 10. Now, if the Net Assets go up by Rs. 2 Crores to Rs. 12 Crores due to value of investment going up (not due to new investors coming in), then NAV will be Rs. 12 Crore/1 Crore = Rs. 12. That means, the value of your investment will go up by Rs. 2 per unit or 20%. The NAV changes as and when the Net Assets change. Just like share prices, NAV also changes frequently and that’s why we see that mutual funds report their NAV’s daily. You buy and sell units of mutual funds at their existing NAV’s just like you buy and sell shares at their existing price at the time of transaction. Simply put, you are making a profit if your NAV is going up and making a loss if NAV is going down.

5. The value of your investment in mutual fund reflects the value of securities held in it – ‘Marked to market’ 

Suppose your mutual fund invests in 100 different stocks in some proportion, then the current value of your mutual fund will be the weighted average of the price of those stocks. That means purchasing those 100 stocks in same proportion as your mutual fund and investing in your mutual fund should cost the same. This process of calculating the value of mutual fund portfolio on daily basis is called as Marking to Market. Quite natural, isn’t it? Now most of the stock are traded on well known stock exchanges, their value is taken from there. If some instrument is not traded, then SEBI has defined methods for valuing such securities. But in any case, the value of your mutual fund is marked to market every day so that it daily reflects the true value of it.

6. When you can purchase or redeem additional units at any time, it’s an ‘Open Ended Scheme’ 

Open ended schemes are one of the ways of structuring the mutual funds. In Open ended schemes, you can invest or purchase the units of mutual fund anytime at the existing NAV. You may also exit from the mutual fund by redeeming your units i.e. selling them back to the fund at NAV. The scheme has no definite time period for existence, and it will generally exist forever unless the investors decide to wind up the scheme.

7. When you can purchase units only during New Fund Offer and the scheme exists for a fixed time period, it’s ‘Close Ended Scheme’ 

Close Ended Schemes are another way of structuring the mutual funds. You can only purchase the units during the New Fund Offer. When the tenure of fund is over, the units are redeemed at the NAV existing at that time and scheme no more exists after that. Well, you need not worry about getting locked up with Close ended schemes :) You can purchase the units from ‘fund’ during NFO and fund redeems those units only on maturity, but close ended schemes have to mandatorily get themselves listed on stock exchanges. That means, although you cannot do any transaction with the issuer of units until the tenure gets over, you can buy and sell units with other investors on stock exchanges at the existing NAV. So yes, you are not locked with close ended schemes :) you have the complete flexibility of entering and existing at any time.

8. When close ended funds becomes ‘open’ for some time, they are called as ‘Interval Funds’ 

As stated, the interval funds are a type of closed ended funds which become open ended for a particular time period. During this period, the fund acts like an open ended scheme and investors can purchase and redeem units just like they can do in an open ended scheme. These funds are also mandatorily listed on stock exchanges. After all they are closed ended!

Well, thanks for your time! These terms should get you started with understanding the mutual fund scheme documents :)

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About the Author
Anmol Gupta
Anmol is CEO at 7Prosper. He is SEBI Registered Investment Adviser, with expertise in Finance and Technology domains. Anmol is committed to help people achieve their financial freedom.

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