What is a Mutual Fund?

Basics of everything mutual fund. NAV, underlying portfolio, expense ratio, dividend vs growth, NFO, and why one should invest in mutual funds.

A mutual fund is an instrument / vehicle by which a company (called Asset Management Company or AMC) collects money from investors by selling units / shares and using that money to make investments.

Depending upon the mandate; a mutual fund can invest in equities, bonds, a mix of both, gold, international equities, other mutual funds etc. So, mutual fund automatically does not mean equity mutual fund. Equity mutual funds are a subset of all mutual funds.

There are some 4000 odd funds presently in the Indian markets.

Portfolio

The combined list of different securities of the fund is called the Portfolio. Because of transparency requirements, the companies have to periodically update their funds' portfolios on their websites.

For Debt mutual funds that invest in various IOUs, bonds etc.; it's required to disclose portfolio every 2 weeks.

Different portals like Morningstar.in, Moneycontrol.com, and Valueresearchonline.com also show these details along with other characteristics.

Net Asset Value (NAV)

This is the price of 1 unit of the particular mutual fund. It's calculated by adding the market value of all the securities (equities, bonds, gold, etc), subtracting the market value of the liabilities, and then dividing this value by the total number of outstanding units.

Mathematically, NAV = (Total market value of Assets – Total market value of liabilities) divided by (number of units / shares)

Features:

• It is calculated daily at the end of the trading sessions and should be available on AMFI website by 11 p.m. Some funds, like those which have securities of foreign assets, can have delayed announcements of their NAVs.

• If the underlying market value of the securities (shares, bonds, gold) increases on that day, the NAV will increase (unless there are other reasons) and vice versa.

• One can purchase / sell the mutual fund at the announced NAV of the day. Usually, the selling and purchasing NAV are similar, but in some cases that can be different.

• Mutual funds can issue fractional units, up to 3 decimal places. A fund can collect ₹1,00,000 and issue 1000 units with NAV of 100. Other one can collect the same ₹1,00,000 and issue 10,000 units at NAV of 10. The underlying net value of the fund is same, only the NAV value is different because of different number of units. This is why when somebody tells you that a fund with NAV of 10 is better than a fund with NAV of 300, you should not agree to it. The total fund value depends upon the securities and not the NAV. Better to avoid such advice.

Dividend Income

When a mutual fund announces dividend, it pays out that dividend money from the net assets and gives it back to the investors. There is no additional money generated, in the same way companies distribute part of their profits to shareholders as dividends.

If the NAV is 100 and the AMC announces a dividend of 5, you will get 5 in your account for every unit you hold, and the NAV would fall to 95. Your own money is being given back to you. It is not like you will get 5 in your account and the NAV would continue to be 100.

Instead of relying on mutual fund dividends for cashflow tricks, it's easier to just withdraw it yourself, periodically; from growth scheme of same mutual fund.

NFO (New Fund Offer)

Companies come up with new portfolio guidelines or asset balancing, etc and create a particular mutual fund for that purpose. One can read about the details of the NFO on their site or SEBI’s. Usually, these are sold at NAV of 10 (but it is just an arbitrary number).

The underlying philosophy of the fund is more important and before buying a NFO, one should see whether that philosophy fits into the overall requirement. Any NFO requires lot of advertisement (online, offline), seminars, selling, etc – all these expenses are deducted from the net assets (in the liabilities section specifically) and gets reflected in the NAV. For 99% cases, don’t invest in NFO.

It's also a misconception that fund's NAV cannot be smaller than 10. JM Core 11 Growth plan, was opened to public in early 2008. Its NAV stayed below that NFO NAV for ~13 years, before reaching same value again in Jan 2021.

Expense Ratio

The funds charge a specific amount of money for using the services. This charge is applied on a daily basis and comes under the Liabilities head in the calculations.

If a fund charges 2.5% expense ratio, then it would deduct about 0.01% on each working day (5 days a week, for 52 weeks) from the net assets and give you the final NAV. For lower expense ratio funds, this value will be lesser.

Presently, each of the mutual fund have two different types based on expenses – a regular / retail plan and a direct plan. In the direct plan, if you invest directly with the AMC through their office / website AND you opt for Direct plan, you will get a lower expense ratio plan (by about 0.5-0.6%). All other methods of investing, namely agents, demat account, banks, investment accounts, etc can only use Retail / Regular plan.

You could also invest through various new-gen free direct plan apps, including but not limited to, Coin / Groww / INDMoney / Kuvera / MFUtility / PayTM Money etc.

Make sure you're investing only in Direct plan of the fund, in growth scheme (not dividend).

Types of Mutual Fund

Open-ended Mutual Fund – The buying and selling of the units from the AMC is open. If you buy, they create more units (if needed) at the day’s NAV and if you sell, they can remove those units.

Closed-ended Mutual Fund – For a 3 year closed fund, the AMC does not allow creation / deletion of units for that period of 3 years.

After 3 years, it can either convert it into an open ended fund or pay back the money and close it.

During the 3 year period, the investor can buy/sell the units on the exchange (NSE/BSE) from other unit holders. Sometimes, the buying / selling price can be different from the NAV of the fund because of supply and demand forces. And sometimes, one may not be able to sell it if there are no other buyers. There can be 5 year funds too. FMPs (Fixed Maturity Plans) are a type of closed-ended funds.

Advantages of Mutual Fund

1. Diversification: Most funds have a number of different securities in their portfolio. Some can have stocks of 25 companies, while others can have stocks of 100 companies. There are guidelines which prevent the companies to invest in only 3-4 companies. This prevents severe loss in case one company is involved in a fraud and its stock price collapses. Same is the case with the bond funds. They can have bonds of different companies and even if 1 or 2 companies default, the overall NAV does not go down to zero.

2. Affordable: With ₹500 / 5000, you can go and buy units in a mutual fund and get that diversified portfolio. If you want to replicate that kind of diversified portfolio on your own, you will have to have a big amount.

3. Professional Management: The management team employed by the AMC use their expertise, research and analyses to manage the portfolios. This is better than most of the investors. The main point is that the aim of the management is same as that of the investor – to maximize the NAV (investment value).

4. Liquidity: By definition, the open-ended mutual funds can be sold back to the AMC and the money can be received in the bank account. Depending upon the type of fund (this will be mentioned in the scheme document), it can take 1 to 10 days for the amount to get transferred.

5. Convenience: Most of the things like buying, selling (partial/full), statements, tax statements, etc. can be done online. Except for the KYC (know your customer) norms which has to be done in person (called In Person Verification). However, these days, KYC done over video call is also accepted. And everything can be done by going to the AMC office or common services like of CAMS / Karvy. Automated investment plans can be done in the form of SIP (Systematic Investment Plan) or SWP (systematic withdrawal plan) and their variations.