What Are Mutual Funds?
Mutual funds are a type of investing where capital is gathered from numerous investors. The money is then invested in a variety of asset classes, including gold, debt, hybrid, and equity.
A mutual fund pools the funds of thousands of individuals who share the same investing goals. Expert fund managers oversee mutual funds. These fund managers make investment decisions on behalf of the investors and are specialists in the financial sector. They want a nominal fee in return, known as the expense ratio. Asset management companies (AMCs) appoint fund managers. Each investor in a mutual fund contributes to the cost of the investment. All investors share in both the gains and losses. Hence, “mutual” fund as a name.
How Do Mutual Funds Operate?
Subscribers to the mutual fund scheme are investors who wish to invest in the companies which are selected by the particular mutual fund house. The fund manager will rake in cash from tens of thousands of investors. He will next use this sum of money to make investments in line with the fund’s purpose.
The fund management does not buy a single stock with the full corpus. They diversifies or divides the acquired funds among various stocks. In this manner, a stock’s loss might be offset by its gain in another. The fund manager’s responsibility is to keep an eye on this portfolio and adjust it as needed.
All gains, losses, and expenses in a mutual fund are distributed equally among unitholders. Because of this, mutual funds are among the most affordable investment solutions available in India. Let’s use this straightforward example to explain how a mutual fund functions:
Let’s say you wanted to purchase a pizza. The pizza costs INR 100. But you only have around ten. Therefore, you and your nine pals agree to chip in INR 10 each to purchase the pizza. You all receive one slice of pizza each.In this illustration, pizza slices stand in for mutual fund units. You, along with your nine buddies, buy shares in a mutual fund scheme. The fund house is the pizza business. Mutual funds are given to investors in the same variety as pizzas. The fund’s Net Asset Value (NAV) is equal to the cost of one pizza slice. The market value of one mutual fund unit is known as NAV. The market value of your investment is determined by multiplying the total number of units by the NAV.
What Does The Fund Manager Do With The Funds?
Depending on the type of mutual fund scheme, the money raised is invested in several asset classes:
- Equity Mutual Funds
Stocks of numerous businesses are purchased with the combined funds. Equity mutual funds are risky and best suited for aggressive investors because their underlying assets, equities, are volatile.
Large cap funds, mid cap funds, and small cap funds are further categories for equity mutual funds. Top 100 stocks in terms of market-cap constitute the large-cap sector, large cap equity funds invest 80% of their corpus in large cap stocks. These securities are also referred to as blue chip stocks. Consequently, large-cap funds are sometimes referred to as blue-chip funds. Large-cap funds have minimal volatility because they invest in industry titans like Reliance Industries, HDFC Ltd., Infosys, etc.
Mutual funds for midcap companies buy stocks having a market value of between Rs 5,000 crore and Rs 20,000 crore. These companies fall between 101st and 250th in terms of market capitalization. Because these businesses are still in mid-cap segment they are relatively more risky than large-cap stocks. Investors with with optimal risk appetite should invest in mid-cap funds.
- Debt Mutual Funds
In this case, the combined funds are invested in fixed income securities like: Government agencies as well as businesses in the public and private sectors may issue these fixed income securities. More stable and less risky than stock mutual funds are debt funds. They are appropriate for conservative investors because they receive a fixed rate of return on their corpus. Commercial Papers Bonds Debentures Zero Coupon Bonds (CPs), Non-convertible debtentures and Certificates of Deposits (CDs) (NCDs), Treasury Bills, CBLO, and other money market securities, Indian government-issued sovereign documents
- Hybrid Mutual Funds
The combined funds in this case are invested in a mix of gold, bonds, and equities. The basic goal is to obtain stability through the debt or gold component and capital appreciation from the equity portion. as well as fixed income securities. For people new to investing in mutual funds, hybrid funds are ideal. They get a decent introduction to the stock markets from it. There are seven different types of hybrid mutual funds that vary in their gold, debt, and equity balances: The aggressive hybrid fund invests between 65% and 80% in equity securities and between 20% and 35% in debt obligations. The Conservative Hybrid Fund invests between 75% and 90% in debt and between 10% and 25% in stock. A fund with dynamic asset allocation adjusts its allocation in response to market prices. It can make 100% stock or 100% loan investments. Each asset class—equity, debt, and gold—receives a minimum 10% investment from the Multi Asset Allocation Fund. Balanced Hybrid Fund places a minimum of 40% of its money in equity and 60% in debt. Equity Savings Fund makes investments in debt, futures, and equity equities. The amount of equity shares the fund can purchase is 100%. Because they use futures contracts to hedge their cash position, arbitrage funds are a special kind of hybrid fund. This indicates that the fund essentially carries no risk.
Risk With Mutual Funds
Every investor considers safety while making an investment. We are investing our hard-earned money, after all. Mutual funds are commonly misunderstood in this sense. People often compare them to chit funds just because they contain the word “fund” in their name. However, you might be shocked to learn that mutual funds have excellent levels of security. The Securities and Exchange Board of India oversees the regulation of mutual funds in India (SEBI). The Association of Mutual Funds in India (AMFI) is another organisation that oversees and governs the mutual fund sector. The goal of SEBI is to protect the interests of regular investors. Therefore, you may rest assured that your money won’t disappear over night. The first mutual fund to be introduced in India was Unit Trust of India (UTI) in 1963. No mutual fund company has gone out of business with investors’ money in the previous 58 years. Mutual funds are heavily regulated and although their returns are not guaranteed, they should not be compared with speculative products like bitcoin etc.
Mutual Fund Returns
Now that you know what mutual funds are we will now define a few phrases that investors frequently use when investing in mutual funds. Did you know the basics of mutual fund investing. We’ll define a few common words related to one of the most crucial elements of investing in mutual funds in this blog post. Why do we make mutual fund investments? For almost all investors, the answer is very obvious: we want returns. You will encounter several return words if you read through various sorts of mutual fund literature, such as research websites, investing blogs, newspaper articles, factsheets, scheme information documents, etc. Let’s examine the definitions of each of these phrases.
- Absolute Return
The increase in your investment expressed in percentage terms is called an absolute return. An easy example will enable you to understand it. Consider making a Rs. 1 lakh investment in a mutual fund plan. The account statement that the AMC or registrant sends you will show you the value of your investment, which is Rs. 1.4 Lakhs after three years (e.g. CAMS or Karvy). You made a total profit of Rs 40,000. You received a 40% absolute return, expressed as a percentage. If your investment of Rs. 1 lakh increased to Rs. 1.4 lakh over the course of five years (rather than three), the absolute return would still be 40%.
Calculating absolute return is straightforward and uncomplicated. Only two values are required to assess this return on investment. They are the initial investment as well as the investment’s current value. The formula to calculate the absolute return is given below:
((Current value of the investment - Initial investment) / Initial investment) / Initial investment * 100 = Absolute return
Let’s use Ms. Vani Kumar as an investor who contributed INR 1,50,000 to a mutual fund as an example. The investment is currently worth INR 2,50,000. The formula above can be used to estimate Ms. Vani Kumar’s absolute return:
Absolute return is equal to (250000-150000)*100
Total return is 66.66%.
Ms. Kumar received a return on her mutual fund investment of 66.66%. However, this return does not account for how long the investment was made for. Ms. Kumar would have received this payment in five or fifteen years. This is not apparent from point-to-point returns. As a result, annualised returns are typically calculated by mutual funds for any period longer than a year.
- Annualized Return
The annualised return, as its name implies, gauges how much your investment increased in value every year. The fact that the effect of compounding is taken into account in annualised returns is crucial to keep in mind. Profits made on top of profits is compounding, to put it simply. Annualized returns equal 11.9% if you invest Rs 1 lakh in a mutual fund scheme and the value of your investment is Rs 1.4 lakh after 3 years. Due to the compounding effect, the annualised return of 11.9% is lower than the absolute return (40%) divided by the investment duration (3 years). Annualized returns are 7% if you put Rs 1 lakh in a mutual fund scheme and the value of your investment is Rs 1.4 lakh after 5 years.
- Total Return
The total return, which includes dividends and capital gains, is the actual rate of return on the investment. Assume you invested Rs 1 lakh at a NAV of Rs 20 in a mutual fund plan. Your purchase of the scheme amounts to 5,000 units (1 Lakh divided by 20). After a year, the scheme’s NAV is Rs 22. Your units will consequently be worth Rs. 1.1 lakhs after a year (22 X 5,000). You will have made a capital gain of Rs 10,000. Assume that the scheme distributed a dividend of Rs 2 per unit throughout the year. The AMC will pay you a total payout of Rs 10,000. (2 X 5,000). Your total return will be 10,000 rupees in capital gains plus 10,000 rupees in dividends, or 20,000 rupees. In percentage terms, the overall return will be 20%.
- Trailing Return
The annualised return over a specific trailing period that ends today is known as the trailing return. Let’s use an illustration to better grasp this. Assume a scheme’s NAV is Rs 100 as of today, March 10, 2017. On March 10, 2014, three years prior, the scheme’s NAV was Rs 60. The fund’s three-year trailing return is 18.6%. Let’s say the scheme’s NAV was Rs. 50 on March 10, 2012, five years ago. The fund’s five-year trailing return is 14.9%.
- Returns from Point to Point
Point-to-point returns, as the name implies, calculates the annualised returns between two points in time. For instance, you would look at point to point returns if you were curious in how a mutual fund scheme did over a specific time period, let’s say from 2012 to 2014. The start date and end date of a mutual fund scheme must be known in order to calculate point-to-point returns. You will first determine the scheme’s NAVs for the start and finish dates before figuring out the annualised returns.
- Yearly Return
The return given by a mutual fund scheme from January 1 (or the first business day of the year) to December 31 (or the last business day of the year) of any calendar year is known as the annual return. For instance, the annual return for the year will be 10% if the NAVs of a scheme on January 1 and December 31 are each Rs 100 and 110. The majority of mutual fund research portals, like our portal, display a scheme’s annual returns on the scheme details page. On the scheme details page of moneycontrol.com and advisorkhoj.com, annual returns are displayed. Annual returns can be found on the scheme information page of valueresearchonline.com and Morningstar.in under the performance sections. Mutual funds are market-linked investments, so their annual returns will be significantly impacted by the state of the markets in any given year. However, you may get a sense of the stability of fund performance by comparing annual returns across years in relation to the benchmark or fund category.
- Recurring Returns
When compared to the scheme benchmark (e.g., Nifty, BSE-100, BSE-200, BSE-500, CNX-500, BSE-Midcap, CNX-Midcap, etc.), rolling returns are the annualised returns of the scheme taken over a specified period (rolling returns period) and taken up until the last day of the duration (e.g. large cap funds, diversified equity funds, midcap funds, balanced funds etc). Rolling returns are typically displayed as a chart. A rolling returns chart compares the scheme’s annualised returns to the benchmark or category for each day after the start date of the rolling returns period.
Although not extensively employed in India, rolling returns are largely regarded as the finest way to evaluate a fund’s performance on a worldwide scale. Point to point returns are unique to the period under consideration, but trailing returns contain a recency bias (as previously explained) (and therefore, may not be relevant for the present time). On the other hand, rolling returns assesses the fund’s performance objectively and consistently over all timescales. The best instrument for understanding performance consistency and fund manager performance is rolling return.
- Returns SIP / XIRR
All of the return metrics we’ve spoken about so far are for one-time or lump sum investments. Because you are simply calculating the increase in investment value between two periods in time, lump sum investment returns are relatively simpler to measure (in the case of total returns, dividends, if any, also need to be factored). The systematic investment plan (SIP) represents a number of cash flows, making it more difficult to calculate returns for SIPs. The Internal Rate of Return is a financial metric used to determine the returns from a sequence of cash flows (e.g., SIP, SWP, STP, etc). (IRR). The IRR formula is not the subject of this post. A variant of IRR known as XIRR (in Excel) is used to calculate SIP returns if cash flows do not occur at precise regular intervals.
Conclusion
Absolute return is not a good indicator of how a mutual fund has performed relative to other similarly situated financial products. Other returns explained above are better indicators of actual growth in your investment.
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