📘 8.1 Introduction to Mutual Funds
📌 Definition
A mutual fund is an investment vehicle where investors pool their money together to invest in a diversified portfolio of securities. This enables individual investors to participate in the securities market and invest in a range of instruments such as equity shares, bonds, and other financial instruments.
💡 Collective Investment Vehicle
📈 Investment Objectives
Each mutual fund has a defined investment objective that outlines how the pooled money will be invested and how the portfolio will be constructed. Investors choose a fund based on their investment goals and risk appetite.
📉 Mutual Fund Example
For example, an equity fund may focus on long-term growth by investing in equity shares, while a liquid fund may aim for high liquidity with short-term investments in money market instruments.
📊 Proportionate Share of Benefits
📈 Contribution and Share
When multiple investors contribute to a mutual fund, they receive units of the fund. The value of these units depends on the performance of the underlying investments. The benefits from the mutual fund’s performance are shared proportionally among the investors based on their investment size.
💸 Example of Proportionate Share
If three investors invest ₹10,000, ₹20,000, and ₹30,000 respectively in a mutual fund, the total pooled amount is ₹60,000. If the value of the fund increases by ₹12,000, the investor’s returns are proportionate to their share in the fund, i.e., ₹12,000, ₹24,000, and ₹36,000 for the three investors respectively.
📅 Units of a Mutual Fund
💡 What Are Units?
When investors subscribe to a mutual fund, they purchase units in the fund. The units represent their share in the total portfolio of the fund. The number of units an investor receives is based on the amount invested and the price of the unit at the time of purchase.
🧮 Unit Calculation Example
If the price of one unit is ₹10, and an investor invests ₹20,000, they would receive 2,000 units (₹20,000 / ₹10 per unit). The total value of the units will change based on the fund’s performance.
📋 Unit Capital of a Mutual Fund Scheme
Unit capital refers to the total value of the fund, calculated by multiplying the number of units outstanding by the face value of the unit. For example, if a fund has issued 10,000 units at a face value of ₹10 each, the unit capital of the fund is ₹1,00,000.
💡 Example of Unit Capital
If the value of a unit increases to ₹10.225, and an investor invests ₹20,000, they would receive approximately 1,955.99 units (₹20,000 / ₹10.225). This shows that the units can also be fractional, depending on the price per unit.
📘 8.2 Advantages of Mutual Funds
📌 Definition
Mutual funds offer a range of advantages to investors, such as portfolio diversification, professional management, low transaction costs, and ease of access. These benefits make mutual funds a popular investment option among individuals with varying investment needs and risk appetites.
💡 Key Advantages of Mutual Funds
📊 Portfolio Diversification
Mutual funds provide portfolio diversification by investing in a variety of securities across different companies, industries, and sectors. This helps reduce the risk of the portfolio being adversely affected by the poor performance of any one security.
💰 Low Transaction Costs
Since mutual funds pool money from many investors, they benefit from economies of scale, which lowers the transaction costs for each investor. Smaller individual investments can thus enjoy the benefits of large-scale investing.
📉 Professional Management
🎓 Expert Fund Managers
Mutual funds are managed by professional fund managers with expertise in market analysis and securities management. These managers make investment decisions based on their market knowledge and the stated investment objective of the fund.
🔍 Risk Reduction
Portfolio diversification and professional management work together to reduce the risk for investors. Instead of investing in a single stock or sector, mutual funds invest across various asset classes, minimizing the impact of market volatility.
💡 Flexibility and Low Minimum Investment
📝 Flexible Transactions
Mutual fund transactions are easy to conduct, and investors can purchase or redeem units at any time, depending on the fund’s structure. Open-ended funds offer flexibility for investors to enter and exit as per their needs.
💸 Low Minimum Investment
Most mutual funds have a low minimum investment requirement, making them accessible to small investors. This provides an opportunity for individuals to invest in diversified portfolios without a large capital outlay.
📅 Liquidity in Mutual Funds
📈 Open-ended Funds
Open-ended mutual funds offer liquidity by allowing investors to buy additional units or redeem existing units directly from the fund at any time, based on the NAV (Net Asset Value) of the fund.
🔒 Close-ended Funds
Close-ended funds have fixed units and are listed on stock exchanges. Liquidity is provided by the ability to buy or sell units on the exchange at market prices, driven by demand and supply.
📋 Example:
For instance, an equity mutual fund aims to generate long-term growth by investing in a diversified portfolio of stocks. An investor, looking for equity exposure, can invest in this mutual fund to benefit from potential capital appreciation while diversifying their risk across multiple stocks.
📘 8.3 Open Ended and Close Ended Mutual Funds
📌 Definition
Mutual funds can be structured in two main ways: open-ended and close-ended. These structures determine how units are issued, traded, and how investors can enter or exit the fund. Open-ended funds allow for continuous transactions, while close-ended funds are fixed and listed on stock exchanges.
💡 Key Differences: Open-ended vs. Close-ended Mutual Funds
📈 Open-ended Mutual Funds
In an open-ended mutual fund, the number of units is variable, changing daily based on investor purchases and redemptions. The units can be bought or sold directly from the fund at the prevailing NAV (Net Asset Value).
📉 Close-ended Mutual Funds
In a close-ended fund, the number of units is fixed post NFO (New Fund Offer). Investors can buy and sell units only on stock exchanges after the NFO, based on market prices, not directly from the fund.
📊 Comparison Between Open-ended and Close-ended Funds
📑 Open-ended Funds
- Unit Capital: Changes regularly
- Number of Outstanding Units: Varies based on purchases and redemptions
- Liquidity: Highly liquid, as investors can enter or exit the fund at any time
- Transactions: Direct purchase and redemption from/to the fund at NAV prices
📑 Close-ended Funds
- Unit Capital: Fixed for the life of the fund
- Number of Outstanding Units: Fixed post NFO
- Liquidity: Liquidity is provided by listing on the stock exchange
- Transactions: Units bought or sold on stock exchanges based on market prices
📘 8.4 Assets under Management (AUM)
📌 Definition
Assets under Management (AUM) refers to the total market value of the securities in a mutual fund’s portfolio. AUM is used to track the size and growth of a mutual fund, and it changes with the performance of the underlying assets and inflows/outflows from investors.
💡 AUM Calculation
A mutual fund’s AUM is calculated by adding the total market value of all its holdings. The value of the portfolio changes based on market conditions, which in turn affects the AUM.
📉 Example of AUM Calculation
Example: Suppose a mutual fund holds 1,000 shares of Company A priced at ₹2,500 per share, and 2,000 shares of Company B priced at ₹50. The total value of the portfolio on Day 1 is ₹25,00,000 (A) + ₹1,00,000 (B) = ₹26,00,000. On Day 2, if the prices of the shares change to ₹2,700 and ₹53 respectively, the total value of the portfolio becomes ₹27,00,000 (A) + ₹1,06,000 (B) = ₹28,06,000, increasing the AUM.
📋 NAV (Net Asset Value) and AUM
As the market prices of securities change, the AUM of the fund also changes. The NAV (Net Asset Value) per unit reflects the current value of one unit of the mutual fund. NAV is calculated by dividing the total AUM by the total number of units outstanding. For example, if the AUM is ₹28,06,000 and there are 2,800 units outstanding, the NAV per unit would be ₹10.00.
💡 Example of NAV Calculation
If the total AUM of a fund is ₹28,06,000 and there are 4,750,000 units outstanding, the NAV per unit is ₹5.91. This allows investors to track the performance and value of their holdings in the mutual fund.
📘 8.5 Total Expense Ratio
📌 Definition
Total Expense Ratio (TER) represents the percentage of the mutual fund’s assets that are used for operating expenses. These expenses are charged to the fund on a daily accrual basis and are reflected in the fund’s Net Asset Value (NAV).
💡 TER Calculation
🔢 Daily Accrual
TER is calculated as a percentage of the fund’s Assets Under Management (AUM). If the TER is 2%, it will be divided by 365 to calculate the daily accrual. This amount is deducted from the AUM daily.
📉 TER Limits
SEBI has set limits on the TER, with higher limits allowed for smaller AUMs, and a reduction in TER as the AUM increases. For example, for equity funds, the TER starts at 2.25% and reduces to 1.05% as the AUM grows.
📋 TER for Different Fund Types
📊 Fund of Funds (FoF)
- Liquid/Index/ETFs: TER limit of 1.00%
- Equity-oriented schemes: TER limit of 2.25%
- Other schemes: TER limit of 2.00%
📑 Index and Exchange-Traded Funds
For index funds and ETFs, the TER is capped at 1.00% of the daily net assets, which includes the investment and advisory fees.
📊 TER Applicability for Direct and Regular Plans
Direct plans of mutual funds have lower TER as they don’t involve distributor commissions, whereas regular plans involve additional costs for commissions. SEBI mandates separate disclosure for TER in direct and regular plans.
💡 Example:
If a mutual fund with ₹100 crores in AUM charges a 2% TER, ₹2 crore would be deducted from the AUM each year. If the AUM increases, the TER percentage reduces, benefiting investors with higher AUMs.
📘 8.6 Open Ended and Close Ended Mutual Funds
📌 Definition
Mutual funds can be classified as open-ended or close-ended, which determines how units are bought, sold, and redeemed. Open-ended funds allow constant transactions, whereas close-ended funds have a fixed number of units that are traded on stock exchanges.
💡 Key Differences: Open-ended vs. Close-ended Mutual Funds
📈 Open-ended Mutual Funds
In open-ended funds, the number of units changes based on daily purchases and redemptions. The fund remains highly liquid as investors can buy or sell units at any time at the NAV price.
📉 Close-ended Mutual Funds
Close-ended funds have a fixed number of units. After the initial offer, units can only be bought and sold on stock exchanges at market prices, not directly from the fund.
📋 Comparison Between Open-ended and Close-ended Funds
📑 Open-ended Funds
- Unit Capital: Changes regularly
- Ongoing Transactions: Allowed directly from/to the fund
- Liquidity: High liquidity with entry and exit allowed at any time
📑 Close-ended Funds
- Unit Capital: Fixed for the life of the fund
- Ongoing Transactions: Allowed only on stock exchanges
- Liquidity: Liquidity is ensured by listing on stock exchanges
💡 Example:
An open-ended mutual fund allows an investor to buy or sell units at the NAV at any time, whereas a closed-ended fund requires the investor to buy or sell units on the stock exchange, based on market conditions.
📘 8.6 Net Assets
📌 Definition
Net assets represent the net value of a mutual fund portfolio after deducting expenses. The net asset value (NAV) is calculated by dividing the total net assets of the fund by the number of outstanding units.
💡 NAV Calculation
📈 NAV Formula
The formula to calculate NAV is:
NAV = (Total Assets – Liabilities) / Number of Units Outstanding
💰 NAV Representation
Mutual funds declare the NAV of all their schemes on a daily basis. The NAV is calculated up to two decimal places for equity-oriented funds and up to four decimal places for debt, liquid, and money market funds.
📋 Assets and Liabilities in a Mutual Fund Portfolio
📊 Total Assets
Total assets refer to the market value of the mutual fund portfolio, including receivables and accrued income, which are considered current assets. This sum is updated daily based on market movements.
📉 Liabilities
Liabilities include current payables, expenses associated with managing the fund portfolio, and short-term deposits made for redemption purposes. Liabilities are subtracted from the total assets to determine the net assets of the fund.
📈 NAV Example
Example 7: A fund’s portfolio has a market value of ₹700 crore, and its current liabilities are ₹5 crore. The net assets of the fund are calculated as:
Net Assets = ₹700 crore – ₹5 crore = ₹695 crore
💡 Unit Capital and NAV
Example 8: If the net assets of a fund are ₹750 crore and the unit capital (face value ₹10) is ₹250 crore, the NAV is calculated as:
Number of Units = ₹250 crore / ₹10 = 25 crore units
NAV = ₹750 crore / 25 crore units = ₹30 per unit
💰 NAV and Net Assets Example
Example 9: If the NAV of a fund is ₹15 and the number of units is 100 crore, the total net assets are calculated as:
Net Assets = ₹15 x 100 crore = ₹1,500 crore
