10 Important Key Terms You Must Know Before Investing In Mutual Funds

Mutual funds are an attractive investment option, where you have the flexibility to invest in different types of funds and assets of your choice, including equities, debt, or gold. AMCs provide professional management through expert fund managers and allow the investor to build a strong corpus to meet their financial goals.  Let us try to understand a few important key terms you must know before investing in Mutual Funds.

1. The Association of Mutual Funds in India 

AMFI is dedicated to developing the Indian Mutual Fund Industry on professional, healthy and ethical lines and to enhance and maintain standards in all areas to protect and promote the interests of mutual funds and their unitholders.

AMFI, the association of all the Asset Management Companies of SEBI registered mutual funds in India, was incorporated on August 22, 1995, as a non-profit organization. As of now, 45 Asset Management Companies that are registered with SEBI, are its members. 

Some of the objectives are,

2.Assets Under Management (AUM) 

Assets Under Management (AUM) is the total market value of the investments (assets) that an asset management company is managing, on behalf of its investors.

3.Asset Management Company or Fund House

Asset Management Company (AMC) is the institution that works as Investment Manager of the Mutual Fund that manages the pool of investor money on behalf of the investors. An AMC carries out all purchase and sale of securities in the portfolio of various Mutual Fund schemes launched by the Mutual Fund.

Fund house is just another name for an Asset Management Company (AMC). Fund house is used more commonly by people when they are referring to an AMC and can be used interchangeably. 

4.Benchmark 

Mutual Fund performance should never be viewed in isolation. The performance of a Mutual Fund or any investment should be evaluated against a standard known as the benchmark. 

The benchmark for a fund is selected at the time the fund is launched and the selection of the benchmark is based on the investment objective of the fund. This benchmark, comprising of either stock, bonds, money market instruments, or other securities, indicates the kind of investment choices the fund will make as part of its stated investment objective. Hence, you as an investor can expect the scheme to perform better than its benchmark over a given time frame.

Investors would have no measure to compare the performance of different funds, that have different investment objectives, and follow different investment strategies. Thus, a benchmark helps bring in standardization in the comparison of the performance of different funds, following the same benchmark or in evaluating how a fund has performed against its own benchmark.

5.Compound Annual Growth Rate(CAGR) & Extended Internal Rate of Return (XIRR)

CAGR is the most common mutual fund return measure used when a fund’s performance is discussed.

CAGR is a representation of the compounded growth of your mutual fund investments. It shows the fund’s average annual growth or decline over a particular period of time.

Let’s check the below example,

CAGR = [(Ending Value/Beginning Value) ^ (1/N)]-1

e.g., the initial value of your investment is Rs 10,000, and the final value is Rs 25,000 in three years (N= 5 years). CAGR is calculated as:

CAGR = [(25,000/10,000)^(1/5)] – 1

CAGR = 20.11%.

CAGR can be a good measure for lumpsum purchases in Mutual Funds, but where there are different cash inflows and cash outflows, like in SIPs, CAGR is may not be the right measure.

That is because each installment in a SIP is a new investment, and therefore you have amounts invested for different time duration. For example, in a 3-year SIP, your first installment will be invested for 3 years, second for 2 years 11 months, and so on. What it translates into is that each amount compounds for a different period. In XIRR, the CAGR of each installment is calculated, and then they are added together to give you the overall CAGR.

6.Close-Ended Schemes & Open-ended schemes

Close-Ended Mutual Fund schemes are open for investing only during the NFO (New Fund Offer) period.

Neither can new investors enter a close-ended scheme nor can existing investors exit the scheme until its maturity. However, for providing interim liquidity to investors, the scheme is listed on a stock exchange post-NFO where its units can be traded. The units may sell at a premium or discount price to the NAV of the fund depending on market conditions, the investor's expectations of the future performance of the fund, and demand and supply of units of the fund.

On the other hand, open-ended schemes are open for investing & redeeming invested amounts throughout its life.

7.Growth, Dividend Payout & Dividend Reinvest

Mutual Fund schemes have three options to grow your money, namely 'growth', dividend reinvest', and 'dividend payout'. Investors can choose different options depending on their financial requirements. 

The objective of a Growth Option is the long-term growth of capital. In a growth option, all gains made by the Mutual fund are reinvested into the scheme. This increases the NAV of the scheme since the profit is retained by the scheme instead of being distributed to the investors. When the fund makes a profit, the NAV of the scheme increases and vice-versa.

The only way an investor in a growth plan can realize a profit is to sell his/her investment in the scheme. The return in a growth plan is calculated by taking the difference in NAV on the purchase date & sale date as there are no intermediate payments like dividends, interests, gains, bonuses, etc.

A growth option investor generally gets higher capital gains at the time of redemption as compared to an investor who has opted for the dividend option. A growth plan is suitable for those who are looking for the growth of their capital over the long term and don’t look forward to intermediate payouts from the fund.

In the case of the Dividend Payout option, you receive any dividend declared by the companies included in the portfolio of your scheme. Within the dividend option, you can either choose to receive the dividend payouts or reinvest the declared dividend back into the scheme. 

Dividend Payout options lets you receive any profit/surplus declared by the Mutual Fund scheme during the time you remain invested in the scheme. 

A Mutual Fund scheme invests in different types of securities like stocks, bonds, gold, and even international securities. Some of these securities pay dividends while others may pay interest and some others may pay bonuses. The profits/surplus made by the scheme can be distributed among the scheme’s investors at the discretion of the fund managers. In the case of the dividend payout option, you will receive the profits made by the scheme whenever the fund manager decides to distribute this profit among investors. The NAV of a dividend scheme falls to the extent of dividend declared on the ex-dividend date i.e. the next business day after the dividend has been declared.

In the case of the 'Dividend Reinvestment option', you can reinvest the dividend made by the scheme during the intermediate period back into the scheme. If a fund manager does decide to distribute the profits, the declared profits in the form of dividends are not paid to investors when they opt for the dividend reinvest option but are rather reinvested in buying more units of the fund. Unlike a growth option where the value or NAV of your holding grows, here the number of units held by you grows since the dividend amount is used to buy more units of the scheme.

8.Expense Ratio 

A Mutual Fund has some operational costs while running its business. As per SEBI guidelines, certain expenses that are incurred by the Mutual Fund in managing a scheme must be attributed to the scheme only. For instance, an AMC must pay a salary to the fund manager & his team of the Mutual Fund scheme, the Mutual Fund distributors' commission, marketing expenses for promoting the scheme to investors. As per the SEBI guideline on expenses, all such expenses for managing and operating the specific scheme must be allocated to the scheme.

A Mutual Fund scheme invests the pool of investor money in certain securities of the Portfolio. The value of this portfolio is the value of securities held by the scheme. On the other hand, the scheme has certain operational expenses as explained above. Apart from the expenses listed above, the scheme also attracts transaction costs while buying and selling securities in its portfolio regularly. All these costs together account for the total expense of the Mutual Fund scheme.

To ensure that Mutual Funds don’t overspend to manage their schemes, SEBI has set guidelines for what the expense ratio of a scheme can be. The expense ratio is the percentage of the scheme’s assets that are used up in managing and operating the scheme. All the expenses we spoke about earlier are paid for by the scheme’s assets. SEBI has set limits for the expense ratio for each type of Mutual Fund, so that fund houses are cautious in their spending. As per an order issued by SEBI on September 18, 2018, Mutual Funds are allowed to charge a Total Expense Ratio (TER) that is linked to their type of fund and Assets Under Management (AUM). Generally, it decreases as AUM increases.

9.Exit Load 

Some Mutual Fund schemes charge an exit load on redemptions or cancellations within a stipulated time period.

Exit Load is like a fine for premature redemptions because it is meant to discourage investors from selling their Mutual Fund investments too soon. Mutual Fund investments are meant for the long-term. Since Mutual Funds are subject to market fluctuations, they are best suited for medium to long-term goals. Hence, most Mutual Fund schemes charge an exit load if investors sell their investment within the specified period.

Exit load is charged as a percentage and is applied to the redemption amount. If the exit load is 1% then you’ll receive 99% of your redemption amount if you sell your investment before the stipulated period. Exit load as a percentage is applied on the NAV applicable to your redemption. If the NAV at the time of redemption is 1000, you will receive only 990 for each unit of Mutual Fund investment you decide to redeem.

10.Mutual Fund units 

Mutual Fund Units are in a way like shares of a company that trades in the market and represent the extent of ownership you have in the Mutual Fund as an investor. As you know, Mutual Funds are investment vehicles that invest in different securities across asset classes like equity, debt, international securities, gold, etc. The amount of money you invest in a Mutual fund decides the number of units of the fund you would be allotted. If an investor invests 1,0000 in a scheme and the NAV for that day is 100, the investor will be allotted 100 units of the scheme (= Amount invested/Applicable NAV). These 100 units represent the investor’s extent of ownership in the Mutual Fund scheme.

These units can be expressed need not always be whole numbers, sometimes it can be in decimal as well.  

The current NAV of a scheme represents the cost of one unit of that scheme. NAV can be calculated as,

NAV = (Assets of the fund-Liabilities of the fund)/Number of outstanding units of the fund.

The value of your holding in a Mutual Fund can be calculated as the number of units of the scheme held by you multiplied by the current NAV of the scheme.

Hope you must have understood some of the key terms which will help you understand mutual funds better.