A few decades ago, if you were a salaried person your go-to investment options included bank recurring or fixed deposits and government-backed savings schemes like the Kisan Vikas Patra or Indira Vikas Patra. Some others would put their money in real estate or gold. Fast forward to today and mutual funds are the top draw among nearly everyone — from pensioners to newly-minted professionals drawing their first salary.
Just how popular mutual funds are can be gauged from their average assets under management, which has risen nearly four-fold over the last decade to over Rs 36 lakh crore as on August 2021, according to data from the Association for Mutual Funds in India. And that’s a remarkable transition for an investment class that, not long ago, used to be viewed with skepticism and distrust for being linked to market volatility and alleged scandals.
How the Indian mutual fund industry has come this far
You may wonder, how despite India having its fair share of market scandals, from the infamous Harshad Mehta scam in 1992 to many more in the subsequent years has the mutual fund industry been doing so well today? Two primary reasons have led to this change.
- The stock market regulator, Securities and Exchange Board of India (SEBI), has taken a proactive role ever since and framed extensive guidelines to prevent similar scandals from occurring in the future.
- A very high degree of professionalism has developed in this industry over the decades. Mutual funds today are managed by professionals who pool money from hundreds of thousands of investors and invest them in financial instruments or securities (that are tradeable assets like stocks, bonds, debentures, futures or treasury bills).
Since the performance of a mutual fund depends on the selection and proportion of different assets, there’s great significance in the way the portfolio of funds is structured. The mutual fund regulators, AMFI, and SEBI leave nothing to chance in this regard and have framed very specific regulations that the funds must comply with.
The guidelines, for instance, specify that a large-cap fund must invest only in stocks and other securities of large-cap companies or the largest 100 companies in terms of market value. That includes companies like the billionaire Mukesh Ambani’s Reliance Industries Ltd., India’s largest software firm Tata Consultancy Services Ltd., the consumer goods giant Hindustan Unilever Ltd., HDFC Bank Ltd. or Bharti Airtel Ltd. Gilt funds invest only in gilts, or government-backed securities.
This also leads to mutual funds not getting diversified adequately and being dependent on a few stocks. Fluctuations in these stocks can affect the returns of mutual funds. Read Appreciate blog to understand more.
Mutual fund terms you must know
- Net Asset Value
If you’re new to investing in mutual funds, the first term you would need to know is net asset value, often abbreviated as NAV. If one were to use an example from science, NAV represents the monetary value of the “atom” of a mutual fund — its smallest and indivisible part.
In other words. just as matter is made up of atoms and listed companies of shares, mutual funds are aggregations of units. When you, the retail investor, invest in a mutual fund, you get units in return. This unit has a value, which keeps varying regularly. Remember, mutual funds invest in stocks, bonds and other financial instruments that are subject to fluctuations.
That value, or the price per unit of the fund that’s available to investors, can be calculated using a mathematical formula.
NAV = Market value of all units of a mutual fund/ Number of units
Since we made a comparison with shares of companies, here’s a fun fact. The same formula can be used to calculate the price of a share, by substituting the market value of all units of a fund with the market capitalisation of a company and the number of units with the number of shares.
- Entry and exit loads
Mutual funds take your money, invest them in the markets or other financial instruments and generate returns for you. For doing so, the fund houses charge you a token fee. These charges can include entry and exit loads, among others.
As their names indicate, entry and exit loads are charged at the time of making investments or while withdrawing them. The SEBI mandated in 2009 that fund houses can’t impose entry loads on investors. Exit load, however, is charged if investors make an exit or redeem their units ahead of a specified time period. This charge is a nominal amount not exceeding 1-2% of the transaction amount and varies from one fund house to another.
Other fees that mutual fund investors need to pay include a one-time transaction charge. This amount, too, varies between fund houses and is dependent on the quantum of investment.
The role of mutual funds in your portfolio
You can invest in mutual funds easily by either the online or offline method. The traditional method, or offline method, involves investing through brokers or distributors of the fund houses. If you’re more tech-savvy, you could open an online Demat account and invest in such schemes via systematic investment plans. Mutual funds are investment plans that help millions of Indians achieve their long-term financial goals by helping smoothen the fluctuations in stock markets in the short term. So, one of the major roles of mutual funds in your investment portfolio is diversification to hedge risk. Yet, there are equally good reasons why investors must avoid them. Examine those in our other blog posts.