Decoding Mutual Fund jargons to help you make informed decisions
Though there is a growing awareness among potential investors about mutual funds, they often find it difficult to understand jargons that are widely used by financial experts. Knowing frequently-used terminologies in mutual funds will help first-time investors understand how mutual funds work and also guide them in investing across asset classes, according to their financial goals.
Financial literacy is crucial and it plays a key role in attracting investments. First-time investor Shanthi Sampath says she listens to financial advisors but it takes time to understand certain jargons. “Though I want to invest on my own I need to spend a lot of time understanding terminologies such as Net Asset Value, Indexation and so on. Sometimes, I restrain myself from investing since I can’t understand the true meaning,” she said.
Here we are decoding mutual fund jargons that will help investors get a clear insight and make informed decisions.
Net Asset Value (NAV)
NAV is most widely used in mutual funds and investors need to understand the meaning of NAV. Ashish Goel, Founder and CEO of Vista Wealth Consultants, explains, “Mutual fund houses invest on behalf of investors. It can be either in equity or debt funds. This NAV is calculated with assets - the total net assets. Total net assets of a fund divided by the total number of outstanding units is NAV.”
When a new scheme is launched, usually, the NAV is fixed at ₹10. For instance, if one invests ₹1 lakh and NAV is 10, that person would receive 10,000 units, as 1, 00,000%10=10,000. The value changes everyday based on the market movements.
Also, investors need to understand that the market price of a share is different from the net asset value.
Open-ended and closed-ended schemes
Goel says that an open-ended scheme or fund is always available for repurchase and investors can redeem according to their preference, but in the case of a closed-ended scheme, new investors can’t enter and even the existing investors can’t repurchase. The time frame will be fixed in the case of a closed-ended scheme.
Investors’ outstanding units will never change in the closed-ended scheme.
Growth Plan and Dividend Plan
In mutual fund schemes, there are two options to withdraw earnings. Zebu Share and Wealth Management Founder and CEO V Viayakumar says, “When profits are distributed by funds, it is called Dividend Option. Here, the fund regularly pays out dividends. This option is highly suitable for people who look for periodic income from their investments. In this option, dividend income attracts TDS of 10% if it is more than ₹5,000. When earned profits are reinvested into the fund for additional returns, it is called Growth Option or Growth Plan.”
In this case, income earned will attract 10% of Long term capital gains (LTCG) tax, if income is more than ₹1, 00,000.
Mutual fund dividends are always calculated on the face value of the schemes.
For instance, if a fund’s NAV is 35.20 of face value ₹10 and you are holding100 units. If the fund declares a 20% dividend, it means the investor will receive ₹2 per unit that is ₹200. Now, NAV becomes 33.20.
In the case of a growth option, the dividend amount would be reinvested into stocks and will increase the value of NAV. In this case, investors will not receive additional shares, rather it will increase the value of the NAV, explains Viayakumar.
Types of Equity Funds
Before investing in mutual funds, investors need to understand various types of equity funds such as Large-cap, Mid-cap funds, small-cap funds and Thematic funds.
According to Securities and Exchange Board of India (SEBI’s) mandate, large-cap funds should invest at least 80% of assets in large-cap stocks; mid-cap funds should invest minimum 65% of assets in mid-cap stocks.
Large-cap funds can offer stable returns as they are quite well-known companies; whereas mid-cap equity funds invest in medium-sized firms. In the case of Mid-and-small-cap funds, these funds invest in both mid-cap and small-cap funds and it is said to have the potential to offer high returns.
There are also Multi-cap funds which can invest across market cap segments and industry sectors. In this fund, there are no minimum or maximum limits.
Apart from these, there are also Sector and Thematic funds. As the name suggests, Sector funds focus on particular sectors such as Information Technology, Real Estate and so on; and Thematic funds are tied to certain theme and invest across different sectors.
Asset Management Company (AMC)
AMC is the one that manages mutual fund schemes. It invests pooled funds collected from clients into a variety of assets. Investors should pick their AMCs wisely as they are the ones who will be managing your hard-earned money.
Systematic Investment Plan (SIP), Systematic Transfer Plan (STP) and Systematic Withdrawal Plan (SWP)
SIP is commonly used in mutual funds, as it allows investors to invest smaller amounts regularly in a particular fund or scheme. This fixed amount can start from ₹500 and investors need not worry about the market dynamics and they benefit in long-term due to average costing. It also gives investors the compounding effect. Also, investors can stop the SIP for a few months and restart the SIP, if there is any shortage of money.
STP is a term that investors might not be familiar with. In the case of SIP, every investor knows that a certain amount is transferred from one’s savings account to a MF plan, in an STP, investors can transfer their money from one plan to another mutual fund plan.
For instance, if an investor starts an SIP at the age of 30, keeping retirement planning in mind, he/she can start an STP, at 45 or 50 years, and ask the fund house to transfer a certain amount from the equity to a debt fund, to prevent loss, if any. Your financial advisor will help you if you want to transfer funds to a less-risky asset class.
SWP, as the name suggests, one can withdraw a certain amount from a mutual fund scheme regularly. Investors can choose the amount and also frequency according to their needs. This will give one a regular source of income.
Financial expert Goel says indexation is adjustment of inflation. Over a period of time, an asset can be inflated and we consider inflation to calculate its current price.
For instance, if someone has invested in a debt fund ₹1,00,000 and after three years, it becomes ₹1,25,000. The profit realized is ₹25,000. Government notifies Cost Inflation Index (CII) and after considering inflation - 4%, 5% and 6% for three years, cumulatively 15%. So, ₹15,000 is tax free and one needs to pay tax for ₹10,000, explains Goel.
The above terminologies help investors not just make the right choice but the right investment decision. Financial experts say that investors need to understand mutual fund jargons so that they will understand what is happening to their funds and when to switch and redeem funds.
This article is part of the HT Friday Finance series published in association with Aditya Birla Sun Life Mutual Fund.
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