In this guide, CA Twinkle Jain explains the fundamentals of mutual funds and ETFs. You will learn about the different types of mutual funds and how to pick the best mutual fund based on your risk and return profile. We also discuss different types of ETFs and parameters to look at while selecting the ETF.
Preview – What to Expect
Before we dive in, let’s take a peek into what we will be covering. After this guide, you will be able to:
- Understand the important jargon used in Mutual Funds
- Know the different types of Mutual Funds
- Learn about the features of Index Tracking Funds
- Evaluate the performance of Mutual Funds
- Know the factors to consider before purchasing Mutual Funds
- Invest in mutual funds using different methods
- Understand taxation on Mutual Funds
- Learn about ETFs and different types of ETFs
Learn from the instructor herself, get the comprehensive course here.
Basics of Mutual Funds
Introduction to Mutual Funds
In 1963, the Government of India set up the first Mutual Fund of India called the Unit Trust of India (UTI) to enable people to invest in the stock market without any knowledge of the same. In 1987, the public sector players also entered into the market. It expanded the horizon of mutual funds in India encouraging people to invest. By 1993, private players entered the market. In the same year, all the mutual funds started to be governed by SEBI to protect the interests of the investors.
Today, the Asset Under Management (AUM) of all the Mutual funds combined is a whopping INR 46.63 lakh crores as of August 2023. A Mutual Fund is an instrument of pulling resources from the investors by giving units in return. These resources are then used to invest in Equity Mutual Fund, Debt Mutual Fund, or Hybrid Mutual Fund as per the objectives of the fund.
Understanding how a mutual fund is built
Let’s understand this with an example of a pizza containing 8 slices. Each of the slices has different toppings. Each slice depicts a mutual fund and the toppings on it are the different securities in which the mutual fund invests. The taste and flavor of each slice of pizza are different, just like every mutual fund is unique in its way.
SEBI defines mutual funds as a mechanism of pulling resources as people like you and me pull in resources to invest in securities in return for a small share in the slice of the pizza. As mutual fund invests in various securities, it gives diversification benefits to the investors. One can start with as small as INR 100 in some mutual funds.
Let me depict the process of a mutual fund.
Investors like you and me invest in mutual funds and generate a pool of resources. Managers then use these resources to buy and sell securities based on their research. They distribute the returns generated by the fund among the investors based on the units held by them.
Stakeholders involved in a mutual fund:
- Sponsor: At the top, there is a sponsor who establishes the mutual fund. They mainly approach the SEBI for the registration of the mutual fund and provide the funding. For eg, Tata Mutual Fund was sponsored by Tata Sons Ltd. and Tata Investment Corporation
- Trustee: He is responsible for protecting the interests of the investors. They check the activities of the fund and make sure that they are in line with the SEBI regulations. For eg: The trustee of Tata Mutual Fund is Tata Trustee Company Private Limited.
- Asset Management Company: It is mainly responsible for managing the investors’ money. They make decisions of the day-to-day activities like investment, purchase, sales, computing net asset value, etc.
- Custodian: It holds and maintains the securities of the fund.
- Distributor and agents: They act as an intermediary between the mutual fund and investor and charge a commission for the same.
- Registrar and transfer agent: They maintain all the investor records which include purchase and redemption, transfers, etc.
- SEBI: It formulates the policy and regulates the mutual fund. It also issues guidelines to protect the interests of the investors.
Important jargon to understand the mutual fund – I:
Say you have a frankie worth INR 100 and you divide it into 4 equal parts. Now, each part is worth INR 25. Similarly, if the mutual fund is divided into several units then the price of each is called NAV (net asset value). The total value of the fund i.e. INR 100 is called the AUM (Asset Under Management).
Say, there is a mutual fund called ABC 50 MF. It has an AUM of INR 1 Lakh collected from 100 investors who have given INR 1,000 each. It issues a NAV of INR 10, then each investor receives 100 units. As the name suggests, the mutual fund will invest the AUM in 50 companies.
Let’s assume that the mutual fund is investing equally in all stocks, then the will invest INR 2,000 in each stock. Funds will also keep some cash balance with them. The stock prices do tend to change. Say, they increase in 3 months and the current value of AUM is INR 1.2 Lakh. (Note – No new investor has been added and there is no change in stock composition.) As a result, the NAV of each unit becomes INR 12. So the investment of investors has grown to INR 1.2 lakhs giving a profit of INR 20,000 or a 20% return.
Changes in NAV
Now, there could be some investors who would like to redeem their money for some personal use. Fund managers can use the cash balance to deal with such requests. If the extra cash is not enough they may sell some stocks to pay back the investors. Say the investor redeems 1000 units, which reduces AUM to INR 1.08 Lakhs. INR 1.08 Lakhs divided by 9000 units gives NAV of INR 12. If the stock price falls to say INR 1 Lakh then the NAV will also fall as 1,00,000/900=11.1. If there’s a new investor who wants to invest 1 lakh then he will get 1,00,000/11.1 = 9,009 units.
NAV = (Total Assets – Total Liabilities) / Total no. of units
Total assets = value of securities at the end of the day + cash & cash equivalents + Accrued income
Total liabilities = short-term liabilities + long term liabilities + accrued expenses
Let’s look at a numerical example :
There is a direct relationship between the value of the securities and NAV. If the value of the securities increases, NAV will also increase and vice versa.
If there are 3 funds – Fund A with a NAV of 10, Fund B with a NAV of 15, and Fund C with a NAV of 20. Can you tell me which fund is better?
We cannot select a stock based on its price, we cannot select the fund only based on its NAV. It is important to look at the past performance of the fund, the securities of the fund, the qualification of the manager, and the expenses related to the mutual fund.
Important jargon to understand the mutual fund – II:
Expenses associated with mutual funds:
2 types of costs involved are:
It includes Entry load, Exit load, and Transaction fees. Entry load is a fee imposed by the mutual fund on the investor when he invests in the mutual fund for the first time. However, it is banned in India. Exit load is a fee charged to the investor if they decide to exit the mutual fund before a certain period. It is levied by the mutual fund to reduce the withdrawal and make the investor stay invested for a long time. Transaction charges are levied only once during the investor’s investment period. An investment of more than INR 10,000 usually requires this.
These are annual charges levied on the investor which include management fees and administrative charges. Management fees are paid to the fund manager and administrative charges include sales and marketing costs.
The expense ratio is the total cost incurred including the one-time cost and recurring cost, calculated as:
Expense Ratio = Total expenses/Average AUM
Total expenses: The costs incurred by the AMC mentioned above like fund manager’s fee, marketing, and distribution expenses, and legal/audit costs.
Average AUM: The total value of all investors’ money in that fund.
The lower the expense ratio, the better it is. The total return on investment is calculated after reducing the expense ratio. The expense ratio varies from fund to fund. But the basic difference is based on the type of fund which you are selecting. That is whether is it an active fund or a passive fund. Active funds have a higher expense ratio than passive funds. Also if you buy mutual funds from a broker or a bank relationship manager it is called a regular plan and the expense ratio will be high as it also includes their commission. In a direct plan, where you buy units directly from the fund house or Registered Investment Advisors (RIA), the expense ratio will be lower as they don’t charge a commission.
Types of Mutual Funds
Types of Mutual Funds
Mutual funds can be classified based on investment structure or investment returns.
Based on investment structure:
A fund can be classified into open and closed-ended mutual funds. The difference between the two is the flexibility of buying and selling the fund. Open-ended mutual funds are more popular among the people. You need to first understand what is New Fund Offering (NFO). It is similar to IPO and it is the first time the fund goes public. The difference between open-ended and closed-ended mutual funds is after the NFO. Open-ended mutual funds allow buying and selling units anytime after it is launched. Closed-ended mutual funds don’t allow entry or exit until maturity which is fixed.
Open-ended mutual funds are more popular than closed-ended mutual funds due to 3 reasons –
As you can buy and sell units anytime, it provides you with high liquidity.
They provide facilities like Systematic Investment Plans (SIPs) and Systematic Withdrawal Plans (SWP) as the units can be bought and sold at any time
Investors can easily track and compare the returns of the mutual fund by comparing the previous NAV. However, past returns don’t guarantee future returns.
The major risk of open open-ended fund is the market risk as the value of the NAV fluctuates depending on the price of the underlying assets which can give stress to the investors. For example, during the Covid-19 lockdown, the NAV for almost all mutual funds fell drastically. Also as there are no restrictions on inflows and outflows, a huge outflow can compel the fund manager to sell securities even at a heavy loss to pay back to the investors. Which leads to loss even for the existing investors. Also, the liquidity of the open-ended funds has a disadvantage as it hampers investors’ investing discipline.
Closed-ended mutual funds allow the manager to invest in assets based on long-term vision without worrying about the sudden withdrawal of the funds. If the manager wishes to, they can list the units of the closed-ended funds on the exchanges, thereby providing liquidity to the investors. However, closed-ended mutual funds are not very popular because the investor has to make a lumpsum investment at the time of the launch. Historically, the performance of the closed-ended mutual fund has not been on par with the open-ended mutual funds. There is now a way to track the returns of the closed-ended mutual fund.
Based on Investment returns
It can be classified into two types: One in which the returns get reinvested in the scheme. In the second type, the investors get returns at regular intervals. With a Growth Plan mutual fund, the profits that you generate are reinvested in the mutual fund. In the Income Distribution cum Capital Withdrawal (IDCW) plan, the returns generated are distributed to the investors at a predetermined interval. It is advisable to invest in a Growth plan that lets you enjoy the power of compounding. IDCW is advisable if you need a regular stream of income. If you have a long-term vision and can wait for the benefit of compounding, we recommend the Growth plan.
Types of Equity Mutual Funds
Equity mutual funds are better than investing in a particular stock as it helps to diversify your investments. Diversification helps to reduce risk. If one stock doesn’t perform well it will not have a huge impact on the overall performance of the portfolio. Equity mutual funds are managed by experienced fund managers, so you don’t have to worry about researching a particular stock. One must keep in mind that equity mutual funds are influenced by the stock market movements and hence are subject to market risk.
Different types of Equity Mutual funds:
Large-cap mutual fund
The top 100 companies based on the market cap are invested in. These are established companies with a proven track record. It includes well-known companies like Reliance, TATA, and ITC. This filter helps to remove small companies which have a higher risk. However, there is a limitation to large-cap companies. It might not provide higher returns as compared to other type of funds. But if one is considering investing in a relatively less risky fund, then a large-cap mutual fund is the right choice for you.
Mid-cap mutual funds
They invest in mid-cap companies that have a high growth potential. It is usually between the top 100 to 250 companies based on the market cap. Mid-cap companies have higher growth potential as compared to large-cap companies as large-cap companies are already the top player in their respective industry. However, mid-cap companies can be more volatile as compared to large-cap companies.
Small-cap mutual funds
As the name suggests, these mutual funds invest in small-cap companies that are below the top 250 companies. These companies are usually in their initial stage of development having huge growth potential along with a high level of risk.
Sectoral mutual funds
These mutual funds invest in a particular sector or industry like hospitals, energy, technology, etc. They capitalize on the idea of growth of a particular sector instead of a particular stock. If you feel that the health sector will do well in the future but don’t know which company will do well, you can directly invest in the health sector through a sectoral mutual fund. The growth of the sector directly impacts the returns of these mutual funds.
ELSS mutual funds (Equity linked savings scheme)
It is mainly created to save taxes and encourage people to invest in the stock market as it provides tax concession. It has a lock-in period of 3 years.
Retirement mutual funds
Retirement mutual funds mainly focus on achieving retirement goals.
Types of Debt Mutual Funds
Debt mutual funds have low risk as compared to equity mutual funds and they provide a steady income. They mainly invest in fixed-income securities like bonds, debentures, and money market instruments. Debt mutual funds provide a steady return.
Equity funds charge an exit load if you exit before a certain period of time. However, debt mutual funds don’t charge any exit load. Debt mutual funds are better than FDs as they provide higher returns and more liquidity.
Few risks associated with debt mutual funds:
Interest rate risk: The returns of the debt mutual funds vary with the changes in the interest rate. Say, you have a bond with a 5% interest rate on the face value of INR 1,000. If the RBI increases the interest rate by 1% to maintain the inflation level and stimulate growth in the economy. If the new bond has a 6% interest rate then the price of your bond will fall due to the lower interest rate. So there is an inverse relationship between the interest rate and the price of the bond.
Liquidity risk: debt mutual funds are usually liquid but the fund manager may invest in some instruments that are not very liquid therefore increasing the liquidity risk
Inflation risk: Returns on debt mutual funds are lower as compared to equity mutual funds in the long run. Hence, if the inflation rate is very high it will reduce the overall return.
Types of debt mutual funds:
Short-term debt mutual funds
It invests in various debt instruments like overnight funds, liquid funds, ultra-short-duration funds, low-duration funds, and money market funds.
- Overnight funds are the safest option as they invest in debt securities that have a maturity period of only One Day. They are suitable for businessmen and entrepreneurs who need to park large amounts of money for a short period of time. It is also ideal for building emergency funds.
- Liquid funds invest in short-term money market instruments with short tenure. It mainly invests in treasury bills, commercial papers, and deposit certificates. This fund has a maturity period of up to 91 days.
- Ultra short-duration funds: It invests in debt securities with a maturity period of 3-6 months. Ideal for those who want to park their money for a long period of time. It offers similar or slightly higher returns as compared to fixed deposits.
- Low-duration funds: It invests in debt securities with a maturity period of 6-12 months. It offers similar or slightly higher returns as compared to fixed deposits.
- Money market funds: these are highly liquid funds and are considered to be cash equivalent. It invests in treasury bills, commercial papers, and deposit certificates.
Long-term debt mutual funds
- Short-duration funds: It invests in fixed-income securities with a maturity period of 1-3 years. It invests in quality companies which has a proven track record of repaying the loans.
- Medium duration funds: They lend to companies for 3-5 years. Due to their long tenure, they are impacted by changes in the interest rate.
- Medium to long-duration funds: They lend to companies for 4-7 years. It has a higher interest rate risk due to fluctuations in the economic cycles
- Long-duration funds: They lend to companies for the duration of 7 years or more. They are the risky among the debt mutual funds.
- Dynamic bond funds: They invest in a mix of debt securities with varying maturity depending on the market conditions and interest rates.
Debt funds based on underlying assets
- Corporate bond funds: As the name suggests, it invests in bonds issued by the corporates. It invests at least 80% of the funds in AA+ and above-rated funds.
- Credit risk funds: It invests around 65% of the funds in AA+ or below-rated corporate funds. It has a higher return for the extra risk taken by investing in lower-rating bonds.
- Banking and PSU debt funds: they lend funds only to banks and public sector companies. Most borrowers are government-backed banks with no risk of default.
- Gilt funds: these are funds that invest only in government securities. Whenever the government needs funds they reach out to RBI which in turn collects money from the banks and lends it to the government. In exchange, RBI issued government bonds for a fixed tenure. Gilt funds subscribe to these securities. These are relatively safe but impacted by changes in the interest rate.
Types of Hybrid Mutual Funds
Hybrid mutual funds invest in a combination of equity and debt securities. It involves asset allocation and rebalancing. Asset allocation refers to the process of deciding how much of your money is invested in which asset. So the first major role of hybrid mutual funds is to decide how much funds to invest in equity and how much in debt. The allocation of funds depends on the investor’s risk tolerance, return expectations, time horizon, and market conditions. Now, as the prices fluctuate, the asset allocation changes. Hence, it requires periodic rebalancing. Rebalancing is the process of returning the values of a portfolio’s asset allocation to the levels defined by the investment plans.
Say, you have invested INR 10,000 in hybrid mutual funds with asset allocation of 60% i.e. INR 6,000 in equity and 40% i.e. INR 4,000 in debt. Now, if the stock price increases the value of equity increases to INR 7,000 while debt remains at INR 4,000. It might look profitable but it will increase the equity exposure and therefore increase the risk of the investor. So, it is advisable to return the asset allocation to 60%-40% by selling stocks worth INR 400 and investing that INR 400 in debt therefore maintaining the asset allocation between equity and debt.
2 benefits of hybrid mutual funds:
- It provides diversification benefits to the investors by investing in both equity and debt securities. So, the investor doesn’t have to choose individual stocks or debt securities. An increase in the other asset can offset the decline in a particular asset, thereby averaging the portfolio returns.
- Investing in hybrid mutual funds provides higher returns than investing solely in debt securities. Debt provides stability and income, whereas equity provides higher returns in the long term. By investing in both securities, investors can enjoy growth potential from stocks with protection from debt.
However, hybrid mutual funds come with market risk and interest rate risk. Debt also involves credit and liquidity risk. Credit risk is the risk that the borrower will default in repayment of the borrowed money. Liquidity risk is the risk of investing in illiquid bonds that the manager cannot sell at the desired price. So, one needs to invest in hybrid bonds depending on their risk appetite.
Hybrid mutual funds can be classified based on their asset allocation strategy between debt and equity:
Aggressive Hybrid funds
They invest 65-80% of their assets in equity and the balance in debt securities. It is normally appropriate for a moderate risk-taking investor with a long-term horizon.
Conservative Hybrid funds
They invest 75-90% of their assets in debt and the balance in equity securities. It is appropriate for a conservative investor. It has a lower risk than other types of hybrid funds but provides better returns than FDs.
Balanced Hybrid funds
They invest 40-60% of funds in equity and the balance in debt. It roughly puts an equal amount in equity and debt.
Dynamic Asset Allocation Hybrid funds
They dynamically change the proportion of debt and equity in the portfolio. There is no minimum or maximum proportion to certain asset allocations.
Hybrid funds can also be classified in the following way:
Multi-asset allocation fund
It invests at least 10% of the assets in each of the asset classes i.e. equity, debt, and gold.
This fund makes an investment of a minimum of 65% in equity. Arbitrage strategy is the strategy of profiting from inefficient markets by simultaneously purchasing securities in one market and selling them to the other. It is a risk-free strategy as the buying and selling price is predetermined. Markets are not necessarily perfect. We can see that the price of stock A is not trading at the same price on NSE and BSE. Though the difference can be very small, you can profit from the arbitrage.
Equity Savings Fund
This fund invests a minimum of 60% in Equity, 10% in debt, and also in arbitrage opportunities. The role of arbitrage in this fund is to hedge or protect the returns against the volatility of the markets.
Features of Index Tracking Funds
The Index is a hypothetical portfolio of investments that represent a particular segment of the market. For eg: The top 50 companies listed on the NSE are represented by the NIFTY index and the top 30 companies listed on the BSE are represented by the SENSEX index. There are other indices too like NIFTY Bank Index, NIFTY smallcap 100, and so on. The index acts as a benchmark.
An index fund aims to match the performance of a particular index. The index fund invests in the same companies and the same proportion of the index to match its return. Say, if NIFTY 50 increases by 10%, the Axis NIFTY 50, which is an index fund, will also increase by 10%.
Why do people invest in Index funds?
It is the easiest way to invest in equity as one doesn’t need to study the fundamentals of the individual stock and also doesn’t have to worry about past performance, fund manager, and expense ratio. The index funds are rebalanced periodically when the index adds, removes, or rebalances the weight of the stock. The expense ratio is the lowest for the index funds as the fund is managed passively and there is no need for the manager to research the individual stock or curate any investment strategy.
Risks in Index Tracking Fund
Market risk can be classified into systematic and unsystematic risks. Unsystematic risk is a risk that is specific to a stock or a sector but doesn’t affect the overall market. Unsystematic risk can be mitigated with diversification. In Index funds, the unsystematic risk is mitigated due to diversification. However, Systematic risk does exist. Systematic risk is a risk that affects the market as a whole and therefore cannot be mitigated.
The tracking error of a fund limits the index funds from getting exactly the same return as that of the index. Tracking errors happen because it is not always possible to hold securities in the same proportion and it also involves transaction costs. The index doesn’t have to incur any cost while rebalancing but index funds do have to bear transaction costs. Also, there could be a time lag when the stock or weightage of the individual stock in the index undergoes some change. This lowers the returns of the investors invested in index funds.
It limits the investment universe. You or the fund manager do not have a choice of investing in stocks outside the universe even if it appears an attractive investment. Managers can not buy an undervalued stock or sell an overvalued stock as they must keep the weight of the stocks in the portfolio as per the index
Index vs. Actively managed funds :
|Index Funds||Actively Managed Funds|
|Investment Strategy||Replicate the performance of a particular market index||Aim to outperform the market by using different strategies|
|Management||The fund manager is limited to tracking the index & managing the fund’s holding||The fund manager decides which stocks to buy or sell based on their research|
|Fees||Lower fees||Higher fees|
|Performance||More predictable||Less predictable|
|Risk||Low risk||High risk|
Understand the difference between active & passive investing with this complete guide.
How to Choose the Right Mutual Fund
Performance evaluation of mutual funds
Investing in mutual funds can be made based on a one-time lumpsum amount or through SIPs (Systematic Investment Plan) where you can invest a fixed amount every week/fortnight/month.
If you are investing for a duration of 1 year, you can calculate the returns using the Absolute return method. A similar method is used for lumpsum investment.
However, if you are investing for more than a year, absolute returns may not be the right choice.
If the investment horizon is more than a year and you are making a lumpsum investment, you should calculate returns in terms of CAGR (Compounded Annual Growth Rate).
So in this scenario,
CAGR = [2,75,000 – 2,00,000]^(⅓)-1
= 11.2% p.a.
Now, let’s see how we can calculate the returns for SIPs
For SIPs, we calculate the return using XIRR i.e. Extended Internal Rate of Return
XIRR is calculated using Excel and it requires, inflows, outflows, and the dates of SIPs.
So, the returns for this fund come to 15.2%
How to quantify the returns of the fund to its benchmark?
1) Alpha: It represents the performance of the fund manager in generating excess returns in comparison to a chosen benchmark index like NIFTY 50, NIFTY Bank, etc.
Alpha > 0: It is outperforming the benchmark
Alpha < 0: It is underperforming the benchmark
Alpha = 0: It is the same as the benchmark
2) Beta: It is the risk indicator. Beta offers insight into the volatility of the mutual fund in response to market fluctuations.
Beta < 1: Less volatile than the benchmark
Beta > 1: More volatile than the benchmark
Beta = 1: Equally volatile as the benchmark
3) Standard deviation: It measures the volatility or riskiness of the fund. The higher the standard deviation higher the return and risk.
Say, a fund gave an annual return of 15% p.a. But this 15% was not constant over the years, there could be some years where the return was more than 15% and some years where the return was less. Let’s say the standard deviation was 3%. The higher the standard deviation, the higher the volatility of the fund.
4) Sharpe ratio: It measures the risk-adjusted return of the fund. It measures the performance of the fund concerning the risk-free asset after adjusting for the risk. The higher the Sharpe ratio, the more the return on investment is expected in proportion to the amount of risk taken.
Sharpe ratio = (Return of the fund – Risk-free return) / standard deviation of the fund
Factors to consider before purchasing mutual funds
2 stages involved:
1) Choosing mutual fund category:
The mutual fund category that you choose depends on your risk tolerance and return objectives. What works for one may not work well for the other individual as everyone has different investment goals, time horizons, and risk tolerance levels.
– Investment goals could be saving to buy a house, save for retirement, or plan a vacation. You would not want to park your retirement fund or emergency fund in a risky mutual fund like small-cap funds. But you can do it for a lifestyle goal like buying a sports car as it is a luxury.
– The time horizon is the duration for which the investor decides to hold the investment. It is important to choose the right time horizon as per your investment goals. Buying a house will have a longer time horizon as compared to going on a vacation. Investors with a longer time horizon can take more risk as compared to investors with a shorter time horizon.
– Risk tolerance measures the amount of risk an investor can handle. It depends on age, income level, dependency, etc. For example, a 20-year-old can take a higher risk as compared to a 40-year-old who has the responsibility of running the family. Based on your risk tolerance, you can be an aggressive investor, a moderate investor, or a conservative investor.
2) Choosing a mutual fund Scheme:
Once you choose the category, you need to choose which mutual fund scheme is better.
Firstly, you can check the performance of the mutual fund concerning the benchmark index. It is mandatory for all mutual funds to mention their benchmark index. The mutual fund’s target is to match or outperform the benchmark index. You can filter out the mutual funds that underperformed the benchmark in the past.
Note: Past performance doesn’t guarantee future performance.
Performance relative to peers
Secondly, compare the performance of the fund within its category. If mutual fund A has given a CAGR of 11.5% p.a. in the last 5 years and other mutual funds in the same category have given a CAGR of between 8.5% to 11% p.a. We can say that mutual fund A has been able to outperform its peers. This comparison is possible only between similar mutual funds in the same category.
Another factor to look at is the fund manager’s performance. It is important to consider his experience, performance, and track record. It is more of a qualitative evaluation.
One also has to look at the AMC’s track record. If the AMC outperforms various categories of mutual fund schemes over a long period, you can consider the mutual fund scheme to be well managed.
You should also look at AUM, Expense ratio, and Exit load.
- Mutual funds with high Assets under Management (AUM) will be more established, however, they will have less opportunity to invest in small-cap companies as their investment will be too large impacting the price of the stock of the company.
- The expense ratio is deducted from the returns generated by the mutual fund for the investors. The lower the expense ratio the better it is as the higher expense ratio will lower the returns.
- An exit load is charged when an investor redeems their investment before a specific period of time. Usually, debt mutual funds do not charge an exit load, especially if they are short-term debt mutual funds.
Methods to Invest in a Mutual Fund
SIP vs. Lumpsum Investing
Systematic Investment Plan: SIP is a method of investing in mutual funds in which investors make periodic payments on a regular and automatic basis. SIP helps to build a corpus for your future goal by investing periodically. Say, you want to travel abroad 3 years from now and you need INR 10 Lakhs by then. You can save INR 23,000 per month. This 23,000 will aggregate to INR 8.33 Lakhs in 3 years. So you need a 12% return p.a. to reach your goal.
Lumpsum Investment: it is a one-time investment in a specific scheme for a specific duration and is suitable when people have a large amount of money to invest at once. For example, you get a one-time bonus that you would like to invest. However, it comes with a market risk that you end up investing a large amount when the market is at its peak. It is therefore suitable for experienced investors with high risk tolerance. If you need to invest a lumpsum amount, you should do it in a staggered manner i.e. by dividing your investment over a 5-6 month period.
Benefits of SIP:
-It allows you to start investing with as low as INR 500 per month. One-time mutual fund investment required a minimum investment of INR 5,000.
– SIPs help to reduce the risk of market volatility. Not even the most experienced investors can time the market efficiently, i.e. buy low and sell high. This is where the lumpsum amount invested can backfire. SIPs help to keep you disciplined no matter what the market condition is.
– SIPs keep you disciplined. Most struggle to invest money because they get tempted to splurge money, but SIP ensures that we automatically invest the amount periodically, thus keeping us disciplined.
SWP and STP
Systematic Withdrawal Plan (SWP): It is a method in mutual funds where you can withdraw a fixed amount of money at regular intervals from your mutual fund investment. This provides you with a steady stream of income while keeping your money invested in mutual funds. You can withdraw money monthly, quarterly, or annually.
- Regular source of income
- Potential for capital appreciation
- Market Risk: If the markets don’t perform well, your fund might dry up before the expected duration of time
- Liquidity Risk: If you require immediate access to your invested capital beyond what you have planned, SWP may not be the best choice.
Systematic Transfer Plan (STP): It is a popular investment strategy that allows investors to transfer a fixed amount of money from one mutual fund scheme to another. This transfer is only possible between different schemes of the same AMC. For example, you can transfer money from the Mirae Asset corporate bond fund (source fund) to the Mirae Asset Large-cap fund (Target fund).
3 ways in which you can arrange STP:
- Fixed STP: In fixed STP, the total amount to be transferred from one mutual fund to another is pre-decided & remains fixed for the duration and frequency set by the investor.
- Flexible STP: In flexible STP, total funds to be transferred are determined by the investors as and when the need arises. Based on the investor’s own analysis of the market, he decides the amount of funds to be transferred.
- Capital STP: In Capital STP the capital appreciated is transferred from the source fund to the destination fund, and the capital part remains safe.
Taxation on Mutual Fund
In this, you can redeem in full or part at a later date. This return is treated as a capital gain. Capital gain is the difference between the price at which units are sold or redeemed and the price at which they were purchased. A fund having exposure of at least 65% is considered an equity-oriented fund for tax purposes. For equity-oriented mutual funds, a holding period of less than 12 months is considered short-term, and more than that is considered long-term. A tax rate of 15% is applicable to short-term capital gains.
However, if you are an individual investor with having income of less than INR 2.5 lakhs, no tax is applicable. The long-term capital gain is exempt from tax for up to INR 1 Lakh in a financial year. In the case of a Debt mutual fund or a Hybrid mutual fund, short-term capital gain tax is applicable as per the income tax slab, and long-term capital gain is taxed at a 20% rate.
For calculating the long-term capital gains, investors get the benefit of indexation. The benefit of indexation is the adjustment to the purchase cost to the factor in the impact of inflation.
In this plan, you receive dividends periodically. This return is treated as dividend income. Before April 2020, the dividend was paid by the mutual fund in the form of dividend distribution tax and not by the individual investor. The tax rate was 11.64% for the equity fund and 29% for the debt fund. DDT was not appropriate because both high-net-worth and low-net-worth individuals have to pay similar tax rates. Now, according to the new tax system, the tax on the dividend will be charged to the investor based on their income level. Mutual funds are now liable to deduct 10% tax at the source i.e. TDS if the total dividend paid to the investor exceeds INR 5,000 in a financial year. You can claim TDS while filing your income tax return.
Current tax structure:
Introduction to ETF
Exchange-traded funds, or, ETFs are a particularly interesting type of security that combines the advantages of mutual funds as well as an equity stock. ETF is an investment fund like a mutual fund, which invests in multiple securities. This helps investors gain exposure to a diversified portfolio that reduces the risk of investing in an individual security. Being passively managed, ETFs have a lower expense ratio. The benchmark can be NIFTY50 or NIFTY Bank for equity and G-sec for debt ETF. ETF will invest in the stock in the same weightage as the weight of stocks in the index.
Additionally, unlike mutual funds, the units of ETF can also be traded on stock exchanges similar to individual stocks. Mutual funds are not traded throughout the day, once you place a buy or sell order the NAV is determined at the end of the day depending on the prices of the underlying stock.
In mutual funds, when you buy a unit, that money gets invested in purchasing stock, and the fund manager needs to sell some of the holdings in case of redemption.
However, for ETFs, you can invest in the fund directly only at the time of NFO i.e. New Fund Offering and later the transactions only take place between the buyer and seller of the ETF. So the manager of ETF doesn’t have to sell stocks in case of redemption
Market Price of ETF
It is the price at which ETF is trading in the market at any point in time.
Determined at the end of the day, it is calculated as:
NAV = ( Value of assets – expenses) / No of units
iNAV: provides an intraday indicative value of an ETF based on the market values of its underlying holdings. The value is calculated by the listing exchange and then disseminated to the public every 15 seconds.
Liquidity of an ETF
The liquidity of an ETF refers to the degree of ease with which its units can be bought for or sold in the secondary market, that is, on the stock exchange. The stock exchange is nothing but a market for buyers and sellers to make a trade.
Having liquidity in ETF means sufficient buyers and sellers are willing to trade in ETF units. This feature allows traders to quickly, efficiently, and fairly trade ETF units without significantly affecting their market value.
As an ETF investor, its liquidity is of particular concern to you. High liquidity ensures that you, as an investor, can enter or exit positions quickly at fair prices.
Bid-ask spreads of an ETF
Bid-ask spreads make this possible. The bid-ask spread of an ETF represents the difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept.
If the ETF is liquid, the bid-ask spread is tight. That is, the difference between the highest bid price and the lowest ask price is less. Say, the fair price of a liquid ETF is Rs. 100. Then, the bid price may be Rs. 99.50 and the ask price may be Rs. 100.50. Whether you want to buy or sell the ETF, you can do it at a near fair price.
On the other hand, illiquid ETFs or ETFs with lower liquidity have wider bid-ask spreads. So, in our example, in the absence of enough buyers, say the bid price would have been Rs. 90. Or in the absence of enough sellers, say, the asking price would have been Rs. 110.
This makes it more challenging to execute trades efficiently, and at a fair price, for you as an ETF trader. Also, it is possible that the investors of illiquid ETFs may face the risk of not being able to exit positions quickly during market stress.
Types of ETF
There are broadly 3 types of ETFs:
- Equity ETFs: These ETFs invest in equity markets. They can be Plain vanilla ETF, sectoral ETF, etc. Plain Vanilla ETF invests equity shares of the companies that constitute the indices like NIFTY50, SENSEX, NIFTY100, etc. Some ETFs also invest in global indices such as the Hang Seng Index, which invests in top Hong Kong-based companies, and NASDAQ, which is a US-based index. Sector ETFs invest in sectoral indices like pharma, IT, banks, etc. This helps to invest in sectors to enjoy the upside potential but at the same time reduce the downside risk of individual companies. Investors also use Sectoral ETFs to rotate in and out of sectors during business cycles. Some ETFs focus on equity shares based on value, high alpha, low volatility, momentum, etc.
- Debt ETFs: They invest money in debt instruments. In India, we have ETFs that invest in government securities. There is also a Bharat Bond ETF that holds corporate bonds issued by the public sector undertakings.
- Commodity ETFs: Commodity ETFs invests in commodity like gold and silver. Investing in commodities helps to diversify the portfolio by hedging the downturn. Holding a commodity ETF is cheaper than holding the commodity as it doesn’t involve storage or insurance costs.
- Other International ETFs: There are also international ETFs based on stock derivatives like futures and options. Inverse ETFs are created using a variety of derivatives to profit from a drop in the value of an underlying benchmark. Leveraged ETFs are designed to deliver a greater return than the return from holding long or short positions in regular ETFs like 2x or 3x returns. For example, if the S&P 500 increases by 1%, leveraged ETF will increase by 2%. Conversely, if it falls by 1%, leveraged ETF will fall by 2%. There is also an Inverse Leveraged ETF. Currency ETFs track domestic and foreign currency. Importers and exporters usually use Currency ETFs as a hedge against the volatility in the forex market. Cryptocurrency ETF tracks one or more cryptocurrencies.
Parameters to look at while comparing ETFs
- Expense ratio: The expense ratio of the different AMCs can be different even if they have the same underlying. The lower the better.
- Tracking error: It is the deviation between the ETF return and the index return.
- Liquidity: The trading volume and order book of ETF can be found on the stock exchange website or the broker’s platform. Market depth indicates its liquidity. If there is not enough liquidity, you might not be able to find enough buyers when you would want to sell your ETFs therefore, putting downward pressure on the price.
Let’s compare the different instruments we discussed:
ETFs vs. Mutual Funds
- Index ETFs bring simplicity to the investment as compared to actively managed mutual funds. One doesn’t have to analyze the past performance or the investment strategy of the fund manager. So, it helps to reduce managerial risks
- ETFs have lower risks as compared to actively managed funds. Mutual funds are subject to two types of risks systematic and unsystematic risks. Systematic risk is unavoidable as equity as an asset class has risk. Both ETF and actively managed mutual funds are subject to market risk. Unsystematic risk is a company or sector-specific risk. Mutual funds try to reduce unsystematic risks by diversifying into different companies and sectors. Active managers might be overweight or underweight in some sectors and companies as compared to the index. ETFs don’t have unsystematic risk as it tracks the index.
- Expense ratio: The expense ratio of the actively managed mutual fund is around 1%-2% of the portfolio which amounts to a big amount due to compounding.ETFs have a much lower expense ratio
Index ETF vs Index Mutual Funds
One doesn’t need a Demat account to buy an index mutual fund as it can be directly bought from the Asset Management Company or through a distributor. To invest in ETF you need a demat or trading account as ETFs are traded on the stock exchange like shares.
Shareholders involved in ETFs are the stock exchange, depository, participant depository, broker, buyer, and seller.
The expense ratio of index ETFs is lower than index mutual funds. ETFs have other costs like security translation tax, brokerage cost, and Demat account charges.
Index mutual funds can be redeemed from the asset management company. So, one doesn’t have to worry about the liquidity. In ETFs, lack of liquidity can be a concern particularly if the trading volumes are low.
We learned about the basics of mutual funds and important metrics to look at for decision-making. We also studied different types of mutual funds and how to pick the right mutual fund depending on your investing goal and risk appetite.
The focus was also on understanding how to evaluate the performance of mutual funds and factors to consider before investing. We also discussed the various methods of investing in mutual funds and how mutual funds are taxed.
Finally, we learned about ETFs and the different types of ETFs. We concluded with the difference between mutual funds and ETFs and the parameters to look at while investing in ETFs.
Learn directly from the examples discussed in the How to Pick the Best Mutual Funds course here.