What is a Mutual Fund?

Advantages of a Mutual Fund:

1. Simple and Easy -Any investor who has not much idea about stock markets, which stocks to buy, when to sell etc. can invest in a Mutual fund and enter the stock market. Since mutual funds are managed by professional fund managers, individual investor will get advantage of professional stock picking capabilities.

2. Diversification of investment is another advantage. A mutual fund invests in stocks of different companies from different industries. They are too diversified so if one company or one particular industry as a whole makes loss it will get covered by gains in other areas. In addition mutual funds invests in safe government bonds and other investment options. Such diversified investment is otherwise impossible for a small investor with low capital to invest.

3. Professional Fund Management – A mutual fund will be managed by professional investment managers who has years of experience in stock markets. Track record of this fund manager shall be checked before making the investment in mutual funds. It’s always better to invest in funds managed by people who enjoys proven track record.

4. Systematic Investment Plan - Most mutual funds offer SIP or Systematic investment plan schemes. This enables small investor to invest in monthly installments, in small amounts.

5. Liquidity – Mutual funds are liquid investments like stocks. You can sell your portion of mutual fund any time and convert it into cash irrespective whether the fund manager sells stocks or not.

Note: Read our article on Risk Mitigation Strategies for your Investments

I guess that’s enough for a basic introduction to mutual funds. You can expect more articles on mutual funds soon.

Mutual fund starter guide

By Jago investor & DSP Blackrock Fund house : http://www.dspblackrock.com/PdfsToDownload/Starters_Guide.pdf

Charges incurred by Mutual Funds

Expense ratio

The expense ratio is the annual fee that all funds or ETFs charge their shareholders. It expresses the percentage of assets deducted each fiscal year for fund expenses, including 12b-1 fees, management fees, administrative fees, operating costs, and all other asset-based costs incurred by the fund.

Portfolio transaction fees, or brokerage costs, as well as initial or deferred sales charges are not included in the expense ratio. The expense ratio, which is deducted from the fund's average net assets, is accrued on a daily basis.

If the fund's assets are small, its expense ratio can be quite high because the fund must meet its expenses from a restricted asset base. Conversely, as the net assets of the fund grow, the expense percentage should ideally diminish as expenses are spread across the wider base. Funds may also opt to waive all or a portion of the expenses that make up their overall expense ratio.

• What Is An Expense Ratio?

An Expense Ratio measures the cost of managing a fund and is expressed on a per unit basis. The formula goes like this: the fund’s total expenses divided by the amount of assets that it is managing.

Now, what are the expenses that a fund might incur? Mutual Fund houses employ professionals for running the fund. This is, of course, a specialised service for which the fund house pays a management fee. Then there are expenses for operating a fund. These include transfer fees and fees for registrar agents. These are entities that help in issuing Mutual Fund units and redeeming them. They also provide other Mutual Fund services such as preparing transfer documents and maintaining investor records. Other expenses include custodian charges, legal expenses, and auditing expenses. We are not done yet! Then there are marketing charges and distribution expenses. Managing a Fund is an expensive affair, indeed! Note that the amount of money that a fund spends for trading in the securities (buying and selling of stocks and bonds) is not included in the Expense Ratio.

So, through the Expense Ratio, the fund is trying to recover these costs from you, the Mutual Fund unit holder. The Expense Ratio is calculated by the fund house and is published in fund house reports twice a year.

• How does it affect you?

Let’s take an example. Suppose you are investing Rs. 2 lakh in a Mutual Fund which has an NAV of Rs. 10. Let’s say the Expense Ratio is 2%. Now, you have got a return of 10% from the Fund after being invested in it for a year. So, the value of your investment would have gone up from Rs. 2 lakh to Rs. 2.3 lakh. But, if after the Expense Ratio has been deducted, your investment value will be only Rs. 2.16 lakh, that’s quite a bit of a loss.

• Is there a limit?

The Securities Exchange Board of India (SEBI) has put in ceiling limits for Expense Ratios. If it is an equity fund, the fund house is allowed to have a maximum of 2.5% as the Expense Ratio. The figure is 2.25% if it is a debt fund. Wait! There are also slabs for these Expense Ratios. For the first Rs. 100 crore of the average assets, the Expense Ratio can be 2.5%. This will go down to 2.25% for the next Rs. 300 crore. And for the assets that go beyond that amount, the Expense Ratio can be only 1.75%. Note that in case the Mutual Fund is receiving funds from the top 15 cities in the country, it is allowed to charge an additional Expense Ratio of 30 basis points. SEBI has come up with proposals to lower the Expense Ratio further and rulings are expected on this front soon. Even though the limit is set, some funds will typically have a low Expense Ratio because of their nature. This includes index funds. These are funds that mimic an index and there is no strategy needed for managing these funds. So, the expenses for these funds are low.

Whether an Expense Ratio is good or bad will depend on the type of fund you choose. For equity funds, the Expense Ratio might not have as much of an impact as for a debt fund. This is because equity funds usually give double digit returns. For debt funds, Expense Ratio is crucial. Consider this: a debt fund is giving you a return of 9% per annum. If the Expense Ratio for the fund is 2%, your actual returns will be just 7%, which is not great. That is why you need to look for funds with a low Expense Ratio – ideally, between 1% and 2%.

An Expense Ratio is a perfect example of how costs can reduce your returns. Here’s another tip on how to save on costs involved in Mutual Fund investments – Invest in Mutual Funds directly through the fund house. This way you can cut the agent commission and save on those costs. Lower costs = higher returns!

How to Evaluate Your Best Mutual Funds?

As an investor, you must look at certain financial ratios to evaluate your funds. Some of the important ratios to be considered are as follows:

• a. Standard deviation

Standard deviation measures the dispersion of a set of data from the mean or average. In finance, standard deviation denotes the annual rate of return on any investment and also highlights the volatility of the investment. A stock with a higher standard deviation has a more significant price range and indicates higher volatility as compared to a stock with a low standard deviation.

• b. Sharpe ratio

This ratio measures the risk-adjusted rerun of a portfolio. A financial portfolio having a higher Sharpe ratio is seen as a relatively superior portfolio as compared to its peers.

Sharpe Ratio = (Average Fund return – Risk-free Rate)/Standard deviation of the fund returns

• c. R-Square

R-Square shows the percentage of fund returns that are in line with the benchmark returns. The value of R-Square lies between 0 and 1 and is reflected as a percentage from 0% to 100%. If a fund has an R-Square of 100%, then it means that the movements in the index explain its securities’ movements. A higher value of R-squared indicates a far more useful beta figure.

Example: A fund is said to be offering a higher risk-adjusted return if it has an R-Square value that is close to 100%, but its Beta is below 1.

• d. Beta

Beta is indicative of a fund’s sensitivity to the correlated movements of a benchmark. If a fund has a Beta of 1.0, then it means that it is as volatile as the benchmark. If a fund has a Beta of say, 0.70 or less, then it means that it is 30% less volatile than the benchmark and if the Beta is 1.30, then it shows that the fund is 30% more sensitive than the benchmark.

• e. Alpha

Alpha is a measure of an asset manager’s ability to make profits when a benchmark is also registering a profit. Alpha can be either less than, equal to or more than 1.0. Higher the Alpha, more significant is the ability of the manager to make profits from the movements in the benchmark.