Mutual funds are an important investment vehicle in overall financial planning. If you are a new investor, please do check out mutual fund’s basics and types of mutual funds. If you are looking to dig deeper or an expert just looking to further refresh your knowledge, this post is for you. I’ve listed down some key mutual funds terms that are commonly used. These terms are instrumental in identifying the right fund as well as right approach of entering and exiting your investments.
This is going to be a long post, so do grab a tea or snacks if you want! Hope this would be useful for you. Let’s get started!
An Asset Management Company or AMC is a SEBI registered company that handles asset management and investment decisions for mutual funds. Sometimes they are also referred to as mutual fund houses.
Alpha is the return earned by a mutual fund scheme in excess to its benchmark index and expense ratio. Ideally, mutual fund managers will always target to beat the benchmark index in order to generate alpha for the investors.
Assets Under Management or AUM is the total value of all investments managed by the mutual fund. It can be at a scheme level, plan level or AMC level.
In order to track whether a mutual fund scheme has performed well or not, we need a parameter to compare its performance. A benchmark index is a suitable index against which performance of a scheme can be compared. A good scheme is expected to beat its benchmark consistently and generate alpha. For example, an equity mutual fund scheme’s performance is tracked against performance of sensex or nifty.
Beta represents the relationship between NAV movement of a scheme with respect to benchmark index. The beta of market is assumed to be 1, hence a beta greater than 1 means that the portfolio of the scheme as a whole is more volatile or riskier than benchmark and vice versa. For example, if beta of a scheme is 1.2, then it is 20% more volatile than benchmark. If benchmark index rises or falls by 10%, the scheme will rise or fall by roughly 12%.
Compounded Annual Growth Rate or CAGR is the overall rate of return on an investment over a period assuming that the annual gains are reinvested every year. It can be simply stated as year on year gain over gains throughout the investment duration.
Credit Rating Information Services of India or CRISIL is a global agency which rates financial institutes and instruments. CRISIL considers various factors like portfolio, mean returns, volatility, quality of assets, liquidity, risk-return etc. to assign mutual fund schemes with a rating from 1-star to 5-star in different time periods ranging from 1 year to 10 years. CRISIL rating is a highly reliable source of bifurcating the mutual fund schemes in best, average and poor performing ones.
This is the time specified by SEBI to determine the NAV at which your investment/redemption will be made. If the investment/redemption request is submitted before cut-off time to AMC, the NAV applicable to the transaction will be of same day. For requests submitted after cut-off time, NAV applicable is of next working day.
A direct plan is what you buy directly from mutual fund company or AMC, there is no third party involved here. The only cost you pay in form of expense ratio is the marginal operating cost of AMC and fund manager. Simply put, the expense ratio is lower which means alpha generated is higher.
Dividend Distribution Option
In a dividend distribution variant of scheme, any dividends that are paid by scheme’s portfolio shares are directly paid to investors which are taxable as per applicable rules.
Dividend Reinvestment Option
In a dividend reinvestment variant of scheme, any dividends that are paid by scheme’s portfolio shares are used to buy units of same scheme on behalf of investor. Simply stated, you buy additional units of scheme using dividend pay-out and your unit balance increases.
Entry load is the percentage fees charged while purchasing a mutual fund. The entry load is charged on top of actual NAV to allocate units. For example, if NAV of scheme is Rs. 100 and entry load is 2%, then effective NAV for purchase will be Rs. 102.
Exit load is the percentage fees charged while exiting or redeeming a mutual fund before a stipulated period. Most of the schemes charge an exit load if redeemed before 1 year. The exit load is deducted from actual NAV to sell units. For example, if NAV of scheme is Rs. 100 and exit load is 2%, then effective NAV for redemption will be Rs. 98, i.e. your profit is reduced by Rs. 2.
Expense ratio is the price you pay to mutual fund company or AMC for managing your money. In simple words, it is your investment cost. AMCs use this money to pay their fund managers and employees, meet administrative and technology expenses. If you invest Rs.10,000 in a scheme whose expense ratio is 2%, then you would be paying Rs. 200 to AMC for managing your money. Higher the expense ratio, higher is your investment cost.
Fixed Maturity Plan or FMP is a mutual fund scheme with fixed tenure. Such schemes usually invest in debt instruments with maturity period in alignment to maturity of scheme.
In a growth option of a mutual fund scheme, any dividends paid out by scheme’s portfolio stocks are not paid to investor. All the dividends are used by fund manager to reinvest in scheme’s portfolio itself and the objective is the grow fund’s NAV which indirectly results in higher returns for investors.
Each mutual fund scheme comes with its own investment objective, for example long term capital appreciation from an equity portfolio or fixed income generation from a debt portfolio or a mix of both. The scheme’s investment objective decides where it sits in your overall portfolio and your investment goals and strategy.
Some mutual fund schemes come with a lock-in period which means that the money invested once can not be redeemed before the end of lock-in period. For example, ELSS schemes come with a lock-in period of 3 years, i.e. you have to stay invested for a minimum of 3 years in an ELSS scheme.
Lumpsum is an investment strategy where you buy bulk units in a scheme in one go, unaffected by market conditions.
Net Asset Value or NAV is the market value of a unit of the mutual fund scheme. Almost all the schemes derive and declare their NAVs every day. NAV is derived based on the actual market value of assets held by scheme minus expenses and liabilities.
New Fund Offering or NFO is introduction of a new fund or scheme in market by an AMC. An NFO is offered at an introductory price at which units are allocated to investors. You can relate it to IPO of shares. For closed ended schemes, NFO is the only period to invest.
Price to Book ratio of a share reflects ratio of share’s market value to its book value, where book value is assets minus liabilities. A funds PB ratio is the weighted average of PB ratio of all the stocks in fund’s portfolio. Since a fund’s PB ratio is average of its overall portfolio and it keeps changing frequently, it is not of much significance except that it can be used to compare a fund with its peers.
Price to Earnings or PE ratio reflects how much price investors are willing to pay for one rupee of earning of one share of a company. For mutual funds, since the portfolio comprises of multiple stocks, PE ratio reflects the weighted average of PE ratio of all stocks in the portfolio. Since a fund’s PE ratio is average of its overall portfolio and it keeps changing frequently, it is not of much significance except that it can be used to compare a fund with its peers.
Redemption means selling the units of mutual fund scheme that you’ve held to book profit (or loss).
A Regular plan is what you buy from a third party which may be a financial advisor, agent or commission based online platform. In regular plans, the AMC has to pay an additional commission to the third party involved. This additional cost is passed on the investor in form of a high expense ratio. This means that expense ratio will consist the marginal cost of AMC and fund manager as well as the commission that AMC pays to third party. Alpha generated for regular plan of same scheme will always be less than direct plan.
Repurchase is another term used for redemption. It is coined from AMC’s perspective i.e. the AMC repurchases its units that an investor wants to redeem.
Return grade is the rating assigned to a fund which shows the risk-adjusted returns generated by the fund as compared to the returns generated by other funds in the same category. For example, a return grade of ‘Low’ means that the scheme’s returns has been on lower side as compared to other funds of its category.
Risk grade is a rating that suggests the overall risk of loss of capital in the fund.
Risk Return Trade Off
In general, higher risk is associated with possibility of higher returns and lower risk is associated with possibility of lower returns. While choosing a scheme for investment, an investor must decide opting for right risk level depending on returns expectation. This trade-off between risk and return is known as risk return trade off.
Systematic Investment Plan or SIP is a strategy to average out the purchase cost by buying units at regular intervals instead of buying at once. This allows you to invest in a disciplined manner and accumulate more units when market is bearish which balances out the units purchased at higher prices when market is bullish.
Systematic Transfer Plan or STP is a combination of SWP and SIP which allows you to transfer fixed amount of money from one scheme to another in regular intervals. Simply stated, it is systematic redemption from one scheme and purchase in other scheme within same AMC in regular intervals.
Switching is transferring money from one scheme to another, i.e. redeeming units from a scheme and buying units from another scheme.
Systematic Withdrawal Plan or SWP is a redemption strategy which allows you to redeem your units in smaller lots in regular intervals. This helps in averaging out selling price, just like SIP helps you average out buying price.
Turnover is the percentage of change in mutual fund’s portfolio as compared to previous year or stipulated period. For example, a turnover of 10% means the portfolio of scheme has 10% new holdings. A higher turnover rate signifies frequent changes in scheme’s portfolio, this is common for aggressive equity funds.
A unit is a share of mutual fund which is bought and sold. When you invest in a mutual fund scheme, you buy units of the scheme.
Yield is dividend or interest that you receive from your scheme holdings.
Yield to Maturity
Yield to Maturity or YTM is the yield or return you can expect on a scheme if you hold it till its maturity date.
I hope you enjoyed this crash course of mutual funds terms. Do let me know if you want me to add any other terms to this list.
Your feedback, comments and questions are most welcome!