Mutual fund as an investment vehicle, is rapidly gaining popularity across India. The April–November period of 2015 saw an addition of 2.5 million new investors in mutual fund sector. However, most of these new investors and in fact, even the existing ones, do not have a clear understanding of important terms and concepts crucial for mutual fund investing.
Here are some of the important terms that you need to know before starting to invest in mutual funds:
1. Net Asset Value (NAV):
It is the price of one unit of a mutual fund. It is derived by dividing the AUM with the number of units issued by the fund. It is the price at which the units of a fund are purchased or sold and its increase/decrease shows how well your fund is performing. If the present NAV of your fund is higher than the amount at which you bought the fund, then you are in profit.
NAV = AUM / Total number of units issued
2. Dividend option:
This option allows you to receive dividend as and when it is declared by a mutual fund. The amount to be paid as dividend is calculated on the face value of the fund (Rs.10 in most cases). So, if a fund having an NAV of Rs.30 declares a dividend of 30%, you will receive Rs.3 (30% of Rs.10) as dividend. However, your NAV will decrease by the amount paid as dividend. So, in the above example, your NAV will become Rs.27 (Rs.30 – Rs.3) after the dividend payout.
Please note, dividends are not extra income. They are just a way of giving you back a portion of your own investment. You should choose this option only if you want to have a regular income from your investment.
3. Growth option:
Under this option, you will not receive any dividend or extra units from the fund. It gives you the benefit of compounding returns, as the principal along with the dividends declared stay invested with the fund. You should opt for this option if you prefer capital appreciation over regular income from your investment.
4. Asset Allocation:
This is the process of distributing mutual fund’s portfolio across various assets classes, such as equities, derivatives, money market instruments, cash and fixed income instruments, such as fixed deposits and bonds. Asset allocation of a fund is based on its investment objectives and may change according to changing market conditions. You can look at the asset allocation of a mutual fund scheme to determine the fund’s growth and risk potential.
5. Systematic Investment Plan (SIP):
The concept of SIPs is similar to investing in bank recurring deposits (RDs). Under SIP scheme, you will invest a predetermined amount in a mutual fund at regular intervals (weekly, fortnightly, monthly or quarterly). So, if you opt for Rs.1000 monthly SIP investment in a mutual fund on every 2nd day of the month, Rs.1000 will be automatically debited from your bank account on the second of every month and the proceeds will be used to buy you units of that fund. This saves the investors from the dilemma of timing their mutual fund investments. Also, as the purchase is spread over a period instead of a lump sum, you get to buy units at lower prices during a falling market and average your purchase costs.
6. Systematic transfer plan (STP):
This option is similar to an SIP except that a debt fund replaces the role of your bank account. Under this plan, you can transfer a predetermined amount on a specified date from one particular mutual fund to another. However, both funds have to be from the same fund house. It is especially helpful when you have a large sum of money for investment but are scared to invest all of it in an equity mutual fund at one go. In such a situation, you can invest the entire sum in a low-risk debt fund (which will give higher returns than savings account) and allow the fund house to transfer a predetermined amount from your debt fund to an equity fund at regular intervals.
7. Assets under management (AUM)/Corpus:
It is the market value of all securities (such as shares, derivatives, gold, cash and bonds) held by a mutual fund minus its liabilities. A mutual fund with a big AUM size can be an indicator of either good performance by that fund or presence of a large number of investors in that fund.
AUM= Market value of all securities of a fund – liabilities of a fund
8. Benchmark Index:
Fund houses select relevant (either equity or a bond) index for measuring mutual fund’s performance. For instance, a large cap fund may use SENSEX, NIFTY or BSE 100 indices as a benchmark, while a mid-cap fund may use NSE Midcap index. A fund outperforming its benchmark index is considered as a good fund. You should compare a fund’s performance with that of its benchmark index before investing in that fund or for evaluating its returns.
9. Dividend reinvestment option:
Under this option, you will receive dividends but they will be used by the fund to purchase new units for you. Thus under this option, you will receive fresh units instead of any cheque or any amount in your bank account.
By Naveen Kukreja First published in Moneycontrol.com on February 24, 2016