Understanding how mutual funds work is not easy for novice investors, but it can get simpler if you become familiar with some of the basic mutual fund terminology. So, let’s understand what common mutual fund-related terms mean.
Net Asset Value (NAV)
NAV stands for net asset value. A mutual fund’s NAV is the per unit price of the fund. NAV is calculated at the end of every trading day by taking into account the total value of the shares held in the fund’s portfolio. When you see that the NAV of a mutual fund is ₹500, it means that you will have to pay ₹500 for one unit of that mutual fund. In other words, if you invest ₹5,000 in that fund at an NAV of ₹500, you will be allotted 10 units of the fund.
One misconception about NAV that investors often have is that a lower NAV means a cheaper fund, and hence a better investment. But that is not the case. A new fund has a lower NAV and it increases as the fund’s assets grows. Hence, NAV should not be the determining factor in choosing a mutual fund.
When you invest in a mutual fund, a small percentage of your investment is deducted as the fund management fee. The fund company charges you a fee for managing your money, which is called the expense ratio. Expense ratio is the annual fee of a fund and is deducted from the fund’s corpus every year. The expense ratio you pay the fund is basically deducted from the gains you have made. For example, if your fund earns a return of 10% and the expense ratio is 2%, then your effective return is 8%.
A mutual fund is free to charge the expense ratio that it wishes to charge, but it should be within the limit imposed by SEBI–2.5% for equity mutual funds and 2.25% for debt mutual funds. The expense ratio can be a good differentiator between two similar funds that are also performing equally.
On most mutual funds, there is a levy that is charged if you exit the fund in less than a year. Charging an exit load is at the discretion of the particular fund. Most equity mutual funds have an exit load of 1% on redemptions made in less than a year. Debt funds have different exit loads for different timeframes. The percentage levied as exit load is deducted from the amount you redeem from the mutual fund. Basically, exit load is levied to discourage investors from exiting too early.
Growth Option and Dividend Option
Mutual funds primarily come in two options–growth option and dividend option. For both the options, the mutual fund portfolio remains the same. The difference lies in how the gains made by the mutual fund are treated. Under the growth option, the returns earned by the fund are added back to the fund’s assets. Under the dividend option, the investors are paid out a part of the returns as dividend. The dividend option is ideal for investors who are looking for a periodic income from their mutual fund investments, while the growth option is ideal for long-term investors who wish to build wealth.
One important point to note is that the dividend paid out under the dividend option is from the fund’s returns itself, it is not something extra that you earn from your investments.
Regular Plan and Direct Plan
In 2013, direct plans of mutual funds were introduced. Since then, all mutual funds have the regular plan as well as the direct plan. The fund’s portfolio remains the same for both plans, but the difference is in their expense ratio. The direct plans have a lower expense ratio as compared to the regular plan. This is because investors have to invest in the direct plans directly from the mutual fund company, while regular plans are sold by mutual fund distributors.
Open-end and Closed-end
Mutual fund schemes can be open-end or closed-end. Open-end funds are those that can be invested in at any time by any investor. However, closed-end funds are open for investments only during their New Fund Offer (NFO) period, which is the initial months when the fund company introduces that fund. After the NFO period ends, a closed-end fund doesn’t accept additional investments and usually also disallows redemptions before the pre-defined investment term of the fund ends.
Assets Under Management
The assets under management or AUM of a mutual fund is the total amount of money that is invested in the fund. As more and more money gets invested in a mutual fund, it’s AUM will rise. A fund with a high AUM will mean that it is popular with a lot of investors, but the AUM alone should not be the deciding factor in choosing a fund.
You will often comes across the term “benchmark” in mutual fund factsheets, offer documents or analysis. A mutual fund’s benchmark is an index that the fund has chosen to measure its performance against. This index can be BSE Sensex or NSE Nifty or any other of the sub-indices of BSE or NSE. The index is chosen according to the fund’s portfolio type to measure the returns that the fund is earning. For example, a large-cap fund will usually have Sensex or Nifty as its benchmark as these indices are also made of up large-cap stocks. The endeavour of the fund would be to beat the returns generated by its benchmark.
Every company is valued at a certain amount based on its share price and outstanding shares (shares in circulation). To calculate a company’s market value, the single share price is multiplied by the number of outstanding stocks. Depending on its market capitalisation, a company can be large-cap, mid-cap or small-cap. An equity mutual fund decides which companies based on their market capitalizations does it want to invest in. For example, a large-cap equity fund will invest primarily in large-cap companies but a multi-cap equity fund will invest in companies that have different market capitalisations.
Trailing Return and Annualised Return
Mutual fund returns are often measured in different ways. The two popular types of returns that investors look at are trailing return and annualised return. The annualised return of a mutual fund, also known as the compounded annual growth rate (CAGR), is the return the fund earned every year over a specific number of years. The trailing return of a mutual fund is the return earned by it between two specific dates. So, if you want to see how a fund has performed over a 5-year period, you should look at the annualised return. But consider the trailing return if you want to see how the fund has done in the past year or past month.
Mean and Standard Deviation
These two are measures of risk associated with investments in an equity fund. Standard deviation tells you how much volatile the fund’s returns can be at the present time in relation to its historic average. For example, if a fund’s average returns are 10% and its standard deviation is 4%, then this means that fund’s return can be between 6% to 14% in the present scenario. The mean is the historic average of the fund’s returns.
Every mutual fund takes certain amount of risks to generate returns. This makes it important to gauge the fund based on its risk-adjusted returns. The fund’s sharpe ratio can help do that. The greater a fund’s sharpe ratio, the better it performs on a risk-adjusted basis.
Beta and Alpha
Alpha and beta are other measures to look at for the fund’s performance and risk. Alpha measures the fund’s performance on a risk-adjusted basis while beta measures the volatility of the fund by comparing it to its benchmark index. The default measure for an index is 1.0. So if a fund has a beta of 1.3, it means that it can go up or down by 30% as compared to its index. A fund that has a positive alpha shows that the fund has performed that much more than what it was expected to.