Mutual Funds : Jargon Buster

Imagine driving a car without knowing what an accelerator or a brake is. Imagine using a computer without knowing what a keyboard or a monitor is. Similarly, imagine investing in Mutual Funds without knowing some key terms. You may have invested in mutual funds on the basis of your friend’s or financial planner’s advice, but understanding a few jargons will assist you in taking better decisions next time. Here is a simplified explanation of the most common terms you must know before investing in Mutual Funds, starting with the term ‘mutual fund’ itself :

1. Mutual Fund : A mutual fund is a “common pool” of money. “n” number of investors contribute towards this pool of money. The money collected from investors is used to buy various categories of assets. These assets can be equity shares, debentures, bonds, gold etc. All the assets are owned by the investors in the same proportion as their contribution bears to the total contributions of all the investors put together.

2. Units : Just like an investor by paying money to a company subscribes to its shares, similarly, by contributing towards the Mutual Funds, the investor subscribes to the units of a scheme launched by the fund. A unit holder of a mutual fund is a part owner of the fund’s assets. These units held by an investor are the evidence of ownership of the fund’s assets.

3. Net Asset Value (NAV) : NAV is the price of a unit of a fund. It is calculated by dividing the value of the total assets of the fund by the total number of units issued by the mutual fund. Let us take a set of numbers to develop a better understanding. Suppose the value of a fund’s assets(shares, bonds, gold etc.) stands at Rs. 1 crore and it had earlier issued 50,000 units. Then the NAV of a single unit at a given date shall be Rs. 200 (1 crore/50,000) . If you, as an investor hold 100 units of this fund, then on the basis of an NAV of Rs. 200, the value of your portfolio shall be Rs. 20,000. Now if the value of the fund’s assets increases, the NAV will also rise, thus moving up the value of your portfolio of 100 units.

4. Corpus : The face value of the units when multiplied by the total number of units issued, gives us the corpus of the fund. If the fund issues 50,000 units at a face value of Rs. 10 each, the corpus of the fund stands at Rs. 5,00,000, irrespective of its NAV. This corpus will rise if the fund further issues some more units.

5. Assets Under Management (AUM) : Moving further with the above example, the fund had issued 50,000 at Rs. 10 each, but as the value of the assets of the fund increases, its NAV starts increasing. Supposes the NAV reaches a level of Rs. 200, then the figure of 1 crore (50,000 units* Rs. 200) is referred to as AUM.

6. Entry Load and Exit Load : The charges which are imposed on the investor to cover the marketing and administrative expenses of the fund are known as loads. The amount which is deducted at the time of investor’s entry (i.e. at the time of buying) into a scheme is known as entry load and the amount which is deducted from the redemption or sale proceeds payable to the investor at the time of exit from the scheme is known as exit load. Lets say, that if you are investing Rs. 10,000 in a scheme and the entry load is 1%, then out of Rs. 10,000, only Rs. 9,900 will be invested in the scheme and remaining Rs. 100 will go towards fund expenses. Similarly, if the exit load is 1%, and you plan to redeem or sell units worth Rs. 10,000, then you will receive an amount of Rs. 9,900 after deducting Rs. 100 as exit load. Recently, SEBI has abolished Entry Load on all mutual fund schemes in India.

7. New Fund Offer (NFO) : NFO is just like an IPO of shares. A new fund offer occurs when a new scheme is launched and it allows the investors to purchase the units of a close-ended scheme.

8. Open-end Fund : An open ended mutual fund is one that sells and repurchases units at all times. In an open ended fund, the purchase and sale of units takes place between an investor and the mutual fund. Here, as new investors can enter and exit from the fund at any time, the corpus of the fund keeps changing daily.

Mutual Funds : Jargon Buster

9. Close-end Fund : Unlike an open-end fund, the corpus of a close-end fund remains fixed. It allows the investors to purchase its units through a New Fund Offer (NFO). After the NFO closes, it does not allow the investors to buy or redeem the units directly from the funds. However, to provide the much needed liquidity, it gets listed on a stock exchange thus enabling the investors to buy or sell the units just like buying or selling the shares of a company.

10. Equity Linked Savings Scheme (ELSS) : ELSS is a diversified mutual funds scheme that invests in shares of various companies across various sectors. Investment in ELSS allows the investor to claim tax benefits under section 80C of the Income Tax Act. Investments in this scheme have a lock-in period of three years.

11. Systematic Investment Plan (SIP) : In a systematic investment plan, an investor makes regular payments on a monthly or quarterly basis towards a mutual fund. Investing in a regular manner through an SIP allows the investor to take the advantages of rupee-cost averaging. For example, if you start an SIP of Rs. 1000 and the fund’s NAV in that month is Rs. 100, you will get 10 units. In the next month, if the NAV rises to Rs. 120, you will get 8.33 units. Further in the third month if the NAV falls to Rs. 80, then you will get 12.5 units.At the end of the third month, you will be able to accumulate 30.83 units by investing Rs. 3000 at an average price of Rs. 97.31 per unit. This always represents a win-win situation as the cost of acquisition is averaged out by purchasing the units regularly at different NAVs.

12. Offer Document : It is an operating document which describes a mutual fund scheme. It is the most important source of information from the perspective of prospective investors. It acts a legal document which protects and governs the rights of an investor.

13. Key Information Memorandum (KIM) : An offer document runs into pages and it may not be possible for a small investor to go through each and every line. Thus, an abridged version of the offer document is distributed with the application form which is known as the Key Information Memorandum. It briefly sets forth the information, which a prospective investor ought to know before investing.

Keep following MONEY MATTERS for more updates on using mutual funds as a tool for wealth management.

Share your views...

8 Respones to "Mutual Funds : Jargon Buster"

niharika said...

Very useful indeed.

August 23, 2010 at 5:37 AM
Nandan Narula said...

Thanks a lot Niharika

Vishal_SEO said...

Hey this is nice article written over basics of Mutual Funds, However I would like to add one advice for the Mutual Fund investors, invest in only Mutual Funds, who are having good track record and those follows the sound investment processes and systems followed by the fund house.
Top Mutual Funds

September 17, 2010 at 3:21 AM
Nandan Narula said...

Welcome to MONEY MATTERS Mr. Vishal and thanks a lot for your valuable advice for the investors

Swapnil said...

yeah, Very useful... Indeed

September 17, 2010 at 8:41 PM
Nandan Narula said...

Welcome to Money Matters Mr. Swapnil and thanks a lot for your valuable feedback

Manish said...

Nandan, this is great information to start with Mutual Funds...thanks

October 27, 2010 at 9:48 PM
Nandan Narula said...

@ Manish : Welcome to MONEY MATTERS and thanks for your valuable feedback

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