Understanding Mutual Funds

A vehicle for investing in stocks and bonds

A mutual fund is not an alternative investment option to stocks and bonds, rather it pools the money of several
investors and invests this in stocks, bonds, money market instruments and other types of securities.
Buying a mutual fund is like buying a small slice of a big pizza. The owner of a mutual fund unit gets a
proportional share of the funds gains, losses, income and expenses.

Each mutual fund has a specific stated objective

The funds objective is laid out in the fund's prospectus, which is the legal document that contains information
about the fund, its history, its officers and its performance.

Some popular objectives of a mutual fund are Fund Objective

What the fund will invest in

Equity (Growth)

Only in stocks

Debt (Income)

Only in fixed-income securities

Money Market
(including Gilt)

In short-term money market instruments (including government securities)

Balanced

Partly in stocks and partly in fixed-income securities, in order to maintain a

'balance' in returns and risk

Managed by an Asset Management Company (AMC)

The company that puts together a mutual fund is called an AMC. An AMC may have several mutual fund schemes
with similar or varied investment objectives.

The AMC hires a professional money manager, who buys and sells securities in line with the fund's stated
objective.

All AMCs Regulated by SEBI, Funds governed by Board of Directors

The Securities and Exchange Board of India (SEBI) mutual fund regulations require that the funds objectives are
clearly spelt out in the prospectus.

In addition, every mutual fund has a board of directors that is supposed to represent the shareholders' interests,
rather than the AMCs.

Net Asset Value or NAV

NAV is the total asset value (net of expenses) per unit of the fund and is calculated by the AMC at the end of
every business day.

How is NAV calculated?

The value of all the securities in the portfolio in calculated daily. From this, all expenses are deducted and the
resultant value divided by the number of units in the fund is the funds NAV.

Expense Ratio
AMCs charge an annual fee, or expense ratio that covers administrative expenses, salaries, advertising
expenses, brokerage fee, etc. A 1.5% expense ratio means the AMC charges Rs1.50 for every Rs100 in assets
under management.

A fund's expense ratio is typically to the size of the funds under management and not to the returns earned.
Normally, the costs of running a fund grow slower than the growth in the fund size - so, the more assets in the
fund, the lower should be its expense ratio.

Load
Some AMCs have sales charges, or loads, on their funds (entry load and/or exit load) to compensate for
distribution costs. Funds that can be purchased without a sales charge are called no-load funds.

Open- and Close-Ended Funds

1) Open-Ended Funds

At any time during the scheme period, investors can enter and exit the fund scheme (by buying/ selling fund units)
at its NAV (net of any load charge). Increasingly, AMCs are issuing mostly open-ended funds.

2) Close-Ended Funds
Redemption can take place only after the period of the scheme is over. However, close-ended funds are listed on
the stock exchanges and investors can buy/ sell units in the secondary market (there is no load).

Important documents
Two key documents that highlight the fund's strategy and performance are 1) the prospectus (legal document)
and the shareholder reports (normally quarterly).

Professional Money Management

Fund managers are responsible for implementing a consistent investment strategy that reflects the goals of the
fund. Fund managers monitor market and economic trends and analyze securities in order to make informed
investment decisions.

Diversification
Diversification is one of the best ways to reduce risk (to understand why, read The need to Diversify). Mutual
funds offer investors an opportunity to diversify across assets depending on their investment needs.

Liquidity
Investors can sell their mutual fund units on any business day and receive the current market value on their
investments within a short time period (normally three- to five-days).

Affordability
The minimum initial investment for a mutual fund is fairly low for most funds (as low as Rs500 for some schemes).

Convenience
Most private sector funds provide you the convenience of periodic purchase plans, automatic withdrawal plans
and the automatic reinvestment of interest and dividends.

Mutual funds also provide you with detailed reports and statements that make record-keeping simple. You can
easily monitor the performance of your mutual funds simply by reviewing the business pages of most newspapers
or by using our Mutual Funds section.

Flexibility and variety

You can pick from conservative, blue-chip stock funds, sectoral funds, funds that aim to provide income with
modest growth or those that take big risks in the search for returns. You can even buy balanced funds, or those
that combine stocks and bonds in the same fund.

Tax benefits on Investment in Mutual Funds

1) 100% Income Tax exemption on all Mutual Fund dividends

2) Equity Funds - Short term capital gains is taxed at 15%. Long term capital gains is not applicable.
Debt Funds - Short term capital gains is taxed as per the slab rates applicable to you. Long term capital gains tax
to be lower of - 10% on the capital gains without factoring indexation benefit and 20% on the capital gains after
factoring indexation benefit.

3) Open-end funds with equity exposure of more than 65% (Revised from 50% to 65% in Budget 2006) are
exempt from the payment of dividend tax for a period of 3 years from 1999-2000.

Note: Equity Funds are those where the investible funds are invested in equity shares in domestic companies to
the extent of more than 65% of the total proceeds of such funds.

Investing in Mutual Funds

Mutual funds are investment vehicles, and you can use them to invest in asset classes such as equities or fixed
income. moneycontrolrecommends that you use the mutual fund investment route rather than invest yourself,
unless you have the required temperament, aptitude and technical knowledge.

In this article we discuss why and how you should choose mutual funds. If you would like to familiarise yourself
with the basic concepts and workings of a mutual fund, Understanding Mutual Funds would be a good place to
start.

We are not all investment professionals

We go to a doctor when we need medical advice or a lawyer for legal guidance. Similarly, mutual funds are
investment vehicles managed by professional fund managers. And unless you have a high Investment IQ, we
recommend you use this option for investing. Mutual funds are like professional money managers, however a key
factor in their favour is that they are more regulated and hence offer investors the ability to analyse and evaluate
their track record.

Investing is becoming more complex

There was a time when things were quite simple - the market went up with the arrival of the first monsoon
showers and every year around Diwali. Since India started integrating with the world (with the start of the
liberalisation process), complex factors such as an increase in short-term US interest rates, the collapse of the
Brazilian currency or default on its debt by the Russian government, have started having an impact on the Indian
stock market.

Although it is possible for an individual investor to understand Indian companies (and investing) in such an
environment, the process can become fairly time consuming. Mutual funds (whose fund managers are paid to
understand these issues and whose asset management company invests in research) provide an option of
investing without getting lost in the complexities.

Mutual funds provide risk diversification

Diversification of a portfolio is amongst the primary tenets of portfolio structuring (see The Need to Diversify). And
a necessary one to reduce the level of risk assumed by the portfolio holder. Most of us are not necessarily well
qualified to apply the theories of portfolio structuring to our holdings and hence would be better off leaving that to
a professional. Mutual funds represent one such option.

What's strategy got to do with selecting a mutual fund? Shouldn't you just go and invest in the best performing
fund? The answer is no. Mutual fund investing requires as much strategic input as any other investment option.
But the advantage is that the strategy here is a natural extension of your asset allocation plan (use our Asset
Allocator to understand what your optimum asset allocation plan should be, based on your personal risk
profile). moneycontrol recommends the following process:

Identify funds whose investment objectives match your asset allocation needs
Just as you would buy a computer that fits your needs and budget, you should choose a mutual fund that meets
your risk tolerance (need) and your risk capacity (budget) levels (i.e. has similar investment objectives as your
own). Typical investment objectives of mutual funds include fixed income or equity, general equity or sectorfocused, high risk or low risk, blue-chips or turnarounds, long-term or short-term liquidity focus. You can use
moneycontrols Find-A-Fund query module to find funds whose investment objectives match yours.

Evaluate past performance, look for consistency

Although past performance is no guarantee for the future, it is a useful way of assessing how well or badly a fund
has performed in comparison to its stated objectives and peer group. A good way to do this would be to identify
the five best performing funds (within your selected investment objectives) over various periods, say 3 months, 6

months, one year, two years and three years. Shortlist funds that appear in the top 5 in each of these time
horizons as they would have thus demonstrated their ability to be not only good but also, consistent performers.
You can engage in such research through moneycontrol's Find-A-Fund query module.

Diversify
Don't just zero in on one mutual fund (to avoid the risk of being overly dependent on any one fund). Pick two,
preferably three mutual funds that would match your investment objective in each asset allocation category and
spread your investment. We recommend a 60:40 split if you have shortlisted 2 funds and a 50:30:20 split if you
have shortlisted 3 funds for investment.

Consider Fund Costs

The cost of investing through a mutual fund is not insignificant and deserves due consideration, especially when it
comes to fixed income funds. Management fees, annual expenses of the fund and sales loads can take away a
significant portion of your returns. As a general rule, 1% towards management fees and 0.6% towards other
annual expenses should be acceptable. Carefully examine load the fee a fund charges for getting in and out of
the fund.

Having made an investment in a mutual fund, you should monitor it to see whether its management and
performance is in line with stated objectives and also whether its performance exceeds or lags your expectations.
Unlike individual stocks and bonds, mutual fund reviews are required less frequently, once in a quarter should be
sufficient.

A review of the funds performance should be carried out with the objective of holding or selling your investment in
the mutual fund. You might need to sell your investment in a mutual fund if any of the events below apply

You change your investment plan.

For example, as you grow older you might adopt a more conservative investment approach, pruning some of your
riskier (equity-oriented) funds.

A fund changes its strategy.

A fund that alters its investment objective or approach might no longer fit your strategy.

The fund's poor results persist.

If a fund regularly trails other funds that invest in similar securities, consider replacing it. The poor performance is
more often than not a reflection on the relative expertise of the asset management company.

By now you would have realized that investing in mutual funds is not just a decision but is more a
process. moneycontrol's Mutual Fund Investing Checklist can help make this process easier and more efficient.

Mutual Fund Investing Checklist

Using the checklist below should help you to extract the most from your mutual fund investment process. We
assume that you will be investing largely through mutual funds to meet your targeted asset allocation plan.

1. Draw up your asset allocation

You can use moneycontrols Asset Allocator for this. Take a printout of your suggested asset allocation plan so
that you can use that to plan your investments across mutual funds.

2. Identify funds that fall into your Buy List

How do you do this? Simple. Just go to Find-A-Fund and run a query specifying the parameters you are seeking.

3. Obtain and read the offer documents

You could do this by either asking your broker or the asset management companies. You might also find some of
these documents if you go to our Request-A-Form service.

4. Match your objectives

Read through the offer documents and check to see whether the mutual funds identified meet your investment
needs in terms of equity share and bond weightings, downside risk protection, tax benefits offered, dividend
payout policy, sector focus and other parameters of relevance to you. For ease in short listing, you can use
our Find-A-Fund query module.

5. Check out past performance

Make sure you do this. There is no other indicator that you can use as effectively to select funds for investment.
Yet again (we wont tire of saying this), for ease you can use our Find-A-Fund query module to find out your
selected funds performance over various time periods.

6. Don't forget the index funds

Index funds offer you probably the ideal hedge against varying performance across sectors and across fund
managers over longer-periods of time. moneycontrol recommends that you have atleast some part of your assets
in index mutual funds (you would have seen this in your recommended asset allocation plan also if you have
used moneycontrols Asset Allocator).

7. Think hard about investing in sector funds

Investing in specific sector funds is recommended for aggressive investors. However, if you are not in close touch
with the developments in the sector or do not review your portfolio regularly, we would not recommend investing
in sector funds.

8. Look for `load' costs

Management fees, annual expenses of the fund and sales loads can take away a significant portion of your
returns. As a general rule, 1% towards management fees and 0.6% towards annual expenses should be
acceptable. Try and avoid funds that have a sales load, unless of course they have a consistent track record of
being a top-performer.

9. Does the fund change fund managers often?

Since you will be giving past track record a consideration, you are inadvertently relying on the continuity of the
fund manager. Stay away from mutual funds whose fund managers change often.

10. Look for size and credentials

As far as possible avoid investing in funds with an asset base of less than Rs25 crores. Which means that we are
recommending you invest in funds only after they have established a track record. And unless it is a really exciting
new (theme) fund that fits into your asset allocation plan, try and avoid new funds.

11. Customer Service

Check out the customer service delivery mechanism of the mutual fund you choose. Can you get in touch with
them easily? How long do they take to disburse payments? How often do they send you portfolio updates? And
investor newsletters? These questions are important to address because shortcomings on any of these factors
could affect your overall returns.

12. Diversify, but not too much

Do not hold just one fund in each asset category. Its good to diversify your risk between different funds, but do not
overdo it. moneycontrolrecommends two, or maybe three funds in each asset category.

13. Style, not returns matter first in the long-term

Don't let a top performing fund veer you away from a disciplined approach. Stick to your chosen asset allocation
plan.

14. Monitor regularly and review

Try to review your mutual fund holdings atleast once a quarter. If you follow the same principles to review as you
did to identify the mutual funds you invested in, you will be able to take `sell decisions' very easily. You can read
more about this approach by clicking Step 3: Invest Monitor and Review.

15. Invest regularly, choose the MIP

Try to make mutual fund investing an integral part of your savings and wealth-building plan. The monthly
investment plan option offered by some mutual funds is a strongly recommended approach for you to execute this
process . However, dont let the availability of this option override your fund selection criteria.

By now you would have identified your list of mutual funds that you want to invest in. List them down with reasons
for your intended purchase. Next, you can fill in the application forms for these funds. You can easily obtain
application forms for most of the mutual funds frommoneycontrols Request-A-Form service.

Do mutual funds offer a periodic investment plan?

Most private sector funds provide you the convenience of periodic purchase plans (through a
Systematic Investment Plan), automatic withdrawal plans and the automatic reinvestment of dividends.
You would basically need to give post-dated cheques (monthly or quarterly, periodic date of the
cheque is fixed by the Asset Management Company). Most funds allow a monthly investment of as
little as Rs500 with a provision of giving 4-6 post-dated cheques and follow up later with more. Regular
monthly investments are a good way to build a long-term portfolio and add discipline to your
investment process.