Dejargonifying Mutual Fund Terms

Defining a simple word can be extremely confusing. Hence in this article, we have simplified the most commonly used terms in financial jargon.

In the popular Bollywood movie, 3 Idiots, in a humorous scene, a book was sarcastically defined as instruments that record, analyse, summarise, organise, debate and explain information; that are illustrated, non-illustrated, hardbound, paperback, jacketed, non-jacketed; with foreword, introduction, table of contents, index; that are indented for the enlightenment, understanding, enrichment, enhancement and education of the human brain through sensory route of vision - sometimes touch.


Below is a list of mutual fund terms that we have chosen:


Alpha

In a class of 30 students, the average marks scored in mathematics is 60%. One student scored 70%. Has this particular student fared better at mathematics than class average? The answer is a simple yes. The 10% gap in simple terms is alpha.

Alpha is a tool to calculate investment progress in comparison to a benchmark like an index. A positive alpha of 1.0 translates into the fund’s outperformance over its benchmark index by 1%. A negative alpha of 1.0 indicates underperformance of 1%.
Alpha= R – Rf – beta (Rm-Rf)
Alpha as per the above formula can explained as Portfolio Return minus the Risk free rate of return minus Beta (measure of volatility of returns in a portfolio) multiplied by Benchmark return minus Risk free rate of return. For example, assuming that the actual return of the fund is 30, the risk-free rate is 8%, beta is 1.1, and the benchmark index return is 20%, alpha is calculated as:
Alpha = (0.30-0.08) – 1.1 (0.20-0.08) = 0. 088 or 8.8%
The above reflects the investment’s outperformance over its benchmark index by 8.8%.

AMC

AMC - 'Asset Management Company’. As the name suggest it is a company that is responsible for managing the assets purchased using one’s investment funds.

AMC is a company that decides to invest funds pooled by clients into different types of securities as per stated objectives, thereby providing clients more diversification and investment options. AMCs earn income by charging service fees to clients.

AUM

AUM – ‘Assets Under Management’
AUM is the total market value of investments managed by AMCs.
Why is it relevant? AMC’s charge fund management fees on the assets managed by them. Thus higher the AUM implies higher is the fees earned by the AMC.

Beta

We all would clearly enjoy higher returns or alpha. However there is no free lunch. Higher returns may also be accompanied with higher risk. Just like alpha measures the return of one’s funds compared to an index, Beta measures the volatility of returns or risk in a portfolio compared to the entire market. Stock with a higher beta has greater risk. It is translated as below:
If Beta is 1, then the risk of portfolio is exactly as per the market. So, if Sensex or Nifty go up by 5%, the portfolio value would go up by 5%. If Sensex or Nifty fall by 2%, the portfolio value is expected to fall by 2%.

If Beta is higher than 1, then the portfolio is more volatile than the market. Example if Beta is 2, if Sensex or Nifty go up by 5%, the portfolio value would go up by 10%, if Sensex or Nifty fall by 2%, the portfolio value is expected to fall by 4%.

If Beta is lesser than 1, then the portfolio is less volatile than the market. Example if Beta is 0.5, if Sensex or Nifty go up by 5%, the portfolio value would go up by 2.5%, if Sensex or Nifty fall by 2%, the portfolio value is expected to fall by 1%.

If Beta is zero, then the portfolio is uncorrelated to the market
If Beta is less than zero, then the portfolio is negatively uncorrelated to the market

Benchmark

Student A has scored 95% in mathematics. How does that compare to another student B who has scored 90% in a literature subject. Difficult to compare right? But if the remaining students have all scored 100% in mathematics then one knows that the student A has not fared well in mathematics. A benchmark is a standard used against which mutual fund performance is measured.
Hence a Pharma fund’s performance would need to be compared to a benchmark made of pharma companies e.g. Nifty Pharma index.

Capital Gain

One has being investing Rs 10,000/- in a balanced mutual funds every month to save for a car. After 4 years one has invested Rs 4,80,000/-. Due to a strong equity market the fund has given good returns and the value of total investment is Rs 6,00,000/- today. One decides it is time to buy a car finally and liquidate one’s investments. The difference between current fund value (Rs 6,00,000/-) and the amount invested (Rs 4,80,000/-) is capital gains earned.

It is the profit earned from disposing of an asset, or from holding it while its market value increases. It essentially is increase in value of an asset (such as stock or real estate) between the time it is bought and the time it is sold.

There are 2 kinds of capital gains, 1) Short Term Capital Gain and 2) Long Term Capital Gain. They are determined by type of fund and the tenor of holding.

  1. Short Term Capital Gain:
    • For equity funds if the holding period is less than 1 year.
    • For Debt funds if the holding period is less than 3 year.
  2. Long Term Capital Gain:
    • For equity funds if the holding period is more than 1 year.
    • For Debt funds if the holding period is more than 3 year.

Closed ended funds

Closed-ended funds are a type of funds that are not redeemable from the fund. Unlike open-end funds, which one can redeem at any given point, investors in closed ended funds commit their funds for the duration of the fund.

At the time of New Fund offering, the AMC issues a specific number of shares based on the amount of money raised. No additions can be made thereafter.

The advantage of a closed ended fund is that the fund manager need not worry about redemptions in the fund and hence can invest for the entire duration of the fund in securities that may provide higher returns but also carry higher risk in short term.

Compounding

Let us assume there are two investors, A & B. They start working at the age of 20. Investor A starts investing Rs. 1000/- per month right from the start of his career for the next 10 years. That’s a total investment of Rs. 1,20,000/-. He leaves the investment in the market for next 30 years, until he is 60 years old. Investor B starts investing after initial 10 years of his career. But to build a nest he starts investing Rs.1000/- per month for the next 30 years. That’s a total investment of Rs. 3,60,000/-.
Assuming a market return of 8% p.a., who would have a larger retirement fund at the age of 60?
Investor A has contributed a lot less than Investor B, but due to the power of compounding, Investor A has a retirement nest of Rs. 20,13,000/- whereas Investor B has managed to accumulate a wealth of Rs. 15,00,000/-.

This is the power of compounding and starting early towards long term goals even with relatively smaller amounts.

No doubt Albert Einstein called compound interest the eighth wonder of the world.

Consolidated Account Statement

Consolidated Account Statement is akin to a bank account statement. Only difference is that a Consolidated Account Statement gives an investor all the details regarding sales, purchases and other transactions in a mutual fund in an orderly manner in a single place whereas a bank account statement would give details of banking transactions.

This is the power of compounding and starting early towards long term goals even with relatively smaller amounts.

No doubt Albert Einstein called compound interest the eighth wonder of the world.

Typical details included are:

  • Investor name and contact details
  • All financial purchases and transactions like switching, redemption or merging of funds,
  • Dividend or bonus payments, reinvestment details
  • Way of investing – lumpsum or a Systematic Investment Plan
  • Closing and opening share unit portfolio balance.

An account statement also gives a proper insight to the investors about how to track mutual fund performance.

ELSS

ELSS schemes are diversified equity schemes, primarily subscribed to, as they offer tax benefits under the Section 80C of Income Tax Act 1961. Returns from an ELSS scheme are tax free. One can claim upto Rs. 1 lakh of one’s ELSS investment as a deduction from one’s gross total income in a financial year.
However they also carry a lock-in period of 3 years.

Entry Load

Mutual fund companies collect a fee from all investors when they enter or exit scheme. This fee is called load. In simple terms, investors would purchase a mutual fund at the net asset value (NAV) plus the entry load. This would increase the purchase price per unit for the investor thereby reducing the amount of units allotted to the investor.

Exit Load

Mutual funds collect a specific amount from all the investors when they enter or exit a scheme. This fee charged is called load.

Frequent withdrawals will force a mutual fund to keep aside more and more funds in cash and thereby impact the overall returns of the funds. The objective of collecting it when investors exit the scheme, is to dissuade them from exiting, thereby reducing the number of investors withdrawing. Various mutual funds houses charge different fees as loads.

Expense Ratio

Expense ratio is basically the total expense amount charged to the fund divided by the total Asset Under Management. It is expressed in percentage terms.

So how does an expense ratio impact investor returns? Higher expense ratio implies lower return for the investor as the expense ratio is deducted from the return generated by the funds from the market.

KYC

Complying with the Know Your Customer or KYC norms is mandatory for every mutual fund's investor. It is important for an investor to submit their identity details to the mutual fund houses.

KYC is one time exercise while dealing in securities markets - once KYC is done through a SEBI registered intermediary (broker, DP, Mutual Fund, etc), one need not undergo the same process again when you approach another intermediary.

An investor needs to submit identity documents along with the KYC form. Typically, the identity document includes ID Proof, Address Proof along with passport size photograph.

Load

Load is a sales charge or commission paid to the mutual fund. The investor pays the load, for compensation to sales intermediary for his time and expertise in selecting an appropriate fund for the investor.

Open Ended Funds

Open-End Fund is the type of mutual fund, that does not restrict the number of units issued by the fund. Investors can issue and redeem units continuously, since there is no limit on the issuance of number of open-end fund units.

Open Ended Funds

Open-End Fund is the type of mutual fund, that does not restrict the number of units issued by the fund. Investors can issue and redeem units continuously, since there is no limit on the issuance of number of open-end fund units.

SIP

Systematic Investment Plan is an investment strategy wherein an investor needs to invest a pre-determined amount of money in a particular mutual fund at every stipulated time period (weekly, monthly, quarterly, etc.).

The investor is allocated certain number of units based on the ongoing market rate (called NAV or net asset value) for the day. Every time one invests money, additional units of the scheme are purchased at the market rate and added to one’s account.

Further investors need not worry about investing at the wrong time. For a regular investor, the same amount of money fetches more units when the prices are low and less units when the price is high. This may help an investor achieve lower weighted average cost per unit.

Standard Deviation

Standard Deviation (SD) is a statistical measure that captures the difference between the average of a data set and how far the individual points are spread out from the average number. A low standard deviation indicates that numbers are close to average. A high standard deviation indicates that numbers are spread out.

In the finance world, Standard Deviation is used to determine volatility of returns. Higher standard deviation implies higher volatility of returns which in turn implies higher the risk of the portfolio. Accordingly lower standard deviation implies lower risk.

Units

Mutual funds issue units to the investors as per funds invested by them. Investors of mutual funds are known as unitholders. Transaction of mutual funds is done in units. For example, consider that one is investing Rs 500 per month through a SIP in a mutual fund. If the NAV of the mutual fund is 25 on the day of the purchase, then 20 units would be bought for Rs 500.

Dividend

As a unit holder in a scheme one is expecting some return on one’s investment. So when the scheme is doing well, one would expect to gain from one’s investments. In case the mutual fund company decides to share the growth in NAV with its unit holders regularly, they can do so by declaring dividend. In simple terms it implies sharing some of the gains with the unit holders during the course of their holding rather than accumulating the gains until the unit holder can redeem the units.

Some important points to remember regarding dividends:

  • The amount and frequency of dividends is not guaranteed.
  • Dividends are declared only when the scheme makes a profit and it is at the discretion of the asset management company.
  • Dividend is paid from the units of NAV. Thus the NAV of the fund will drop atleast to the extent of the dividend declared.

NFO

A new fund offer (NFO) is a subscription offer for the first time for a new scheme launched by the asset management companies (AMCs). A new fund offer is launched to raise public capital to buy stocks and bonds from the market.

Flexi-SIP

A Flexi SIP allows an investor to vary the amount of one’s investments every month. If the investor does not want a fixed amount but wants more control over ones investments, the investor can set up a Flexi SIP.

With Flexi-SIP, an investor needs to choose a mutual fund scheme, a minimum investment amount, and an investment date like for any other SIP. However, investors can choose maximum investment amount.

After this, every month, the investor will have the flexibility to set the amount for the next SIP instalment. This can be any amount between the minimum required for that scheme and the maximum set by the investor.

ULIP

Unit Linked Insurance Plan is a financial product that combines investment as well as insurance. In an ULIP the premium amount, after deduction of charges, is invested into funds of one’s choice. Funds could be equity or debt based.

Fund performance depends on the market. ULIPs are similar to mutual funds, except that ULIPs are like investment products with insurance benefits.