Monday, 30 November 2015

Crash course in mutual fund investing

Investing in a mutual fund is easy. All you have to do is to buy shares of the fund (called units) and become a shareholder. Your money, pooled with money from other investors, is what constitutes the fund. These funds are then invested by a professional money manager in various stocks, bonds etc. 

So how does a mutual fund make money? In two ways: by earning dividends or interest on its investments and by selling investments that have appreciated in price. The fund pays out, or distributes, its profits (less fees and expenses) to its shareholders. That's how you make money. Most funds offer investors the option of reinvesting their distributions in the fund by buying more shares.
Why invest in a mutual fund?
Well, there are several reasons. First, since a fund can own hundreds of different securities, its success or failure is not going to be dependent on how well a handful of securities perform. In other words, a mutual fund is well diversified. Spreading your money in this way among many different companies and industries effectively reduces your risk--it reduces the possibility that you may lose money. This diversification is one of the biggest advantages of mutual funds. For most of us, the amount of income and investment knowledge required to accomplish similar diversification would be impossible to obtain. Also, sharing expenses with millions of like-minded investors, through a mutual fund, significantly reduces your investment cost. That's because a mutual fund is an "institutional trader" and can therefore buy securities at wholesale prices. There's also an additional reason for investing in mutual funds now. The dividend in the hands of the receiver (that means you) is tax-free.

By investing in a well-managed mutual fund, you share the expense of hiring a professional money manager with a proven track record. Your Rs500 will receive the same attention, and get the same returns, as the money of institutional investors, who place billions of rupees a year.
Choosing the right fund is critical
There are other benefits. You don't have to bother with the task of keeping a record of your investments. Your investment is liquid, at least for open-ended funds, and you can surrender your units to the fund and get your refund within a few days. Of course, not all funds are equally liquid, which is why choosing a fund is so important.

Before you buy units in any mutual fund, it is important that you know exactly how much it is going to cost. All mutual funds charge a management fee. It doesn't matter if you buy from a bank or a broker, you will pay a management fee. These fees are usually given as a percentage of the fund's total assets and pay the administrative costs and the wages and bonuses of fund managers. In addition, some mutual funds charge a "load" when you buy or sell your mutual fund units. A fee when you buy your units is known as front-load and if the fee is on redemption, it is known as a back-load.
What is the net asset value of a fund?
The net asset value (NAV) of a mutual fund is the rupee value of one unit of the fund and is calculated by dividing the current market value of the fund's assets, less liabilities, by the number of units already sold. For example, if the fund you are interested in has assets worth Rs20 crore, after deducting the liabilities, and there are 1 crore units already sold, each unit is worth Rs20 (Rs20 crore divided by 1 crore). This means you would pay Rs20 for one unit of the fund,and the NAV is Rs20.

The only way the NAV will change is due to the rise or fall in the market value of the assets held by the fund. Let's say that the same fund's assets increased to Rs30 crore due to some great investment decisions of the fund manager and the number of units outstanding (sold) remained unchanged at 1 crore. The NAV of each unit you held would now be worth Rs30 (Rs30 crore divided by 1 crore). Anyone now buying into the fund would have to pay the new NAV of Rs30 per unit. If you decided to sell, you would have made a capital gain of Rs1,000. On the other hand, if you decided to stay with the fund, this capital gain would be paid out in the form of distribution of the Rs1,000 or be reinvested in additional units. Once distributed, or converted into additional units, the NAV will fall. Clearly, the NAV will fluctuate according to the market value of the stocks and bonds the fund has invested in.

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