HOW MUTUAL FUNDS WORK?
Mutual funds are diversified investment across different securities, which is made by collecting money from various investors. A mutual fund has many investors, ranging from hundreds to thousands. These investors with similar investment goals and objectives pool their money together at a lower cost, with minimum risk to get desired returns.
Various mutual funds schemes for investors
Usually, a mutual fund introduces various schemes, each with a different investment objective. Thereafter, the units of the said schemes are offered to investors at the face value, usually Rs.10, which is equal to the amount of their investment in the scheme.
Open-ended and Close-ended entry and exits
Open-ended and close-ended are types of mutual funds. Investors usually consider mutual funds to be open-ended and placing the close- ended mutual funds in another category. Open-ended is described as when shares are issued in the fund or sold back whenever the investors want. Whereas, close-ended schemes permits only a limited number of shares to be issued for a specific fund and can be sold or exit when the fund or scheme is terminated.
Since a mutual fund consists of a huge amount collected from numerous investors, there comes a need for proper guidelines and regulations. Hence, mutual funds are strictly regulated by the Securities and Exchange Board of India (SEBI). SEBI regulates the basic principles of trust, aims to protect the interests of investors, and offers transparency and compliance with laws.
Custodian by SEBI
A custodian, who is registered with SEBI. He takes charge of all the assets of the mutual fund. The custodian is held responsible for holding and protecting the securities that are invested in a mutual fund, and for the benefits. This process of segregating the fund managers from securities and investor records ensures that any kind of dishonest activity is eliminated. Moreover, only SEBI can approve or disapprove for the replacement of any custodian.
The responsibility of a fund manager
A person who manages and controls all the schemes is known as the fund manager. The fund manager is supposed to buy and sell securities from the portfolio according to the objectives, goals, and suitability for an investment in the portfolio. For managing the portfolio and rendering other services, the fund manager charges a fee which is based on the value of assets of the funds. All the necessary information an details regarding a fund manager can be accessed at Statement of Additional Information (SAI).
The expense ratio
The expense ratio is actually the amount that is paid by an investor to a mutual fund for managing the money. It is computed as a percentage of investment and charged annually. The amount is charged for the services such as expertise by the fund management team, administrative costs that are spent for running the mutual fund operations, fees of service providers, distribution and marketing expenses.
Total annual expense
There is a limit imposed on Total annual expense by SEBI which depends on the AUM of a fund. Maximum 2.50% p.a. on a corpus of up to Rs. 100 crores in equity funds (2.25% in debt funds), which is reduced in slabs with the increase in assets. Limits are computed on a daily average AUM.
Lower the expenses, better the return
Expenses are knocked down from the market value of your investments while calculating the NAV. Here’s how: NAV = [Portfolio Value + Dividends + Interest Income – Expenses)] ÷ [No.of Units]. In other words, if the underlying investments generated a 20% return in any year, the NAV of the scheme will increase only 18% if the expense ratio is 2%. Expenses eat into NAV each year, so the compounding impact of expenses on the portfolio is very significant.
Entry and Exit Charges
There is always a sales charge compiled with the mutual fund whenever it is purchased called LOAD. Fund salesperson tends to receive the load charges for the services and research rendered in form of commission. Load charges can be up to 8.5 percent of the selling price and can be considered as a front-end load, which is paying when investors purchase the mutual fund or a back-end load, which is paying the amount at the time of selling the mutual fund. However, there are many mutual funds on which load charges are not charged. This implies that no sales fee is imposed and the fund is said to be directly marketed and hence can be bought without involving any salesperson. Investors can rely on internet and online research to make wise choices regarding mutual funds. There are also some mutual funds that low-load funds, meaning they charge only a minimum amount of sales charge that is up to 3.5 percent as a sales fee.