A variety of schemes are offered by mutual funds. It is critical for investors to know the features of these products, before money is invested in them. Let us first understand what are Open Ended and Close Ended funds.
WHAT ARE OPEN ENDED AND CLOSE ENDED FUNDS?
Equity Funds (or any Mutual Fund scheme for that matter) can either be open ended or close ended. An open ended scheme allows the investor to enter and exit at his convenience, anytime (except under certain conditions) whereas a close ended scheme restricts the freedom of entry and exit. Whenever a new fund is launched by an AMC, it is known as New Fund Offer (NFO). Units are offered to investors at the par value of Rs. 10/ unit. In case of open ended schemes, investors can buy the units even after the NFO period is over. Thus, when the fund sells units, the investor buys the units from the fund and when the investor wishes to redeem the units, the fund repurchases the units from the investor. This can be done even after the NFO has closed. The buy / sell of units takes place at the Net Asset Value (NAV) declared by the fund. The freedom to invest after the NFO period is over is not there in close ended schemes. Investors have to invest only during the NFO period; i.e. as long as the NFO is on or the scheme is open for subscription. Once the NFO closes, new investors cannot enter, nor can existing investors exit, till the term of the scheme comes to an end. However, in order to provide entry and exit option, close ended mutual funds list their schemes on stock exchanges. This provides an opportunity for investors to buy and sell the units from each other. This is just like buying / selling shares on the stock exchange. This is done through a stock broker. The outstanding units of the fund does not increase in this case since the fund is itself not selling any units. Sometimes, close ended funds also offer ‘buy-back of fund shares / units”, thus offering another avenue for investors to exit the fund. Therefore, regulations drafted in India permit investors in close ended funds
to exit even before the term is over.
WHAT ARE EQUITY FUNDS?
Salient Features
These are by far the most widely known category of funds though they account for broadly 40% of the industry’s assets, while the remaining 60% is contributed by debt oriented funds. Equity funds essentially invest the investor’s money in equity shares of companies. Fund managers try and identify companies with good future prospects and invest in the shares of such companies. They generally are considered as having the highest levels of risks (equity share prices can fluctuate a lot), and hence, they also offer the probability of maximum returns. However, High Risk, High Return should not be understood as “If I take high risk I will get high returns”. Nobody is guaranteeing higher returns if one takes high risk by investing in equity funds, hence it must be understood that “If I take high risk, I may get high returns or I may also incur losses”. This concept of Higher the Risk, Higher the Returns must be clearly understood before investing in Equity Funds, as it is one of the important characteristic s of Equity fund investing.
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Equity Fund Definition
Equity Funds are defined as those funds which have at least 65% of their Average Weekly Net Assets invested in Indian Equities. This is important from taxation point of view, as funds investing 100% in international equities are also equity funds from the investors’ asset allocation point of view, but the tax laws do not recognize these funds as Equity Funds and hence investors have to pay tax on the Long Term Capital Gains made from such investments (which they do not have to in case of equity funds which have at least 65% of
their Average Weekly Net Assets invested in Indian Equities). Equity Funds come in various flavors and the industry keeps innovating to make products available for all types of investors. Relatively safer types of Equity Funds include Index Funds and diversified Large Cap Funds, while the riskier varieties are the Sector Funds. However, since equities as an asset class are risky, there is no guaranteeing returns for any type of fund. International Funds, Gold Funds (not to be confused with Gold ETF) and Fund of Funds are some of the different types of funds, which are designed for different types of investor preferences. These funds are explained later.
Equity Funds can be classified on the basis of market capitalization of the stocks they invest in – namely Large Cap Funds, Mid Cap Funds or Small Cap Funds – or on the basis of investment strategy the scheme intends to have like Index Funds, Infrastructure Fund, Power Sector Fund, Quant Fund, Arbitrage Fund, Natural Resources Fund, etc. These funds are explained later.
WHAT IS AN INDEX FUND?
Equity Schemes come in many variants and thus can be segregated according to their risk levels. At the lowest end of the equity funds risk – return matrix come the index funds while at the highest end come the sectoral schemes or specialty schemes. These schemes are the riskiest amongst all types’ schemes as well. However, since equities as an asset class are risky, there is no guaranteeing returns for any type of fund.
Index Funds invest in stocks comprising indices, such as the Nifty 50, which is a broad based index comprising 50 stocks. There can be funds on other indices which have a large number of stocks such as the CNX Midcap 100 or S&P CNX 500. Here the investment is spread across a large number of stocks. In India today we find many index funds based on the Nifty 50 index, which comprises large, liquid and blue chip 50 stocks.
The objective of a typical Index Fund states – ‘This Fund will invest in stocks comprising the Nifty and in the same proportion as in the index’. The fund manager will not indulge in research and stock selection, but passively invest in the Nifty 50 scrips only, i.e. 50 stocks which form part of Nifty 50, in proportion to their market capitalization. Due to this, index funds are known as passively managed funds. Such passive approach also translates into lower costs as well as returns which closely tracks the benchmark index return (i.e. Nifty 50 for an index fund based on Nifty 50). Index funds never attempt to beat the index returns, their objective is always to mirror the index returns as closely as possible.
The difference between the returns generated by the benchmark index and the Index Fund is known as tracking error. By definition, Tracking Error is the variance between the daily returns of the underlying index and the NAV of the scheme over any given period.
Concept Clarifier – Tracking Error
Tracking Error is the Standard Deviation of the difference between daily returns of the index and the NAV of the scheme (index fund). This can be easily calculated on a standard MS office spreadsheet, by taking the daily returns of the Index, the daily returns of the NAV of the scheme, finding the difference between the two for each day and then calculating the standard deviation of difference by using the excel formula for ‘standard deviation’. In simple terms it is the difference between the returns delivered by the underlying index and those delivered by the scheme. The fund manager may buy/ sell securities anytime during the day, whereas the underlying index will be calculated on the basis of closing prices of the Nifty 50 stocks. Thus there will be a difference between the returns of the scheme and the index. There may be a difference in returns due to cash position held by the fund manager. This will lead to investor’s money not being allocated exactly as per the index but only very close to the index. If the index’s portfolio composition changes, it will require some time for the fund manager to exit the earlier stock and replace it with the new entrant in the index. These and other reasons like dividend accrued but not distributed, accrued expenses etc. all result in returns of the scheme being different from those delivered by the underlying
index.
This difference is captured by Tracking Error. As is obvious, this should be as
low as possible.
The fund with the least Tracking Error will be the one which investors would prefer since it is the fund tracking the index closely. Tracking Error is also function of the scheme expenses. Lower the expenses, lower the Tracking Error. Hence an index fund with low expense ratio, generally has a low Tracking Error.
WHAT ARE DIVERSIFIED LARGE CAP FUNDS?
Another category of equity funds is the diversified large cap funds. These are funds which restrict their stock selection to the large cap stocks – typically the top 100 or 200 stocks with highest market capitalization and liquidity. It is generally perceived that large cap stocks are those which have sound businesses, strong management, globally competitive products and are quick to respond to market dynamics. Therefore, diversified large cap funds are considered as stable and safe. However, since equities as an asset class are risky, there is no guaranteeing returns for any type of fund. These funds are actively managed funds unlike the index funds which are passively managed, In an actively managed fund the fund manager pores over data and information, researches the company, the economy, analyses market trends, takes into account government policies on different sectors and then selects
the stock to invest. This is called as active management.
A point to be noted here is that anything other than an index funds are actively managed funds and they generally have higher expenses as compared to index funds. In this case, the fund manager has the choice to invest in stocks beyond the index. Thus, active decision making comes in. Any scheme which is involved in active decision making is incurring higher expenses and may also be assuming higher risks. This is mainly because as the stock selection universe increases from index stocks to largecaps to midcaps and finally to smallcaps, the risk levels associated with each category increases above the previous category. The logical conclusion from this is that actively managed funds should also deliver higher returns than the index, as investors must be compensated for higher risks. But this is not always so. Studies have shown that a majority of actively managed funds are unable to beat the index returns on a consistent basis year after year. Secondly, there
is no guaranteeing which actively managed fund will beat the index in a given
year. Index funds therefore have grown exponentially in some countries due to the inconsistency of returns of actively managed funds.
WHAT ARE MIDCAP FUNDS?
After largecap funds come the midcap funds, which invest in stocks belonging to the mid cap segment of the market. Many of these midcaps are said to be the ‘emerging blue-chip’ or ‘tomorrow’s largecaps’. There can be actively managed or passively managed mid cap funds. There are indices such as the CNX Midcap index which tracks the midcap segment of the markets and there are some passively managed index funds investing in the CNX Midcap companies.
WHAT ARE SECTORAL FUNDS?
Funds that invest in stocks from a single sector or related sectors are called Sectoral funds. Examples of such funds are IT Funds, Pharma Funds, Infrastructure Funds, etc. Regulations do not permit funds to invest over 10% of their Net Asset Value in a single company. This is to ensure that schemes are diversified enough and investors are not subjected to undue risk. This regulation is relaxed for sectoral funds and index funds.
There are many other types of schemes available in our country, and there are still many products and variants that have yet to enter our markets. While it is beyond the scope of this curriculum to discuss all types in detail, there is one emerging type of scheme, namely Exchange Traded Funds or ETFs, which is discussed in detail in the next section.
OTHER EQUITY SCHEMES :
Arbitrage Funds
These invest simultaneously in the cash and the derivatives market and take advantage of the price differential of a stock and derivatives by taking opposite positions in the two markets (for e.g. stock and stock futures).
Multicap Funds
These funds can, theoretically, have a smallcap portfolio today and a largecap portfolio tomorrow. The fund manager has total freedom to invest in any stock from any sector.
Quant Funds
A typical description of this type of scheme is that ‘The system is the fund manager’, i.e. there are some predefined conditions based upon rigorous back testing entered into the system and as and when the system throws ‘buy’ and ‘sell’ calls, the scheme enters, and/ or exits those stocks.
P/ E Ratio Fund
A fund which invests in stocks based upon their P/E ratios. Thus when a stock is trading at a historically low P/E multiple, the fund will buy the stock, and when the P/E ratio is at the upper end of the band, the scheme will sell.
Concept Clarifier – P/ E Ratio
P/ E Ratio stands for Price Earnings Ratio. It is also known as Price Earnings multiple.
This is a ratio of the current market price (CMP) of a share to its earning per share (EPS).
Thus if a company has issued 100 cr. shares and the profit after tax; i.e. the net profit of the company is Rs. 2000 cr., then the EPS for this company will be 2000/ 100 = Rs. 20.
If this company’s share’s CMP is Rs. 200, then the P/ E ratio will be 200/ 20 = 10x.
The unit of P/E Ratio is ‘times’. In the above example we say that the P/E Ratio is 10
times; i.e. the price (CMP) of the company’s share is 10 times its EPS.
International Equities Fund
This is a type of fund which invests in stocks of companies outside India. This can be a Fund of Fund, whereby, we invest in one fund, which acts as a ‘feeder’ fund for some other fund(s), i.e invests in other mutual funds, or it can be a fund which directly invests in overseas equities. These may be further designed as ‘International Commodities Securities Fund’ or ‘World Real Estate and Bank Fund’ etc.
Growth Schemes
Growth schemes invest in those stocks of those companies whose profits are expected to grow at a higher than average rate. For example, telecom sector is a growth sector because many people in India still do not own a phone – so as they buy more and more cell phones, the profits of telecom companies will increase. Similarly, infrastructure; we do not have well connected roads all over the country, neither do we have best of ports or airports. For our country to move forward, this infrastructure has to be of world class. Hence companies in these sectors may potentially grow at a relatively faster pace. Growth schemes will invest in stocks of such companies.
Concept Clarifier – Growth and Value Investing
Investment approaches can be broadly classified into Growth based and Value Based. While Growth investing refers to investing in fast growing companies, Value investing approach is based upon the premise that a stock/ sector is currently undervalued and the market will eventually realize its true value. So, a value investor will buy such a stock/ sector today and wait for the price to move up. When that happens, the Value investor will exit and search for another undervalued opportunity.
Hence in Growth investing, it is the growth momentum that the investor looks for, whereas in Value investing, the investor looks for the mismatch between the current market price and the true value of the investment.
Contra Funds can be said to be following a Value investing approach.
For example, when interest rates rise, people defer their purchases as the cost of borrowing increases. This affects banks, housing and auto sectors and the stocks of these companies come down. A Value fund manager will opine that as and when interest rates come down these stocks will go up again; hence he will buy these stocks today, when nobody wants to own them. Thus he will be taking a contrarian call.
The risk in Growth investing is that if growth momentum of the company goes down slightly, then the stock’s price can go down rather fast, while in Value investing, the risk is that the investor may have to wait for a really long time before the market values the investment correctly.
ELSS
Equity Linked Savings Schemes (ELSS) are equity schemes, where investors get tax benefit upto Rs. 1 Lakh under section 80C of the Income Tax Act. These are open ended schemes but have a lock in period of 3 years. These schemes serve the dual purpose of equity investing as well as tax planning for the investor; however it must be noted that investors cannot, under any circumstances, get their money back before 3 years are over from the date of investment.
Fund of Funds
These are funds which do not directly invest in stocks and shares but invest in units of other mutual funds which they feel will perform well and give high returns. In fact such funds are relying on the judgment of other fund managers.
Let us now look at the internal workings of an equity fund and what must an investor know to make an informed decision.
Concept Clarifier – AUM
Assets Under Management (AUM) represents the money which is managed by a mutual fund in a scheme. Adding AUMs for all schemes of a fund house gives the AUM of that fund house and the figure arrived at by adding AUMs of all fund houses represents the industry AUM.
AUM is calculated by multiplying the Net Asset Value (NAV – explained in detail later) of a scheme by the number of units issued by that scheme.
A change in AUM can happen either because of fall in NAV or redemptions. In case of sharp market falls, the NAVs move down, because of which the AUMs may reduce.
WHAT IS NAV?
Net Assets of a scheme is that figure which is arrived at after deducting all scheme liabilities from its asset. NAV is calculated by dividing the value of Net Assets by the outstanding number of Units.
Concept Clarifier – NAV
The above table shows a typical scheme balance sheet. Investments are entered under the assets column. Adding all assets gives the total of Rs. 387.7 cr. From this if we deduct the liabilities of Rs. 2 cr. i.e. Accrued Expenditure and Other Current Liabilities, we get Rs. 385.7 cr as Net Assets of the scheme.
The scheme has issued 30 crs. units @ Rs. 10 each during the NFO. This translates in Rs. 300 crs. being garnered by the scheme then. This is represented by Unit Capital in the Balance Sheet. Thus, as of now, the net assets worth Rs. 385.7 cr are to be divided amongst 30 crs.
units. This means the scheme has a Net Asset Value or NAV of Rs. 12.86.
The important point that the investor must focus here is that the Rs. 300 crs. garnered by the scheme has increased to Rs. 387 crs., which translates into a 29.23% gain, whereas, the return for the investor is 28.57% (12.86-10/ 10 = 28.57%).
Concept Clarifier – Fund Fact Sheet
Investors must read the Offer Document (OD) before investing. If not the OD, at least the Key Information Memorandum (KIM), which has to be provided with the application form. After an investor has entered into a scheme, he must monitor his investments regularly. This can be achieved by going through the Fund Fact Sheet. This is a monthly document which all mutual funds have to publish. This document gives all details as regards the AUMs of all its schemes, top holdings in all the portfolios of all the schemes, loads, minimum investment, performance over 1, 3, 5 years and also since launch, comparison of scheme’s performance with the benchmark index (most mutual fund schemes compare their performance with a benchmark index such as the Nifty 50) over the same time periods, fund managers outlook, portfolio composition, expense ratio, portfolio turnover, risk adjusted returns, equity/ debt split for schemes, YTM for debt portfolios and other information which the mutual fund considers important from the investor’s decision making point of view.
In a nutshell, the fund fact sheet is the document which investors must read, understand and keep themselves updated with.
WHAT IS EXPENSE RATIO?
Among other things that an investor must look at before finalizing a scheme, is that he must check out the Expense Ratio.
Concept Clarifier – Expense Ratio
Expense Ratio is defined as the ratio of expenses incurred by a scheme to its Average Weekly Net Assets. It means how much of investors money is going for expenses and how much is getting invested. This ratio should be as low as possible.
Assume that a scheme has average weekly net assets of Rs 100 cr. and the scheme incurs Rs. 1 cr as annual expenses, then the expense ratio would be 1/ 100 = 1%. In case this scheme’s expense ratio is comparable to or better than its peers then this scheme would qualify as a good investment, based on this parameter only.
If this scheme performs well and its AUM increases to Rs. 150 cr in the next year whereas its annual expenses increase to Rs. 2 cr, then its expense would be 2/ 150 = 1.33%.
It is not enough to compare a scheme’s expense ratio with peers. The scheme’s expense ratio must be tracked over different time periods. Ideally as net assets increase, the expense ratio of a scheme should come down.
WHAT IS PORTFOLIO TURNOVER?
Fund managers keep churning their portfolio depending upon their outlook for the market, sector or company. This churning can be done very frequently or may be done after sufficient time gaps. There is no rule which governs this and it is the mandate of the scheme and the fund managers’ outlook and style that determine the churning. However, what is important to understand is that a very high churning frequency will lead to higher trading and transaction costs, which may eat into investor returns. Portfolio Turnover is the ratio which helps us to find how aggressively the portfolio is being churned.
While churning increases the costs, it does not have any impact on the Expense Ratio, as transaction costs are not considered while calculating expense ratio. Transaction costs are included in the buying & selling price of the scrip by way of brokerage, STT, cess, etc. Thus the portfolio value is computed net of these expenses and hence considering them while
calculating Expense Ratio as well would mean recording them twice – which would be incorrect.
Concept Clarifier – Portfolio Turnover
Portfolio Turnover is defined as ‘Lesser of Assets bought or sold/ Net Assets’. A scheme with Rs. 100 cr as net assets sells Rs 20 cr of its investments. Thus its Portfolio Turnover Rate would be 20/ 100 = 20%.
If this scheme’s net assets increase to Rs. 120 cr and the fund manager decides to churn the entire portfolio by exiting all stocks, then the Portfolio Turnover would be 120/ 120 = 100%.
If the fund manager churns the entire portfolio twice in a single year then we would say that the Portfolio Turnover rate is 200% or that the portfolio is churned once every 6 months. Liquid funds have very high portfolio turnover due to less maturity of the paper. Once the paper matures, the fund manager has to buy another security, thus churning the portfolio.
HOW DOES AUM AFFECT PORTFOLIO TURNOVER?
The scheme’s AUM can also have an impact on the performance of the scheme. In case the scheme performs well and thereby attracts a lot of money flow, it may happen that the fund manager may not be able to deploy that extra money successfully as he may not find enough opportunities. Thus an increased fund size may result in lower returns. If the fund manager tries to acquire significantly large quantities of a stock, the buying pressure may
lead to higher stock prices, thereby higher average cost for the scheme. Also, if the holdings by the scheme in any stock are huge, then exit may be difficult as selling from the scheme itself can put pressure on the prices. Thus the first share may be sold at a higher price and as the supply increases the prices may fall, and the last share may get sold at a lower price.
A scheme with a very small AUM does not face these problems but has its own set of problems. The Expense Ratio of such a scheme will be very high as expenses are calculated as a percent of Average Weekly Net Assets. As the fund size increases, the Expense Ratio tends to go down.
Similarly Portfolio Turnover will be magnified as the denominator (Average Net Assets) is small and hence the turnover appears to be very high.
Thus, the investor must look at AUM for the previous few months, say last 12 months and compare the same with that of the industry and also similar schemes. If it is found that the scheme’s performance is in line or better than its peers consistently, even though the AUM is increasing, then it can be a fair indicator that increased AUM is not a problem for the fund manager.
HOW TO ANALYSE CASH LEVEL IN PORTFOLIOS?
The next logical point of focus must be the Cash Level in the scheme. The Cash level is the amount of money the mutual fund is holding in Cash, i.e. the amount not invested in stocks and bonds but lying in cash. If the scheme is having higher than industry average cash levels consistently, more so in a bull market, it will lead to a inferior performance by the scheme than its peers. However, in a falling market, it is this higher cash level that will protect investor wealth from depleting. Hence whenever one is analyzing cash levels, it is extremely important to see why the fund manager is sitting on high cash levels. It may be so that he is expecting a fall therefore he is not committing large portions of monies. It may be so in a bull market or a bear market. The strategy could be to enter once the prices correct. High cash levels can also be seen as a cushion for sudden redemptions and in large amounts.
WHAT ARE EXIT LOADS?
Exit Loads, are paid by the investors in the scheme, if they exit one of the scheme before a specified time period. Exit Loads reduce the amount received by the investor. Not all schemes have an Exit Load, and not all schemes have similar exit loads as well. Some schemes have Contingent Deferred Sales Charge (CDSC). This is nothing but a modified form of Exit Load, wherein the investor has to pay different Exit Loads depending upon his investment period.
If the investor exits early, he will have to bear more Exit Load and if he remains invested for a longer period of time, his Exit Load will reduce. Thus the longer the investor remains invested, lesser is the Exit Load. After some time the Exit Load reduces to nil; i.e. if the investor exits after a specified time period, he will not have to bear any Exit Load.
Corporate actions. https://www.youtube.com/watch?v=V8wKtp4aeQQ&t=2195s
Private Equity-03 https://youtu.be/Wip9pwV7fZU
Derivatives https://youtu.be/iV2p9a-TUFU
Cash Recon https://youtu.be/F6H-wgwuDa8
Cash Dividend https://youtu.be/F6H-wgwuDa8
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