Terms and concepts related to mutual funds

Mutual Fund scheme: A mutual fund may offer multiple products, called schemes, plans and funds to investors. For example the Franklin Templeton Mutual Fund offers the following schemes, among others, to investors:

• Franklin India Blue-chip Fund, which invests in equity shares;
• Templeton India Income Fund, which invests in debentures and other debt instruments;
• FT India Monthly Income Plan, which invests in both equity and debt instruments

Asset management companies (AMC): The Asset Management Company (AMC) is the specialist investment manager that manages the mutual fund. For example, Franklin Templeton Asset Management (India) Pvt. Ltd  is an AMC that manages the Franklin Templeton Mutual Fund. The fund manager of the mutual fund are employees of the AMC. The AMC launches mutual fund schemes, collects money from investors and manages it. Investors of a mutual fund deal with AMC for their operational requirements.

Pooling and Proportionate Representation: Mutual funds pools the money contributed by investors to a scheme and invests them in a portfolio of securities. The investments made by the fund belong to the investors, who will share the profits or losses made in proportion to their investment.

• For example: Three investors invest Rs. 10,000, Rs. 20,000 and Rs. 30,000 respectively in a mutual fund. The pooled sum is Rs. 60,000 and their proportionate holding is in the ratio 1:2:3. The money is invested in equity shares. With time, fund’s portfolio appreciate in value and is now worth Rs. 72,000. The value of the investors’ holding also goes up proportionately (ratio of 1:2:3) to Rs. 12,000, Rs. 24,000 and Rs. 36,000 respectively.

Units and Unit capital: An investor’s investment in a fund is represented in units and a mutual fund investor is called a unit holder. Each unit has a face value, typically Rs.10. In above example, if the investors bought the units at the face value, the number of units that will be allotted to them is 1,000 units (Rs.10,000/Rs.10), 2000 units (Rs.20,000/Rs.10) and 3000 units (Rs.30,000/Rs.10) respectively.

Mark to Market (MTM): Fund Managers invest pooled money in a variety of securities such as different shares, debentures etc as per investment objectives. As the prices of portfolio securities change, the value of portfolio will also decrease/increase. Mutual funds have to monitor the securities prices and its effects on the portfolio market value. Mutual Funds inform investors about the current market value of portfolio based on securities current market prices. This process of valuing the securities at its current market price is called marking to market (MTM). In the above example, the cost of investment was Rs. 60,000 and its MTM value was Rs. 72,000.

Net Asset Value (NAV): The NAV is the current market value of a mutual fund unit. This will depend upon the current MTM value of the securities held in the portfolio of the fund and adding any income earned such as dividend and interest. The costs and expenses charged for managing the fund are deducted from above value. The remaining value is called the net assets of the fund. The NAV of a fund is calculated every business day so that investors know the value of their investments. Investors buy and sell units at a price based on NAV. Consider the example we used earlier:

• • There were 6000 units of Rs.10 each issued.
  • The current market value of the portfolio was Rs. 72,000.
  • Assume dividend income of Rs.3000 and expenses of Rs.600.
  • The net assets are calculated by adding income earned and reducing expenses from the current market value of the portfolio. The net asset is Rs.74, 400.
  • As total number of units is 6000, so the net asset value per unit is 74,400/6000 = Rs.12.40.
  • The NAV of the fund has moved up from Rs.10 per unit to Rs.12.40 per unit.

Pricing of transactions: In “open – ended” Mutual Funds, there is no fixed maturity date of the funds, i.e investors can purchase(buy)/ redeem (sell),the units of mutual funds at any point. The units of mutual funds are bought/sold at the current NAV and not face value because this helps maintain equality between existing investors and new entrant investors. The fund in our earlier example had 6000 units, whose current market value is Rs. 74,400. The face value per unit is Rs.10; the NAV per unit is Rs.12.40.

• If a new investor buys 1000 units and pays the face value of Rs. 10 per unit.
  • Assets of the fund are now 74400+10000 = 84400
  • The NAV will be = 84400/7000 = Rs. 12.05

In above example, The NAV has dropped from 12.40 to 12.05, not because the portfolio lost in market value, but because a new investor came in. Existing unit holders face a loss in NAV due to the entry of the new investor at face value.

• If new investor buys 1000 units and pays the NAV of Rs.12.40 per unit.
  • Assets of the fund are now 74400+12400 = 86800.
  • The NAV will be = 86400/7000 = Rs.12.40.

The NAV has remained unchanged since the incoming investor paid the NAV not face value.

• Existing investor sells 1000 units and receives the face value of Rs.10 per unit.
  • Assets of the fund are now 74400 – 10000 = 64400.
  • The NAV will be = 64400/5000 = Rs.12.88.

The NAV has increased from 12.40 to 12.88, not because the portfolio gained in market value, but because an existing investor left. Existing unit holders face a gain in NAV due to the exit of investors at face value.

• Existing investor sells 1000 units and receives the face value of Rs.10 per unit.
  • Assets of the fund are now 74400 – 12400 = 60000.
  • The NAV will be = 60000/5000 = Rs.12.40

The NAV has remained unchanged since the outgoing investor received the NAV not face value.

Thus when units are bought/sold at NAV and not face value, equality between new and existing investors can be maintained.

Fund Running Expenses: Direct expenses incurred in managing the investment portfolio are charged to investors. It is calculated as a percentage of the daily average net assets managed by the fund. These expenses are already deducted at the time of calculating NAV thus investors don’t have to pay these expenses separately.

Loads: Mutual funds may impose a charge on the investors at the time of exiting from a fund called the exit load. It is linked to the period a fund is held by investors. It is calculated as a percentage of the NAV and reduced from the NAV to arrive at the price that the investor will get on exiting from the investment.

Mutual fund exit load

The picture alongside states that if a the particular mutual fund is exited within 1 year, 1% of NAV will be charged as exit load. If the NAV is Rs. 12, then the exit load will be Rs 0.12 (1% of Rs. 12). Investor will get Rs 11.88 (Rs.12-.12) on redemption.