5 commonly used mutual fund terms that investors should be aware of

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June 21, 2021 11:17 AM

Let us understand 5 commonly used mutual fund terms that new mutual fund investors should know.

Fund houses make use of particular indices as a reference point to measure mutual funds' performance.

Increasing participation of retail investors in mutual funds has led to a steep growth in its size. According to the data published by AMFI, the AUM of the Indian mutual fund industry has increased two fold from Rs 14.22 trillion as on April 30, 2016 to about Rs 32.38 trillion as on April 30, 2021. A considerable section of the fresh inflows came from fresh investors, many of whom lack fundamental understanding of the commonly-used mutual fund terms.

Let’s understand 5 commonly used mutual fund terms that new mutual fund investors should be aware about:

Net Asset Value (NAV)

NAV refers to the per unit value of a mutual fund scheme. It is obtained by dividing AUM (Asset Under Management) with total units outstanding on a specific date. AUM refers to the market value of securities like shares, cash, derivatives, bonds, gold, etc held by the mutual fund. For example, suppose a mutual fund’s market value of securities is Rs 200 crore and units issued by mutual fund is 100 lakh units, then the NAV per unit of the fund would be Rs 200 (i.e 200 crore/100 lakh). Note that fund units are purchased or redeemed at NAV.

Dividend & Growth Option

Dividend option allows one to avail dividend as and when they are declared by the mutual funds. Many investors opt for this option due to the misconception that mutual fund dividends are an additional source of income. However, what they fail to understand is such declared dividends are paid out from their fund’s own AUM. As an outcome, NAV of the dividend declaring mutual fund falls by the amount of dividend paid. Moreover, the dividend amount is calculated as per the funds’ face value and not based on their NAVs. For instance, if a mutual fund with NAV of Rs 80 declares a dividend of 20%, the dividend amount will be Rs 2 i.e. 20% of Rs 10 (face value of the fund). Thus the fund’s NAV will fall to Rs 78 after the dividend record date.

Growth option, on the other hand, does not offer you any dividend from the fund. In fact, it allows you to benefit from the power of compounding as the returns stay invested, which in turn start generating returns on their own. Thus, if you prefer long term capital appreciation over regular income, you should choose this option.

Moreover, the growth option beats dividend option in terms of taxation for those in higher tax slabs. Mutual fund dividends are taxed as per the investor’s tax slab. The gains realised from redeeming equity mutual funds within 1 year of investment are taxed @ 15% whereas those redeemed after 1 year are taxed @10% if the gains realised from equities and equity mutual exceed Rs 1 lakh in a financial year. The gains realised from redeeming other mutual funds, including debt funds, within 3 years are taxed as per the investors tax slab whereas those redeemed after 3 years are taxed @ 20% after indexation.

Systematic Investment Plan (SIP)

New mutual fund investors mostly consider SIP to be a separate investment product. However, SIP is an automated mode of investment where a predetermined amount is automatically deducted from the investor’s bank account at a pre-set date for purchasing units in the selected mutual fund. Automated investment mode allows regular investment and saves investors from being influenced by twin emotions of greed and fear. Moreover, regular investments in mutual funds through SIP also instil financial discipline and ensure rupee cost averaging during bearish market phases/market corrections.

Expense Ratio

Expense ratio refers to the proportion of mutual fund’s daily net assets utilized for meeting its annual operating expenses. Annual operating expenses include various costs incurred for fund management, advertising, administration and commissions to distributors and agents. As fund houses do not need to pay any commission to distributors selling the direct plan, operating expenses of direct plans can be up to 1% lower than their regular counterparts. The savings made in operating expenses remain invested in direct plans, which allow them to generate much higher returns over the long term due to the power of compounding.

Benchmark Index

Fund houses make use of particular indices as a reference point to measure mutual funds’ performance. For instance, mid cap funds might use the NSE midcap index as a benchmark while large cap funds might use SENSEX, NIFTY50 or BSE 100 indices. A fund outperforming its benchmark index by a wide margin can be considered as a better performing fund.

(The author is Senior Director, Paisabazaar.com)

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