Glossary of Mutual Fund Terms

Under SEBI (Mutual Funds) Regulations, 1996, Mutual Funds are permitted to charge certain operating expenses for managing a mutual fund scheme – such as sales & marketing/advertising expenses, administrative expenses, transaction costs, investment management fees, registrar fees, custodian fees, audit fees – as a percentage of the fund’s daily net assets.

All such costs for running and managing a mutual fund scheme are collectively referred to as ‘Total Expense Ratio’ (TER)

The TER is calculated as a percentage of the Scheme’s average Net Asset Value (NAV). The daily NAV of a mutual fund is disclosed after deducting the expenses.

The regulatory limits of TER that can be incurred/charged to the fund by a Mutual Fund AMC have been specified under Regulation 52 of SEBI Mutual Fund Regulations.
Effective from April 1, 2020, the TER limit has been revised as follows.
 

*In case of Index Funds and ETFs: The total expense ratio of the scheme including the investment and advisory fees shall not exceed 1.00 percent of the daily net assets.
In case of Fund of Funds: 
(i) investing in liquid schemes, index fund schemes and exchange-traded funds, the total expense ratio of the scheme including a weighted average of the total expense ratio levied by the underlying scheme(s) shall not exceed 1.00 percent of the daily net assets of the scheme. 
 
(ii) investing a minimum of 65% of assets under management in equity-oriented schemes as per scheme information document, the total expense ratio of the scheme including a weighted average of the total expense ratio levied by the underlying scheme(s) shall not exceed 2.25 percent of the daily net assets of the scheme. 
 
(iii) investing in schemes other than as specified in (i) and (ii) above, the total expense ratio of the scheme including a weighted average of the total expense ratio levied by the underlying scheme(s) shall not exceed 2.00 percent of the daily net assets of the scheme: 
 
Provided that the total expense ratio to be charged over and above the weighted average of the total expense ratio of the underlying scheme shall not exceed two times the weighted average of the total expense ratio levied by the underlying scheme(s), subject to the overall ceilings as stated above in (i), (ii) and (iii). 

This, if a mutual fund scheme has assets worth INR 100cr and spends INR 2cr in managing the fund, we say the fund has an expense ratio of 2%.
For more details, refer to the link below: amfiindia.com/investor-corner/knowledge-center/Expense-Ratio.html

TER has a direct bearing on a scheme’s NAV. Lower the expense ratio of a scheme, higher will be its NAV. Thus, TER is an important parameter while selecting a mutual fund scheme.

Some Mutual Fund schemes charge an exit load on redemptions or cancellation within a stipulated time period.

Exit Load is like a penalty for premature redemptions because it is meant to discourage investors from selling their Mutual Fund investments too soon. Mutual Funds are not meant for short-term investments unless you are parking your surplus cash in a liquid fund. Since Mutual Funds are subject to market volatility, they are best suited for medium to long-term goals. Hence, most Mutual Fund schemes except liquid funds charge an exit load if investors sell their investment within the stipulated period.

Exit load is charged as a percentage and is applied on the redemption amount. If exit load is 1% then you’ll receive 99% of your redemption amount if you sell your investment before the stipulated period. Exit load as a percentage is applied on the NAV applicable to your redemption. If the NAV at the time of redemption is ` 100, you will receive only ` 99 for each unit of Mutual Fund investment you decide to redeem.

When a Mutual Fund scheme declares dividend, the NAV of the scheme falls to the extent the amount of dividend was declared on the next business day, when the units of the scheme are available for trading in the market. The day when the NAV of the scheme falls by the same amount as the amount of dividend declared or capital gain distributed to investors, is called the Ex-Dividend Date.

If the NAV of a Mutual Fund scheme is ` 200 before the dividend was declared and the scheme declares a dividend of ` 20 per unit, the NAV of the scheme will fall to ` 180 on the ex-dividend date i.e. the day on which the scheme will start trading in the market at a NAV of ` 180.

Fund house is just another name for an Asset Management Company (AMC). Fund house is used more commonly by people when they are referring to an AMC. Fund house and AMC can be used interchangeably. The fund house or AMC is the investment manager of the fund and carries out all the investment related activities of the Mutual Fund, like purchase and sale of securities in the portfolio of various Mutual Fund schemes launched by the Mutual Fund.

The fund house provides professional investment management services to its investors, by hiring talented and experienced fund managers to manage the pool of investor money on behalf of the investors

G-secs are a short form for Government securities that are issued by the government to finance its fiscal deficit. The government collects taxes from its citizens which is the primary source of revenue for the government. On the other hand, the government also spends on things like healthcare, education, defence and infrastructure. These expenses are funded by the taxes it collects from us. But when the expenses exceed the revenue it results in a fiscal deficit. In such a case, the government issues various kinds of debt securities to raise money from investors and use this money to finance its expenses. Debt securities issued by the Government are called G-secs.

G-secs are a debt obligation of the Government that promises to pay its holders (G-sec investors) a fixed or floating interest rate at periodic intervals and the initial invested amount or principal at the time of maturity. Since G-secs are issued by the government, they are considered safe as far as default risk is concerned i.e. the chances of the borrower or issuer (the Government in this case) failing to pay its obligations is remote.

G-secs with less than one-year maturity are called T-bills or Treasury bills and those with more than one year of maturity are referred to as Government bonds.

Mutual Funds provide different options to investors which they can choose depending on their financial requirement. A Growth Option focuses on long-term growth of capital. In case of the growth option, you choose not to opt for dividends.

Thus, if you invest in the growth option of a Mutual Fund scheme, you will not receive any intermediate payouts from the scheme. In a growth option, all profits made by the fund are reinvested into the scheme. This leads to an increase in the NAV of the scheme, since the profit is retained by the scheme instead of being distributed to the investors. When the scheme makes a profit, NAV of the scheme increases and vice-versa.

The only way an investor in a growth plan can realise profit is to sell his/her investment in the scheme. The return in a growth plan is calculated by taking the difference in NAV on the sale date and purchase date as there are no intermediate payments like dividends, interests, gains, bonus, etc.

A growth option investor experiences a higher capital gain at the time of redemption as compared to an investor who has opted for dividend option. Thus, the growth option investor will end up paying higher capital gains tax as compared to the dividend option investor for the same duration of investment. However, the dividend option investor has to bear the impact of Dividend Distribution Tax (DDT) which is the tax the fund house deducts from the dividend to be paid out. Since a DDT is deducted every time the scheme announces a dividend, this reduces the amount of money available for future reinvestment in case of a Dividend Reinvest option as compared to a Growth option where capital gain tax is levied only at the time of withdrawal. The DDT also reduces the dividend being received by the investor who has opted for Dividend Payout option.

A growth plan is suitable for those who are looking for the growth of their capital over the long-term and don’t look forward to intermediate payouts from the fund.

The price of a bond is closely linked to the prevailing interest rate in the market. Since bonds are issued with the promise of a fixed coupon or interest rate, their attractiveness is dependent on the interest rate available on bonds of similar risk profile. Suppose a power company, Energy Grid Pvt. Ltd., issues  bonds with coupon rate of 10% and face value of INR 1000. This implies Energy Grid will pay 10% or INR 100 as coupon payment every year to its bond holders.

Suppose one year later, the market interest rate for bonds of similar risk profile is 12%. This can happen because RBI has increased the key rate at which it lends to other banks. Now the new bonds look more attractive at 12% as compared to the earlier bonds. Hence, the price of the earlier bonds offering 10% coupon will drop below the face value of INR 1000. If interest rates were to drop to 8% on similar kind of bonds, then the bonds issued by Energy Grid at 10% coupon will look more attractive than bond opportunities of similar risk available in the market. This will increase the price of these bonds and the Energy Grid bonds will start trading above par i.e. they will sell for more than INR 1000 in the market.

As you can see, bond prices have an inverse relationship with interest rates. Bond prices will fall when interest rates rise, and bond prices will rise when interest rates fall. Interest rate risk refers to this change in bond prices due to movement in interest rates. Interest rate risk is the most important risk associated with debt investments. A bond investor faces interest rate risk because the value of his/her bond holding may change with fluctuations in interest rates.

Indexation is the process by which purchase price of assets like Gold, Real Estate and Debt Mutual Funds are adjusted to reduce the impact of inflation, while calculating return from these investments. Inflation is the gradual increase in price levels of goods and services over time, without any real increase in the value of the goods and services. For instance, a chocolate bar costing ` 50 today may cost ` 60 next year, even though there is no change to the weight or quality of the chocolate bar. This increase in price level of the chocolate bar is an example of inflation.

Here we’ll explain indexation with respect to Debt Mutual Funds since indexation benefit is applicable to Debt Mutual Fund investments that are held for more than 3 years. When you sell your Debt Mutual Fund investment after 3 years, you have to pay a tax on long-term capital gain of 20% after indexation benefit. Capital gain is calculated as the difference in the purchase price and selling price of your investment.

Suppose, you had invested ` 100,000 in a debt scheme ABC at a NAV of ` 10 three years back in Aug. 2015. You received 10,000 units of scheme ABC in return for your investment. Let’s assume the current NAV of the scheme is ` 20 and you sell all the 10,000 units at this NAV in Sept. 2018. The capital gain in this case would be the difference between the NAV at which you sold and the NAV at which you had invested 3 years back, multiplied by the number of units being sold.

Your capital gain would be = 10,000 units * ` 10 (i.e. ` 20 – ` 10) = ` 100,000

Now you need to pay a 20% LTCG (Long-Term Capital Gains Tax) on all Debt Mutual Fund investments that are held for more than three years as per current regulations.

But when indexation is applied to your capital gain, it will adjust the purchase price of your investment upward, so that the purchase NAV of Aug. 2015 reflects the impact of inflation over the three-year period. When the purchase NAV is revised upwards, it reduces the overall capital gain and thus the tax applicable.

Inflation-adjusted cost price =  Actual cost price  X  CII of sale year

CII of purchase year

CII or Cost Inflation Index is a value published by the finance ministry that is used to measure inflation. CII for 2018-19 is 280 and CII for 2015-16 is 254.

Hence, the inflation adjusted cost of acquisition would be = 100,000* (280/254) = ` 110,236

Your Long-Term Capital Gain post indexation would be, the difference in sale price and inflation adjusted purchase price = ` 200,000 – ` 110,236 = ` 89,764

Hence, you’ll now pay 20% LTCG on ` 89,764 and not on ` 100,000.

Indexation results in lower tax payout for debt Mutual Fund investments unlike traditional fixed income products like bank FDs. Thus, debt funds are more tax efficient than investments offering similar returns.

The investment objective is the most important aspect of a Mutual Fund scheme that outlines the financial objective the scheme intends to achieve and spells out the level of risk it is likely to assume, while trying to achieve this objective. Thus, the investment objective of a Mutual Fund scheme helps investors decide,

• If the scheme is suitable for their financial goal
• The level of risk they should be comfortable with and
• The time horizon for which investors must consider staying invested in the scheme if they plan to invest their money in the scheme

The scheme’s investment objective helps investors in deciding if the scheme is suitable for their portfolio or not. In short, the investment objective of a scheme attracts like-minded investors, who share a common investment goal and have similar risk and time horizon preferences.

The kind of securities held in a scheme’s portfolio are determined by the investment objective of the scheme. The objective could be capital appreciation over the long-term or regular income generation or capital protection or something else. The fund manager will follow an investment style that is in sync with the scheme’s stated investment objective.

For instance, the investment objective of a well-diversified equity folio may read as follows:

The investment objective of ABC Fund is to provide growth of capital plus regular dividend through a diversified portfolio of equities, fixed income securities and money market instruments.

As evident from the investment objective, ABC Fund will invest in large, mid and small-cap stocks thus providing diversification. Since the objective of this fund is capital growth along with regular income, the fund will invest in a mix of stocks and fixed income securities like bonds and money market instruments like Commercial Papers, T-bills, etc. Also, this kind of an objective would require investors to be prepared for a long holding period since investing in equities especially in the small and mid-cap segment requires at least a 5-year tenure. The scheme is likely to carry moderate to high risk since it will invest primarily in equities across capitalisation i.e. large, mid and small caps.

A Mutual Fund cannot change the investment objective of any of its scheme without prior approval from the trustees and informing the existing investors about the same. The investors are given a choice to exit the scheme without any charges within a specified period before the scheme’s investment objective can undergo a change.

The price of a bond is closely linked to the prevailing interest rate in the market. Since bonds are issued with the promise of a fixed coupon or interest rate, their attractiveness is dependent on the interest rate available on bonds of similar risk profile. Suppose a power company, Energy Grid Pvt. Ltd., issues bonds with coupon rate of 10% and face value of ` 1,000. This implies Energy Grid will pay 10% or ` 100 as coupon payment every year to its bond holders.

Suppose one year later, the market interest rate for bonds of similar risk profile is 12%. This can happen because RBI has increased the key rate at which it lends to other banks. Now the new bonds look more attractive at 12% as compared to the earlier bonds. Hence, the price of the earlier bonds offering 10% coupon will drop below the face value of ` 1,000. If interest rates were to drop to 8% on similar kind of bonds, then the bonds issued by Energy Grid at 10% coupon will look more attractive than bond opportunities of similar risk available in the market. This will increase the price of these bonds and the Energy Grid bonds will start trading above par i.e. they will sell for more than ` 1,000 in the market.

As you can see, bond prices have an inverse relationship with interest rates. Bond prices will fall when interest rates rise, and bond prices will rise when interest rates fall. Interest rate risk refers to this change in bond prices due to movement in interest rates. Interest rate risk is the most important risk associated with debt investments. A bond investor faces interest rate risk because the value of his/her bond holding may change with fluctuations in interest rates.