Glossary of Mutual Fund Terms
Mutual Fund Units are in a way like shares of a company that trade in the market and represent the extent of ownership you have in the Mutual Fund as an investor. As you know, Mutual Funds are pooled investment vehicles that invest in different securities across asset classes like debt, equity, international securities, gold, etc. The amount of money you invest in a fund decides the number of units of the fund you would be allotted, and these units represent the extent of your ownership in the pool of money managed by the fund on behalf of all its investors.
The number of units allotted to an investor depends on the money invested by the investor and the applicable NAV. If an investor invests ` 1,000 in a scheme and the NAV for that day is ` 100, the investor will be allotted 10 units of the scheme (= Amount invested/Applicable NAV). These 10 units represent the investor’s extent of ownership in the scheme.
These units can be expressed in decimal as well and need not always be in whole number. In the above case, if the closing NAV of the scheme was ` 98 when the investor submitted his purchase application, he would have been allotted 10.204 units instead of 10 units as we saw in the above example.
The current NAV of a scheme represents the cost of one unit of that scheme. The value of your holding in a Mutual Fund can be obtained by multiplying the number of units of the scheme held by you multiplied by the current NAV of the scheme.
New Fund Offer is like an IPO (Initial Public Offering) except that, IPO is marketed by a company trying to go public while NFO is marketed by a Mutual Fund trying to launch a new scheme. When a Mutual Fund wishes to launch a new scheme in the market, it does so by way of an NFO. The NFO has a start date and an end date. The Mutual Fund advertises about its NFO to the public that includes both prospective investors and Mutual Fund distributors. Subscription or application from investors is invited, to invest in the NFO during the NFO open period. NFO’s are open for subscription for a maximum of 15 days. During this time, the units of the new fund being launched are available at the face value. This means investors can buy units of the new scheme at this face value.
The Mutual Fund uses the capital raised during the NFO to buy securities in the new fund’s portfolio after the NFO has closed. The new fund reopens for further subscription on an ongoing basis, few days after the NFO end date, if the nature of the scheme is open-ended. If the scheme is a close-ended fund, it does not open for further subscription after the NFO is over.
Reinvestment is the process of investors of equity or fixed income securities reinvesting the intermediate disbursements they receive from their investment in the form of dividends, interests or coupon payments, capital gains, bonus, etc. to buy more units of the same investment be it a stock or bond or any other security.
Reinvestment in case of fixed income securities like bonds is very critical because bonds have a fixed and assured payment schedule of regular coupon payments. The YTM or Yield-to-maturity of a bond is the expected return an investor can get by holding the bond to maturity and reinvesting all coupon payments at the YTM. The investor must reinvest all the coupon payments he/she receives from the bond at the available interest rate which may be different from the coupon rate of the bond.
Assume an investor has bought bonds of Energy Grid Pvt. Ltd. with face value of ` 1,000 that have a maturity of 3 years and a coupon payment of 10% paid semiannually. The investor will get ` 50 as coupon payment every six months which must be reinvested back at the available interest rate. If interest rates in the market falls and hence newly issued bonds of Energy Grid are offering 8% coupon, then the investor ends of reinvesting the ` 50 coupon amount in the newly issued bonds offering a 2% lower coupon. Reinvesting here would mean additional units of the bond are bought for ` 50. The current market price of the bonds at this point would be lower than its face value of ` 1,000 since the bonds are offering a lower coupon (8%) than the previously issued bonds (10%).
Thus in case of bond investment, investors are prone to interest rate fluctuations while reinvesting their coupon proceeds until the maturity of the bonds when they finally get back their principal.
Switching refers to the process of shifting your investments from one Mutual Fund scheme to another within the same Mutual Fund. You can switch or move your investments from one scheme to another when both schemes are managed by the same AMC i.e. they belong to the same fund house. To switch funds, the investor needs to fill up a switch form specifying the amount/number of units to be switched from the source scheme and name of the destination scheme.
Switching is considered as a sale or redemption for the source scheme and a purchase for the destination scheme. Hence, one must fulfill the minimum investment amount criteria for both switch-in and switch-out schemes. There may be implications of exit-load and capital gains tax while switching since it is a sale transaction for the source scheme.
Switching is currently not possible between two schemes belonging to two different fund houses.
A Systematic Transfer Plan (STP) allows you to transfer a fixed number of units or amount from your investment in one Mutual Fund scheme to another scheme managed by the same fund house on a prespecified day every month.
You can start a STP by investing a lumpsum amount in a mutual fund scheme and giving instruction to the fund house to transfer a fixed no. of units or amount from this investment to the destination scheme. As a result, your account balance in the source scheme i.e. the scheme in which you had made the lumpsum investment gradually decreases every month while your investment in the destination scheme increases gradually every month. The STP automatically stops when all the money from the source scheme has been transferred to the destination scheme over a period of time.
STP is a risk mitigation strategy where you move your investments from an equity fund to a debt fund or vice-versa depending on the market outlook you hold. STP is usually done by investing a lump sum amount in a debt scheme and transferring the money over time to an equity scheme or vice-versa.
STP is best advisable when you have a large sum of money to invest but are not sure how the market will move once you’ve invested your money. So, you gradually move or switch your money from one scheme to another in a phased manner over time.
Yield-to-maturity is the expected total return or rate of interest an investor would earn, by holding a bond until maturity and reinvesting all cashflows from the bond (coupon payments and principal repayment at maturity) at this rate.
The price of a bond at any time reflects the present value of all its future cash flows. At the time of issue, the bond’s market price is equal to its face value (the issuing price, e.g. ` 1,000) since it is assumed that all coupon payments will be reinvested at the coupon rate, until maturity. The coupon rate at this point, is same as what is currently available in the market for other debt instruments with similar risk and maturity profile. However, as time passes by, the market interest rate fluctuates while the coupon rate on the bond remains fixed. When the market rate rises above the coupon rate being offered on the bond, the bond looks less attractive and starts trading at a discount (price drops below face value). When market interest rates drop below the coupon rate, the bond sells at a premium (price rises above face value).
The calculation for YTM at any point assumes that all coupon payments during the life of the bond, are reinvested at an interest rate such that the present value of these cashflows equals the bonds current market price. This interest rate at which all cashflows are assumed to be reinvested is called the Yield-To-Maturity of the bond, at that point in time.
Suppose a power company, Energy Grid Pvt. Ltd. issues 10% semiannual bonds of face value ` 1,000, and 3 years maturity on 1st Oct. ’18. These bonds will pay 5% coupon or ` 50 every six months until 30th Sept. ’21. The first coupon payment of ` 50 will be received on 31st Mar. ’19, the second coupon will be received on 30th Sept. ’19 and so on. The investor will reinvest these payments at the available interest rate on receiving them. He will receive back his principal of ` 1,000 on maturity (30th Sept. ’21) along with the last coupon payment of ` 50. YTM is the interest rate at which we assume the investor reinvests all these payments.
YTM helps in comparing returns from two bonds or debt investments. YTM is never constant during the life of a bond. If Energy Grid bond sells for less than ` 1,000 today, this implies the current market rate is higher than its coupon rate. Hence YTM at this point will be higher than 10% (coupon rate). If the bond was selling for more than ` 1,000 i.e. the available rates is less than the bond’s coupon rate, YTM would be less than 10%.