LEARN

NGSTAR
MORNI FUND
THE
THE L
MUTUA ER
SCREEN

JOURNAL
JOURNAL

OF
OF MUTUAL
MUTUAL

FUNDS
FUNDS
HOW TO SELECT
WINNING MUTUAL
FUNDS

ZEBRA LEARN
For those without the skill or time to invest directly in an asset class, they can invest in the same
via an indirect method, which involves using expert help, also known as mutual funds. As we
have already discussed earlier, mutual funds are like a collection of small individual investors
who pool in their resources and get an expert to manage the same. For instance, 100 investors
together pool Rs. 10,000 each to a mutual fund which now has Rs. 10 lac. The fund now
appoints an expert to manage their money. Independently, none of these individuals would
have been able to afford an expert. But together, their money is being managed effectively by
an expert. This is the underlying math behind the functioning of mutual funds. It is built on the
power of collective investing i.e.mutual investments.

In reality, thousands of people contribute lacs of rupees into mutual funds. Mutual funds today
have thousands of crores to manage. The funds can very effectively manage such large
amounts by having a team to carry out extensive research and investment activities.

Passes to Pool their

INVESTORS
money with

RETURNS

FUND MANAGER

SECURITIES
Choose securities
Generates
to invest in

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 Well, can mutual fund managers do whatever
they like with our money? Each mutual fund
scheme has a ‘Mandate’ attached to it. It is a
guide to what can or cannot be done with the
money, for instance, the kind of assets and
the sub-categories they can invest in and the
restraints they might have. For instance, some
mutual funds can only invest in equities, some
only in debt, some in a mixture, some can only
invest in mid-cap equities, others only in
banking stocks, and so on.

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 MANDATE
A mutual fund mandate is a document that acts as a guideline for the
scheme. Following are a few factors that it consists of. It is
compulsory for the fund to make decisions based on the mandate

ASSET CLASS TENURE OF SECTORS OF

Eg: Equity,
INVESTMENT INVESTMENT
debt, etc. Short-term, Eg: Technology,
Mid-term, Banking, etc.
Long-term

INVESTMENT ACCEPTABLE BENCHMARK

LIMIT LEVELS OF RISK RETURNS
Max & Min

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 TERMS TO KNOW

NET ASSET VALUE (NAV)

Similar to buying ‘Shares’ of a company, we buy ‘Units’ while investing in
mutual funds. If ‘Share Price’ is the price at which we can buy a company’s
share, the ‘NAV’ denotes the price at which we can buy one ‘unit’ of a mutual
fund.

TOTAL UNITS ISSUED BY ASSETS UNDER

NAV
MUTUAL FUNDS MANAGEMENT

SHARE PRICE TOTAL SHARES ISSUED MARKET CAPITALIZATION

SCHEME SIZE
The size of a scheme is the total assets that are being managed under the
scheme. This is also called an asset under management (AUM) by certain
companies. The total number of units multiplied by the NAV would give us
the AUM. Think of this as market capitalization as learned in the equity
section.

Too small a scheme size increases the cost of managing the scheme and too
large a scheme size limits the places that the company can effectively invest
in.

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 CAGR
The compounded annual growth rate is the average compounded return
that we receive on our investment. If we earn a CAGR of 18%, that means our
asset is compounded at 18% annually for N number of years. CAGR is
calculated based on compound interest and not simple interest.

EXPENSE RATIO
It is the percentage of scheme size/AUM that is being spent to run the
mutual fund. A mutual fund has a lot of expenses such as costs related to
asset research, office expenses, distribution and marketing expenses, and
so on. These costs are denoted as a percentage of scheme size. So, if a
mutual fund scheme incurs a cost of Rs. 5 crore to manage Rs. 300 crore, we
can say that the expense ratio is 1.66% (5Cr / 300Cr). Lower the expense
ratio, more efficient is the fund in its operations. This forms a key decision
factor when selecting mutual funds. The expense ratio can range between
0.5% and 2.5%.

SECTORS
This refers to the different business sectors that the fund is allowed to
invest in as per its mandate. For example, sectors may include
pharmaceuticals, telecom and infrastructure, financial services, consumer
durables, food and beverages, and so on. Some mutual funds are sector
agnostic i.e. they can invest in all sectors and others may be sector-specific
i.e. they invest in select sectors.

TOP 10 STOCKS (%)

Each mutual fund has a majority of its investments distributed in a few key
holding. The rest are a small percentage of multiple stocks. So, typically we
will see 60% of assets in the top 10 stocks and the rest 40% distributed in
the next 25 companies. This has a positive side as well as a negative side. So,
the top 10 stocks (%) refer to the percentage of holding in the top 10 stocks.
It shows how concentrated the fund is.

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 CATEGORY
Mutual Funds have a lot of categories based on asset classes and
subclasses that they invest in. These include mid-cap fund, small-cap fund,
high-duration bond fund, gilt funds, BFSI sector fund, an international
fund, etc. Mutual fund schemes in the same category have similar behavior
and risk-reward characteristics. We will use categories defined by
Morningstar. Getting the category right is 80% of the mutual fund selection
process.

PORTFOLIO P/E
P/E or Price to Earnings ratio is one of the most commonly used valuation
metrics. It illustrates how much the company is being valued for each
rupee of earnings that it makes. In a P/E multiple, P stands for the price
of the company and E stands for the earnings (profits) of the company.
So if a company has a P/E of 20 and its earning is Rs. 1 crore, then the
company will be priced at Rs. 20 crore. If we have an identical company,
but its P/E is 15, then it would be priced at Rs. 15 crore. P/E depends on
the strength of the business and market sentiments.

The higher the P/E multiple, the higher is the valuation of the company,
and the higher are the chances that the price is currently above the
company’s true value. Portfolio P/E is the weighted average of the P/Es of
all the companies owned by the scheme. Portfolio P/E is one of the
indicators of valuation used.

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 OPEN-END MUTUAL FUND CLOSE-END MUTUAL FUND
It allows us to invest & redeem at We are allowed to invest in closed-
any given time based on our end mutual funds exclusively
convenience. Mutual funds where upon their announcement or
we can enter and exit at any given when the fund manager
point in time are called open-end specifically opens the fund for new
mutual funds investments. Funds, where entry &
exit is restricted, are called closed-
end mutual funds.

GROWTH MUTUAL FUND DIVIDEND MUTUAL FUND

In dividend mutual funds, the
In a growth fund, the profits of the profits of the fund are regularly
fund are reinvested in the fund distributed among the investors in
instead of distributing it to the the form of dividends. It is not
investors. Due to this, the wealth reinvested and hence the growth
compounds. The objective is to of the originally invested amount
increase the amount so that we is slower. It is suitable for those
can sell off the mutual fund at a who want a steady source of
high price. income.

FRONT LOAD EXIT LOAD

Mutual funds at times charge the Mutual funds at times charge the
investors when they invest money investors when they withdraw
in the scheme. It is charged upfront money from the scheme. It is
at the time of investing and is charged at the time of withdrawal
called the front load. and is called exit load.

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 EXPECTATIONS
The return expectations from mutual e can create a personal finance plan only
funds are based on the underlying assets using different types of mutual funds.
owned by the scheme. If the mutual fund Instead of buying any asset directly. we
owns equity, we can expect a return that pool in the same with mutual funds and
matches equity. If the fund only owns get an expert to manage the same. It is
debt, we can expect a return that matches just an alternate way of owning assets.
debt.
Because the fund expectations in terms of With mutual funds, we pay a small portion
risk and return depend on what assets of the return as an expense that was
they own, getting the category right incurred in running the mutual fund
becomes very critical in our lazy Financial operations and getting the expert team to
Plan. The category determines the assets manage the money. So, if we earn 16%
that the fund can invest in and will CAGR with a fund and it has a 1.5%
therefore determine the risk-return expense ratio, then the NAV will only
characteristics. For instance, small-cap reflect an increase of 14.5% (16% - 1.5%).
mutual funds shall give relatively higher However, paying out the expense ratio
but more volatile returns than large-cap makes sense because if we were to
funds. manage the money ourselves, we might
not get such high returns. Even after
Mutual funds can be used to substitute paying the expense ratio, our portfolio is
direct investments in almost any asset still doing good for itself by earning 14.5%
class. every year.

EFFECTIVE RETURN CAGR EXPENSE RATIO

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 SUITABILITY
Most people do not have the skill or time to identify and invest in individual securities. As a
result, irrespective of what assets we want to invest in, mutual funds are suitable for most
people as most assets like equities, fixed income assets, commodities, etc . can be bought via
a mutual fund ownership scheme. Real estate mutual funds called REITs are also picking up
now.

We need to be realistic about our skill and time and decide if we want to pick individual
investments or go via mutual funds. In reality, it does not matter, both can be used to meet
financial goals. For simplicity, anyone who does not have a bare minimum of 6 hours a week
to invest in understanding their investments have should opt for mutual funds. Now we
know if mutual funds will be appropriate for us or not. For most people, it will. There are
multiple categories of mutual funds. Different categories are suitable for different people.
There is no one size fits all. Now we will find out the type of mutual funds perfectly suited for
us.

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