This write up is the sequel to my previous article on Mutual Fund, if you have not read it yet, you can check it out at Mutual Fund – The Beginning.

In this write-up, I am going to touch upon various terminologies/jargon used in mutual industry (i.e NAV, Sharpe Ratio, Beta, Standard Deviation, Factsheet, etc.), different alternatives to invest in mutual fund (i.e Direct and Regular) and finally, I will share information on how to select a mutual fund scheme, which is divided into two steps 1. Internal Analysis and 2. External analysis.

In the Mutual fund industry, there is one disclaimer that you will come across every time, “Mutual Fund investments are subject to market risks. Read all scheme related documents carefully”

Just like that our discussion on MF also comes with a disclaimer “Creation of this content is for learning purpose only. The same is created based on publically available information and should not be considered as investment advice. Readers must seek advice from their financial advisors before taking any investment decisions based on the views expressed in this article. The creator of this content shall not be held responsible in any way by the use of the information”

Mutual funds

So with this disclaimer, let’s start our discussion.

1. Jargons / Terminologies in Mutual fund

a. SIP/Lumpsum – A person can invest in the mutual fund or buy the mutual fund units by two ways Lump sum and SIP

i. Lump-sum – in a Lumpsum, the investor buys units of the mutual fund at the prevailing NAV for a certain amount. It is like a simple purchase.

ii. SIP –SIP or systematic investment plan works on the principle of making periodic investments of a fixed sum. It works similar to a recurring bank deposit. In SIP, the predefined amount is deducted through ECS from the bank account and units are issued to the unitholder based on the prevailing NAV till the predefined time and at a predefined interval. In simple language, SIP is a systematic lump sum. For instance, an investor may opt for a SIP that invests Rs 500 every 15th of the month in an equity fund for three years.

Now, the question might arise which is a better option? If you have enough time to watch the market’s performance and the fund’s performance regularly, then you can opt for a Lumpsum. Where you can invest in a mutual fund when the market is bearish i.e when the NAV is low. If you do not have enough time to watch, then you can opt for SIP. It will average out the big ups and downs in the market in the long run.

b. NAV – The NAV or the net asset value is the total asset value per unit of the mutual fund after deducting all related and permissible expenses. The NAV is calculated at the end of every business day. It is the value at which the investor enters or exits the mutual fund.

It is calculated as,

Net Asset – Expenses/liabilities / no. of units of the fund.

c. Expenses Ratio – There are many expenses like Fund Manager’s Expenses. Distributor Expenses, Taxes on purchase/sale of securities, Brokerage on purchase/sale of securities, etc. A total of such expenses charged to scheme for the month expressed as a percentage of average monthly net assets is known as Expenses Ratio. Expenses Ratio for a regular Scheme will always be more than a direct Scheme.

d. Risk – Risk shows the risk of a portfolio managed by the fund managers. As a rule of thumb, high risk, high returns, and low-risk low return. One must select the portfolio as per his/her risk appetite. Mutual funds are categorized into 5 categories based on its nature of risk i.e. Low, Moderately Low, Moderate, Moderately High and High.

e. Entry Load – A mutual fund may have a sales charge or load at the time of entry and/or exit to compensate the distributor/agent. Entry load is charged at the time an investor purchases the units of a mutual fund. The entry load is added to the prevailing NAV at the time of investment. For instance, if the NAV is Rs. 100 and the entry load is 1 %, the investor will enter the fund at Rs. 101.

f. Exit load – Exit load is charged at the time an investor redeems the units of a mutual fund. The exit load is reduced from the prevailing NAV at the time of redemption. The investor will receive redemption proceeds at a net value of NAV less Exit Load. For instance, if the NAV is Rs. 100 and the exit load is 1%, the investor will receive Rs. 99.

g. Sharpe Ratio – The Sharpe Ratio, named after its founder, the Nobel Laureate William Sharpe, is a measure of risk-adjusted returns.

Sharpe Ratio is a risk to reward ratio, it measures portfolio returns generated in excess to the investment in the risk-free asset, for per unit of total risk taken.

In simple language, it is a ratio to depict, how much excess return is generated per unit of risk.

While, positive Sharpe ratio indicates, portfolio compensating investors with excess returns (over risk-free rate) for the commensurate risk taken; negative Sharpe ratio indicates, investors are better off investing in risk-free assets.

h. Standard Deviation – Standard deviation is a statistical measure of the range of an investment’s performance. When a mutual fund has a high standard deviation, it means its range of performance is wide, implying greater volatility.

i. Beta – Beta (ß) of a portfolio is a number indicating the relation between portfolio returns with that of the market index.

Beta is a measure of an investment’s volatility vis-a-vis the market. The beta of less than 1 means that the security will be less volatile than the market. A beta of greater than 1 implies that the security’s price will be more volatile than the market.

In simple language, Beta shows how much the fund will react with each change in the market.

j. Factsheets – Asset Management Companies (AMCs) usually publish monthly reports known as factsheets, It contains critical information related to the performance of the portfolio & details of the schemes managed by the AMC. The idea is to help investors (both existing and potential) to track the overall performance of the mutual fund schemes to make an informed decision.

If you come across any term which you don’t know, please share in a comment, I would be happy to assist you.

2. How to select a mutual fund?

In this excerpt, we will discuss how to select a mutual fund scheme. The whole selection process can be divided into two parts, Internal Analysis, and External Analysis.

a. Internal Analysis includes analyzing yourself. It is divided into 4 steps:

i. Goal – One must first select his/her financial goal. For Example, if the goal is tax saving and return, then tax saving schemes i.e Equity Linked Saving Scheme or ELSS, will be preferable if the goal is capital appreciation with a long term horizon than the Equity scheme will be preferable. So depending upon the goal, the scheme will vary.

ii. Asset Allocation & Risk Determination –The first thing here is to understand what kind of portfolio you want. This is known as asset allocation.

Your asset allocation should have a healthy mixture of high risk and low-risk components. In general, the percentage of funds you allocate to low-risk debt instruments should be equal to your age.

For instance, if you are a 30-year-old, then 30% of your fund allocation should go toward debt instruments. This will cushion you against any downturns in the remaining assets that you have invested in.

A golden rule here is that the younger you are, the more you can invest in equities and other high-risk mutual funds. Up to a certain age, your risk profile should be moderately high as you have certain flexibility to invest in high-return funds without getting too worried about potential losses.

iii. Tenure – Person with a longer time horizon can prefer an equity scheme, it will give a better return in the long term by averaging out the volatility. If the person has a shorter time horizon then Liquid or debt schemes must be preferred as it will have low volatility.

iv. SIP/Lumpsum – If you don’t have enough money, or you are a salaried person then SIP will be a preferable option.

b. External Analysis – Once the internal analysis is done, External Analysis can be commenced. The external analysis is nothing but finding the right schemes fitting the requirements as per internal analysis and comparing all such befitting scheme to find the best-suited scheme.

i. The first step is to find the top-rated scheme in the same type. There are many credit rating agency ranks the schemes of the mutual fund, so first, one can go and check the top-rated schemes, For example, CRISIL, it provides a rating on the mutual fund, the CRISIL’S ranking can be accessed for free on their website.

(Please note, CRISIL is just used as an example, there are other rating agencies which also provide such data like Morningstar, etc. At this juncture, I would like to share that, I am not connected with any of the agencies while writing this article)

 Select the Top 5 funds in each of the categories you want to invest in.

ii. Once you finalize the top 5 schemes, gather their prospectus, factsheet, and previous years data to analyze and understand the one  which is best suited to you

iii. Some tips for picking the best-suited funds are:

  • When looking for a mutual fund, check its history from shareholder pattern or by checking performance online.
  • Check the performance of the funds in different periods such as 3 months, 6 months, 1 year, 2 years and so on.
  • The funds that feature in all of these lists denote all-round performance and are most likely managed by exceptional fund managers.
  • Check for the profile of fund managers and asset allocators. This can be found in the prospectus of the respective mutual funds.
  • The decision you make here will help you in coming to an informed decision that covers all the corners of your financial decision-making process.

At this juncture, I would like to share one bonus tip, just because a mutual fund performed well in the past, it may not perform well in the future. The growth of funds also depends on the efficiency and expertise of the fund manager. So it might happen that a fund which performed well under the management of a fund manager might not perform well under the management of another fund manager

In case of doubt, one should consult a financial advisor before taking any financial decision.

3. Direct Vs Regular Option

Once you have finalized the scheme the next step is how to invest, you can have two option for investing in mutual fund 1 Direct 2 Regular

Direct plans are those where AMC do not charge distributor expense, which results in lower expenses ratio and higher return.

While Regular Plans are those where AMC charges the distributor expenses which result in higher expenses ratio and lower return.

The portfolio of the scheme remains the same so the gross return will be the same under both the option but the net return will be lower in regular plan compare to direct plan.

The difference in expenses ratios of both the fund is negligible, so the effect of wealth increment can be seen in the long term. For an investor, with a short term horizon, it will hardly make a difference.

So in conclusion, direct plans in mutual funds are good for investors who wish to invest in Mutual fund schemes by directly dealing with AMC without intermediary/Mutual Fund Brokers. These are good for investors who want to increase their return by way of reducing the expense ratio. An investor should do their analysis before investing in any scheme.

Regular plan in a mutual fund is good for an investor who does not wish to do any analysis before selecting a scheme and has a short term investment perspective.

With this topic, our discussion comes to an end. I have tried to cover all the topics which one may come across while investing in a mutual fund,  still, if there is any topic that is not covered or needed further explanation, feel free to comment below. I will do my best to respond at the earliest opportunity.

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October 2020