Investing might feel complicated, especially if you are just starting. But here is a simple solution – mutual funds. These are like a shared piggy bank managed by a pro called a Fund Manager. Lots of people put money into it, and the manager invests it in things like stocks and bonds. Whatever profit comes, they share it among everyone. It is like teamwork in investing. This article will break down mutual funds, explaining types, perks, and why they can be great for your money.
What are mutual funds?
A mutual fund is an investment where a bunch of people chip in money to buy different assets such as stocks, bonds, and money market instruments. The assets are managed by professional investment managers, who aim to generate returns for the investors. Mutual funds are regulated by the Securities and Exchange Board of India (SEBI).
When you invest in a mutual fund, you are spreading your money across various investments, reducing the risk compared to putting all your money in one stock or bond. Your returns depend on how well the fund does, minus any charges. This way, mutual funds give you access to professionally managed investments without needing a lot of money.
How mutual funds work?
The Net Asset Value (NAV), which represents the fund's per-unit value, is calculated by dividing the total value of all the fund's investments by the total number of units held by investors. As the underlying investments in the portfolio change in value, the NAV also changes, reflecting the fund's performance. Investors can buy or redeem units at the current NAV, allowing them to enter or exit the fund based on their investment needs and market conditions. Mutual funds offer several advantages to investors.
Understanding the functioning of mutual funds involves understanding the concept of Net Asset Value (NAV). NAV is the per-unit value, determined by dividing the total value of all fund investments by the total units held by investors. Imagine investing Rs. 1,000 with an NAV of Rs. 10; you would get 100 units. As the fund's assets change in value, so does the NAV, reflecting the fund's performance. For instance, if the NAV rises to Rs. 20, your 100 units worth Rs. 1,000 become Rs. 2,000, showing how performance impacts returns.
Mutual Fund portfolios fluctuate daily based on the underlying assets. Redeeming units means converting them back into money. Importantly, the market value of the portfolio varies daily, making returns dynamic and market-linked. In the above example, the gain of Rs. 1,000 is known as a capital gain, subject to capital gains tax upon redemption.
Differentiating short-term and long-term capital gains tax is vital. The holding periods define these taxes, with specific rules for mutual funds. Remember, staying invested does not attract tax, and the extent of tax depends on your investment choices and the type of mutual fund. Understanding these tax implications is key to smart and informed mutual fund investing.
Objectives of mutual funds
Mutual funds aim to achieve the following objectives for their investors:
- Diversification: Spreading investments across various securities, assets, and regions helps mitigate risk, promoting a balanced portfolio.
- Capital preservation: Funds like money-market and liquid funds prioritise safeguarding investors' capital, though they typically yield lower returns.
- Capital appreciation: Equity funds primarily target growth to counteract inflation by investing in stocks, offering higher potential returns alongside increased risk.
- Tax savings: Equity-linked savings schemes (ELSS) or tax-saving funds offer tax deductions up to Rs. 1.5 lakh per financial year, particularly beneficial under the old income-tax regime.
How to calculate mutual fund returns?
Calculating mutual fund returns involves several methods, each offering unique insights into investment performance.
- Absolute returns: Absolute returns measure the overall percentage change in a mutual fund's value over a specific period, irrespective of time or compounding. Calculated using the formula:
Absolute Return = (Present NAV – Initial NAV) / Initial NAV × 100
For instance, if your initial NAV was 30 and the present NAV is 45 over nine months, the absolute returns would be 50%.
- Annualised returns: To assess annual returns, Simple Annualized Return (SAR) is used. Derived from the absolute return, the formula is:
SAR = [(1 + Absolute Rate of Return) ^ (365/number of days)] – 1
Considering the previous example,
Simple Annualised Return = [(1 + 50%) ^ (365/270)] – 1
Therefore, with a 50% absolute return, the simple annualized return is approximately 73%.
- Compounded Annual Growth Rate (CAGR): CAGR offers an average annual growth rate over multiple years, providing a standardized measure. The formula is:
CAGR = {[(Present NAV / Initial NAV) ^ (1 / Number of years)] - 1} × 100
To calculate the compounded annual growth rate (CAGR) for a lump sum investment, let's use the given example:
Assuming you invested Rs. 10 lakh in a mutual fund scheme in 2016 with an initial NAV of Rs. 200, and after five years in 2021, the NAV increased to Rs. 700.
CAGR = {[(700 / 200) ^ (1 / 5)] - 1} × 100
CAGR ≈ 28.47%
Alternatively, if you prefer using Excel, you can use the RRI function:
=RRI(Nper, PV, IV)
Where:
Nper = Time in periods (calculated in months)
PV = Present Value (ending value)
IV = Initial Value (beginning value)
This will give you the CAGR, which you can format as a percentage to obtain the result.
- Extended Internal Rate of Return (XIRR): XIRR is an advanced method accounting for timing and amount of cash flows. It's crucial for investments with varying durations, such as Systematic Investment Plans (SIPs). The formula is:
XIRR = XIRR(Values, Dates, Guess)
To calculate SIP returns using XIRR in Excel, create a table with SIP dates and amounts, add redemption details, and use the XIRR function, formatting the result as a percentage. This method provides accurate returns when cash flows vary.
