At its core, a mutual fund is a type of investment where several persons or investors, pool together their money. This money is managed by an expert or experts known as fund manager. Fund managers are designated as such, due to their vast experience or technical knowledge.
For the sake of simplicity, this article has been split into two: brief and simple explanation and additional information.
Brief and simple explanation
In simple terms, a mutual fund is a fund managed by a professional/ expert, known as fund manager. Several persons pool together their funds, and invest in a mutual fund, to enable the fund manager to invest the collected money, on their behalf. A mutual fund exists to collectively invest on behalf of the investors.
Fund managers have expertise and professional knowledge, which enables them to make good decisions, to increase the money pooled from the investors. Typically, the funds received from investors are utilised to purchase shares/ bonds/ debentures/ money market instruments/ other securities which yield returns, based on the goals of the mutual fund scheme.
The gains received by the mutual fund, are then split amongst the investors, as a whole. The fund also charges a specific fee from the investors, in order to pay the fund managers and to ensure its functioning. This fee is built into/ automatically deducted from the money receivable by the investors. Such fee is also known as the fund management charges or annual fee or expense ratio.
OK so, what are mutual fund units?
When a mutual fund scheme is started/ initiated, the total money pooled is divided into units, where each unit, generally holds a value of Rs. 10. Therefore, the total money pooled divided by Rs. 10 will give you the number of units that the mutual fund scheme has issued, at its initiation. For example, XYZ bluechip fund was started with a pool money of Rs. 1 crore. It shall have issued 10 lakh units to its investors during its formation.
However, the number of units can continue to increase as and when the mutual fund scheme receives more money.
Well then, what does NAV stand for?
NAV stands for Net Asset Value. That is, how much money each unit of the mutual fund is worth.
As the mutual fund keeps growing, its profits start increasing and the assets of the mutual fund scheme increase, as compared to its liabilities. In order to determine the net worth of the mutual fund we need to subtract liabilities from assets, i.e. Assets – Liabilities.
For example, if a mutual fund has Rs. 100 crore in assets and Rs. 5 crore in liabilities and has 1 crore units outstanding, then the NAV per unit shall be Rs. (100 crore – 5 crore)/ 1 crore units. In other words, it shall be Rs. 95 crores divided by 1 crore units; or Rs. 95 per unit.
Understood. So what are the different types of mutual fund schemes?
There may be various mutual fund schemes depending on the investment options they choose to invest in or their investing type or depending on any other criteria. Some of the common types of mutual fund schemes are:
- Equity Mutual Funds: They invest a majority of their funds in equity shares.
- Debt Mutual Funds: They invest a majority of their funds in debt or debentures or bonds.
- Hybrid Mutual Funds: They invest in both equity shares and debentures/ bonds.
Amongst the above too, there may be several types of mutual fund schemes. Equity funds have small cap funds, large cap funds, blue chip funds etc. Debt funds may be classified into long term debt funds, short term debt funds, overnight funds etc.
Alright. So why does the NAV keep changing everyday?
The NAV is generally calculated daily, and published at different times, depending on the mutual fund scheme. The NAV changes everyday to reflect the gains or losses incurred by the fund, for the investors. Any charges by the Asset Management Company, for managing the scheme, are also deducted from the NAV.
Therefore, if the NAV of a fund is increasing everyday, it means that it is performing well and making gains. Whereas if it keeps reducing, it means that it is making losses day by day.
Additional Information
As explained above, a mutual fund is a cumulative investment vehicle for investors which different interests and backgrounds, to collectively invest funds and benefit from gains.
Structure of Mutual Funds
Every mutual fund has a three tier organisation structure. The three tiers are:
- Sponsor
- Trust and trustees
- Asset Management Company
I. Sponsor
A sponsor is a person or entity that takes the initiative to set up a mutual fund scheme, to generate income through mutual fund management. A sponsor is usually an entity with high credibility and experience. The sponsor then approaches SEBI (Securities and Exchange Board of India) to grant permission to set up a mutual fund. Once SEBI grants such permission, a trust is formed by the sponsor. Such trust is registered under the Indian Trusts Act, 1882 and trustees are appointed for such trust. The trust is also registered with SEBI.
Along with formation of such trust, a company is incorporated under the Companies Act, 2013. This company is known as the Asset Management Company.
There are certain eligibility criteria for a sponsor:
- The sponsor must have experience in the financial services sector with a positive Net Worth for all 5 years,
- The sponsor must show profits in the previous year of operation, and in at least 3 of the last 5 years (including the previous year),
- The net worth of the sponsor in the immediately preceding year must be greater than the capital contribution of the Asset Management Company,
- The sponsor must have at least 40% share in the net worth of the Asset Management Company.
II. Trust
The Trust is formed through a document known as the trust deed. The trustees appointed are in a way, guardians of the assets of the fund. The trustees monitor the functioning of the Asset Management Company. Every six months, they are required to report to SEBI on the activities of the Asset Management Company. The Asset Management Company can float any new mutual fund schemes only after due approval from the trust.
III. Asset Management Company (AMC)
The Asset Management Company, is incorporated under the provisions of the Companies Act, 2013. It is the primary layer involved in operation of the mutual fund schemes. The Asset Management Company floats the mutual fund schemes. The AMC coordinates with various other parties involved in management of the scheme. It receives a small fee from the trust for managing the fund. Since the AMC is incorporated as a company, it has flexibility in its own operations and is able to solicit with various parties such as Custodian, Auditor, Investors, Registrar and Brokers.
Other parties involved in the functioning
Custodian
A custodian is responsible for keeping custody of all assets of the fund. The Custodian manages the investments of the mutual fund, keeping track of all investments received or transferred along with the interest and dividend received by the fund.
Registrar & Transfer Agents (RTA)
The RTA is responsible for securely tracking and keeping data of all transactions and investors of the fund. They update the data of investors as per their instructions, they keep a record of the dividend payouts and also send out periodic statements. Carvy, CAMS, Sundaram and Franklin are some of the popular RTAs providing their services in India. AMCs associate themselves with an RTA convenient to them, for successful operation of the scheme.
Auditor
Auditors are responsible for scrutinising the books of accounts of the scheme. They ensure all accounting and auditing policies are being properly followed by the AMC and that the financial statements present an accurate picture of the profitability of the scheme at the end of the financial year.
Brokers
Brokers are essential for marketing of the scheme. They are registered with the AMC and render the services for a fee. Brokers assist the AMC in procuring funds from investors in the market.
