BackTypes of funds
It's important to choose carefully among the given options before putting money into mutual funds.
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OPEN-END AND CLOSED-END
Another distinction in funds is based on the length of time for which the fund is collecting money. There are two kinds of funds through this classification: open-end and closed-end.
Open-end
These are funds where you can get in and out anytime you want as these have perpetual life. As inflows are unlimited and, typically, unrestricted, there is no limit to which the corpus can grow to. According to mutual fund tracker Value Research, the largest scheme in India as on May 2013-end portfolios had a corpus of R11,315.6 crore. At present, most fund houses prefer to launch open-end funds as it helps the fund house to garner money consistently and manage it on a continuous basis.
Closed-end
These are funds that restrict their inflows. Once they are launched, they are open for subscription for a few days. Once the subscription period ends, they stop accepting money from the public. Closed-end funds, therefore, also come with a fixed tenor such as three, five or 10 years. Once the period gets over, closed-end funds either redeem the money to their investors or convert them to open-end funds. Different periods of time in the last 20 years have seen open-end and closed-end funds change in popularity, not due to investor interest but due to what the asset management companies (AMCs)—the corporations that carry out the asset management function for the mutual fund—wanted to launch. In the early years of the opening up of the mutual fund market, fund managers were not sure if investors would come and stay in the fund. Out of this uncertainty on account of investor behaviour, most schemes launched in the 1990s were closed-end schemes. As the market matured, fund houses moved to offering open-end products—they now knew that real retail money (your money) is sticky and does not like to shift in and out of funds. Funds switched to launching closed-end funds in the years 2006 and 2007 due to a cost advantage that closed-end funds had that allowed them to charge initial marketing fee from you. That arbitrage is over and currently funds launch open-end and closed-end funds with the investor and purpose of the fund in mind, though a majority of funds are now open-end.
ACTIVE AND PASSIVE
Another distinction that is important for the investor is the difference between active and passive funds. This distinction is based on how the fund manager views his role. Active funds are those that aim to beat the market benchmark. A benchmark is a reference point against which fund managers and investors can compare performance. For example, most equity funds will have either the Sensex or the Nifty as benchmarks. The funds that want to just mimic an index are called passive funds. Investors who want to have an investment vehicle that they want to choose once and then just use over their investment lifetimes without worrying about whether their fund manager is going to stay with the fund or whether he will sustain the performance or not choose passive funds. Investors who want returns that are ahead of the market and do not mind taking higher risk that comes due to fund manager choose active funds.
Active fund
The reason for the existence of an active fund is to beat the benchmark it has chosen to measure its performance against. Fund managers of active funds believe that they have the ability to select stocks and time the market in a manner that makes the returns on their portfolio higher than what the market (in the form of the benchmark) gives over a specific period of time.
Active funds have fund managers who have the freedom to pick and choose stocks they want to buy or sell. Of course, the freedom comes in an institutional structure with internal rules. Since fund managers are actively involved, there are costs on research and transaction. The best performing active funds have beaten their benchmarks by an average of 6% on a compounded annual growth rate basis over the last 10 years.
Passive fund
Also called index funds since their only aim is to mimic an index they choose, passive funds don’t have fund managers. In fact, they don’t need fund managers to manage them. They simply mimic their benchmark indices. They invest in scrips—and in exactly the same proportion—as they lie in their benchmark indices. They move up and down as much as their benchmarks move.
For example, a passive fund on the Nifty index will buy all 50 stocks in the Nifty in the same proportion as are held by the Nifty. Each time a stock is taken out or added to the Nifty index, the fund will do the same. On a day-to-day basis, this makes for lesser work than those managing active funds. Changes in the composition of the index are usually not more frequent than once a year. However, individual weights of scrips in an index change every day and since index funds are mandated to simultaneously change their scrip weights in the last half hour before the equity market closes, by rebalancing their existing portfolios index funds do end up incurring some cost.
Investors can expect almost the same return as the index their fund tracks, though there will be a small difference between an index fund’s performance and that of its benchmark’s. Called the tracking error, this is caused because of the small cash component that every index fund keeps (to face redemption pressures) and also the various costs it incurs (that eventually reduce your fund’s net asset value) such as brokerage, advertising, marketing and so on. Costs are lower in a passive fund compared with an active fund. Passive funds are of two kinds—index mutual funds and exchange-traded funds (ETFs).
An ETF is a index fund with just one difference from the investor’s point of view. Investors can buy and sell ETFs on the stock markets as ETFs need to be listed on a stock exchange. ETFs come with several advantages over an index fund.
First, they have lower fees than index funds and lower tracking error. They also allow you the facility of real-time buying and selling, unlike index funds that will give you the price once a day on which you will invest. But you will need to open a demat account to buy and sell ETFs.
GUIDE TO UNDERSTANDING
Mutual fund growth and dividend option
Most mutual fund schemes have dividend and growth options. The dividend option gives out a cash flow by liquidating some units periodically, while the growth option allows the money to stay invested. While filling the form, if you forget to choose one, your fund will allot you the default option, which may not be the one you really want. Mutual funds pay dividends whenever your investments earn a profit that they can pay out. If you need periodic dividends as a source of income from, say, debt funds, or if you feel the need to periodically book profits in your equity funds, choose the dividend plan. Remember, dividends come out of your own pocket. When a fund declares dividend, its net asset value (NAV) comes down by that extent. If a fund’s NAV goes up to ₹ 15 and it declares ₹ 3 dividend, the NAV drops to about ₹ 12. Dividends are good for those who reinvest them effectively or those who need them as current income.
Dividends from equity-oriented funds, which invest at least 65% in equities, are currently tax free, though this will change post the direct taxes code comes in. Dividends from all types of debt funds, including liquid funds are taxed at 28.325%, including surcharge and cess. Earlier dividends from debt funds, other than liquid funds, had a lower dividend distribution tax (DDT), but budget 2013 hiked the DDT for these debt funds and brought them at the same level.
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