Total Returns in Debt Funds
A debt fund earns its returns from two sources: Interest income and capital gains/losses from change in the value of the securities. The value of a debt security changes with changes in interest rate, in inverse proportion. When interest rates move up, they loose value and vice versa. How much the value would change depends, pre-dominantly, on the tenure (period to maturity) of the security. Therefore an investment in debt funds is subject to the risk of change in the value of the investment, from changes in interest rates. By the same count, it can be rewarding when total returns far exceed the interest income.
Rupee Cost Averaging
When an investment is made, the cost incurred is the price times the number of units purchased. If investors buy their units at various points in time, they pay the price prevailing at each of those points in time. Their cost of investment for all such units acquired over time is obviously the average of all the purchase transactions. If the same amount is invested across time, as is the case in a Systematic Investment Plan (SIP), the number of units purchased each time varies depending on the price. At a higher price, less units are purchased; at a lower price more units are purchased. This results in the average cost in a SIP averaging down. This is called rupee cost averaging.
Equity Style Matrix
Building and managing an investment portfolio is not just about selecting the correct stocks and sectors. It is also about choosing a set of strategies that will underlie the selection and management process. The investment strategy that a fund manager chooses is represented in a style matrix. An equity fund’s style matrix features large medium and small cap on one side, and growth, value and blended on the other. Style indicates the factors that dominate the portfolio construction strategy.
Indexation of Capital Gains
When an investor holds a mutual fund investment for a period longer than 12 months and sells it at a profit, the gains to the investor are called as long term capital gains (LTCG). However, LTCG, having accrued over a long period of time, is likely to be higher not merely from appreciation in the value of the investment, but also an increase in the rate of inflation. In order to nullify the effect of inflation on LTCG, the income tax laws allow an investor to index the LTCG, before subjecting it to tax.
Dividend Distribution Tax
Mutual fund dividends are fully exempt from tax. This means the investor does not pay any tax on the dividends received from a mutual fund. Mutual funds however may receive their income either as dividends or as interest income (from the debt securities that they hold). Therefore dividends paid out by funds that are not equity-oriented, is subject to dividend distribution tax (DDT). DDT is paid directly by the mutual fund, before the dividend is distributed to investors, on all schemes where the equity holding is less than 65% of net assets.
Cash Reserve Ratio
Cash reserve ratio (CRR) represents the amount of cash banks have to keep with the Reserve Bank of India (RBI) out of the deposits that they hold. CRR is stipulated to ensure that at least some portion of the bank’s assets are held in cash, to be available for meeting any sudden need. The CRR is determined by the RBI and is subject to change by RBI. It is stipulated as a percentage of net demand and time liabilities of a bank.
Short-term markets enable borrowing and lending money, to meet liquidity needs. Mutual funds usually do not indulge in borrowing, but are only lenders in the short term markets. When they are faced with short-term liquidity needs, they can borrow by providing the government securities that they hold in their portfolios as collateral. Such borrowings are called repos.
EET stands for ‘exempt-exempt-taxable’ regime. Several times, when the Income Tax authorities provide a tax deduction at the time of making an investment, they indicate how the subsequent incomes and the redemption proceeds will be taxed. EEE means, the investment enjoys deduction, the interest earned is exempt, and the redemption proceeds will not be added to taxable income in the year of receipt. EET means, investment and income are exempt, but redemption proceeds will be taxable. This regime is also called as ‘deferred taxation’ where saving is encouraged by exemption during high-tax earning years, and subject to tax in the los-tax retirement years.
Time Value of Money
Time value of money refers to the potential that money has to change in value over a period of time. The change in the value is due to the re-investment of returns over time. This ability of money to earn makes the money in hand today more valuable than the same amount of money received on a future date. Inflation has the opposite effect on the time value of money. Money left idle loses value over time. The purchasing power of a sum of money reduces over time because inflation makes goods and services more expensive.
Credit spread is the difference between the yield on a corporate bond and a government bond. The government is the lowest risk borrower in the economy, since it is not expected to default. Therefore the lowest interest rates are offered on government bonds. Any other borrower will have to borrow at a rate higher than this rate, reflecting the fact that they are risky as compared to the government. The most significant risk for non-government borrowers is that they may default on the repayment of interest or principal or both. This risk is also known as credit risk. The difference in the borrowing rate of other non-government borrowers and the government bond rates is called credit spread.
Term Structure of Interest Rates
The term structure of interest rates is the relationship between interest rates and term to maturity of bonds. The graphical representation of this relationship is commonly called the yield curve. The term structure or yield curve represents the yield that the market is willing to pay for different maturities of bonds. The yield of government securities is used to draw the yield curve. This is because there is no credit risk associated with such securities and the yield reflects no other risk except the cost of borrowing. All other bonds are traded at a spread to the yield of the government security of similar maturity. The yield curve normally slopes upwards, from left to right, to indicate that the yield goes up with the term to maturity though at a diminishing marginal rate.
In order to earn higher returns, investors tend to invest in high beta funds/ stocks. High beta Funds/ stocks are those that have greater sensitivity than the index (which represents market). Market sensitivity is taken as 1. In light of above, if an investor wishes to know if the returns generated by high beta funds are sufficient or not, Alpha comes in the picture. Alpha tells you whether that fund has produced returns justifying the risks it is taking by comparing its actual return to the one predicted by the beta.
The "cap" part means ‘Capitalization’, which is a measure by which one can have an idea of the size of the company. It is the market value of a company's outstanding shares. This figure is found by multiplying stock price with the total number of shares outstanding.
Open Market Operations
OMO is a measure by which a central bank controls the nation’s money supply by buying and selling Government Securities. It helps regulate interest rates and foreign exchange rates. RBI acts according to the liquidity available in the market. When there is surplus liquidity in the market, RBI intervenes and absorbs the liquidity by issuing bonds and when there is liquidity crunch in the markets, the RBI intervenes and infuses liquidity by buying back the bonds that are with the investors.
Purchasing Managers Index
The Purchasing Managers Index or PMI, as it is more commonly called, is a composite measure of a range of industrial indicators in an economy. Jointly released by Economic Research Agencies and mostly by some of the banks, the PMI is closely watched by economists to discern the trends in different sectors.
Net Asset Value
Also known as NAV, this is the unit price (or rupee value) of one unit of a mutual fund. NAV is calculated at the end of every business day. It is calculated by adding up the value of all the securities and cash in the mutual fund's portfolio (its assets), subtracting the fund's liabilities, and dividing that number by the number of units that the fund has issued. It does not include a sales charge. The NAV increases (or decreases) when the value of the mutual fund's holdings increase (or decrease).
The date on which a fund's Net Asset Value (NAV) will incorporate the effect of dividend. Only those investors who have invested before this date will be eligible for dividends. All those who buy after this date are buying on an 'ex' basis, i.e on the understanding that the dividend payout will not be made to them. The price at which they buy the units, will therefore be reduced by the extent of dividend that was announced. This adjustment is made to the NAV on the ex-dividend date. Dividend re-investment will also happen at the ex-dividend NAV.
The face value is the term used to describe the value of a unit in the books of the mutual fund. If a mutual fund issues 1000 units in a IPO at Rs. 10 each, it collects Rs. 10000. If subsequently the value of the Rs. 10000 invested goes up to Rs. 12,000, the value of 1 unit is Rs. 12. New investors will pay Rs. 12 to buy the units, Rs.2 being the premium over the face value of Rs. 10. In order to keep a count of the number of units, it is important to assign a face value to a unit.
Systematic Investment Plan
Many mutual funds offer investment programs whereby unitholders can invest. The Unitholders of the scheme can benefit by investing specific Rupee amounts periodically, for a continuous period. The SIP allows the investors to invest a fixed amount of Rupees every month for purchasing additional units of the scheme at NAV based prices.
According to the SEBI (Mutual Funds) Regulation, mutual funds have to disclose their portfolios to investors only once in six months. The monthly fact sheet that discloses the portfolio to investors is a voluntary disclosure undertaken by mutual funds.
Until 1995, mutual fund investors were issued certificates when they invested in an NFO. Most funds were closed end and had to be sold in the stock markets, if the investors needed to liquidate them. In 1995, a set of new open ended funds began the practice of issuing account statements and agreeing to repurchase the units at their own offices. Soon the industry shifted completely to account statements.
Option and Portfolio
Mutual funds offer various options such as dividend payout, dividend reinvestment and growth, within a particular product. These also feature different NAVs. However, the underlying portfolio may not be different. For example, the portfolio for a growth option and a dividend option within a product, are not different. Since dividend has been paid out in one, the amount of funds being managed under that option is lower. Therefore, the NAV is different.
SAI and SID
The offer document that a mutual fund files with SEBI has now been split into Statement of additional information (SAI) and Scheme information document (SID). The common information about organisation, sponsors, financial information about schemes in operations, valuation norms and such is published in SAI. It need not be updated for every scheme, but only once a year. The SID contains information specific to a scheme, and needs to be filed for every scheme that needs approval.
Trustees are expected to do a due diligence of practices adopted by the AMCs. Among the many things that they check is whether the agreements with sponsors or other related entities are not on preferential terms as compared to other vendors. Checks and balances are part of the routine diligence structure in a mutual fund.
A service offered by most mutual funds whereby income, dividends and capital gain distributions are automatically invested into the fund by buying additional shares and thus building up holdings through the effects of compounding.
A closed-end fund that invests in debt and money market instruments of the same maturity as the stated maturity of the plan. The focus of a fixed maturity plan is to provide a stream of income through interest payments, while exposing the investor to a lower level of risk.
The ratio of total expenses to net assets of the fund. Expenses include management fees, the cost of shareholder mailings and other administrative expenses. The ratio is listed in a fund's prospectus. Expense ratios may be a function of a fund's size rather than of its success in controlling expenses.
When an equity portfolio is disclosed, it is normal practice to show the weights for each sector. This indicates the industry exposure of the portfolio. In order to ensure that the industry classification is uniform across funds, AMFI has prescribed a 4-level industry classification of equity stocks. Mutual funds classify their stocks according to these standard sector classes. This makes the sector weightings across funds, comparable.
In the money markets, all return is from interest income. There is really no capital gain or loss to be made on very short term securities. Therefore it is customary to quote yields as an annualised number. The same applies for liquid funds that invest in very short term money market instruments. If a liquid fund earns 0.50% in a month, this means, its annualised yield is 0.50 x 12 = 6%. Changes in NAV for liquid funds are very small, due to this annualisation factor,
Fund managers who manage the various schemes of a fund house, are key employees of the fund. If any of them were to leave the fund, such change is notified to investors through an advertisement in a national newspaper, and by issuing an addendum to the offer document.
If a mutual fund launches an international fund, that makes overseas investments, it must designate a specific fund manager responsible for managing the global assets. This is part of the regulation that applies to international funds.
Investors who buy an ETF, do so on the stock exchange, through their trading platforms or brokers. Such investments do not require filling up an application form, or getting an updated statement of account. The settlement of such purchases is through the normal cycle of the exchange, and units are credited to the demat account of the investor.
An NRI investor can invest in a mutual fund by directly remitting the funds from his overseas account, to the collecting bank of the mutual fund scheme. Such remittance however, has to be accompanied by a foreign inward remittance certificate (FIRC) given by the collecting bank, certifying that the remittance was in foreign currency. Otherwise such investments may not be repatriable.
Active Portfolio Management
Is a systematic and proactive approach to investment with the goal of beating the market. This strategy is based on the premise that markets are not efficient and that there is scope to earn abnormal profits through an active investment strategy.
Money Market Fund
A mutual fund that aims to pay money market interest rates. This is accomplished by investing in safe, highly liquid securities, including certificates of deposit, commercial paper, and Government securities. Money funds make these high interest securities available to the average investor seeking immediate income and high investment safety.
A gold ETF will hold gold and its equivalent, to the extent of its corpus. The buying and selling of ETFs in the market do not impact this holding. However, if new units have to be created, they are done by the ETF in bulk, and backed up by holding of physical gold.
Liquid Fund NAV
Liquid funds invest in short term instruments and earn most or all of their incomes from interest. Therefore the change in their NAV is small on an everyday basis. To estimate the yield on the liquid fund, is therefore necessary to annualise the changes in NAV.
Contingent Deferred Sales Charge (CDSC)
A fee (or back-end load) imposed by certain funds on shares redeemed within a specific period following their purchase. These charges are usually assessed on a sliding scale, such as four percent to one percent of the amounts redeemed, with the fee reduced each year the units are held.
The danger that overall stock markets could fall. Fund managers may try to deal with this risk by moving a larger percent of their portfolios into cash or by hedging with futures and options. However, market risk is not a one-way street; it's also the peril of being on the sidelines when the stock prices surge.
Portfolio Turnover Rate
The rate at which the fund's portfolio securities are changed each year. If a fund's assets total $100 million and the fund bought and sold $100 million worth of securities that year, its portfolio turnover rate would be 100%. Aggressively managed funds generally have higher portfolio turnover rates than do conservative funds that invest for the long term. High portfolio turnover rates generally add to the expenses of a fund.
SEBI has now clarified that for all investments in debt and liquid funds, for values above Rs.1 crore, the applicable NAV will depend on the realisation of funds. The NAV on the date on which the funds actually were realised will apply, irrespective of when the application was handed in.
When mutual funds invest in overseas securities, the permitted class of debt securities should all be of investment grade or above. All equity investments should only be in regulated entities abroad. The guidelines provide a base level of safety in the choice of investments that international funds can make.
The time available to mutual funds to send an abridged annual report of their schemes, has been reduced from six months from the date of closure of accounts, to four months. Investors can obtain an unabridged version of the report, from the AMC offices, after paying a fee for the same.
Average Maturity as per definition is the average time to maturity for all Debt securities held in a portfolio. It is an important consideration for investors in Debt Funds and Money Market funds. The significance of Average Maturity lies in the fact that it shows the sensitivity of a Debt Fund to change in interest rates.
System of evaluating the probability of whether a bond issuer will default. CRISIL, ICRA, CARE and other rating agencies, analyze the financial stability of both corporate and state government debt issuers. Ratings range from AAA (extremely unlikely to default) to D (likely to default). Mutual funds generally restrict their bond purchases to issues of certain quality ratings, which are specified in their prospectuses.
When the fund sells a stock, it incurs short-term and long-term capital gains or losses. Unlike a corporation, a mutual fund does not itself pay income taxes. By law, each year the fund must distribute that year's net investment income (the total of dividends and interest received less fund expenses) and net realized gain (gains less losses on securities sales) to the fund's shareholders. That means that you get to foot the taxes due on those gain.
The danger that the issuer of a corporate or municipal bond will experience financial difficulties causing deterioration in credit worthiness, perhaps even a default. Treasury securities are considered free of this risk.
Treasury Bills are Short Term Money Market instruments issued by RBI on behalf of the Government of India. Treasury Bills or T-Bills as they are called are issued only by the Central Government and unlike Government Securities State Governments cannot issue T-Bills. T-Bills are issued in the form of a zero coupon instrument at a discount to face value, redeemable at par on maturity. The return to the investor is thus the difference between the maturity value and the issue price.
When a fund is taken-over or the AMC sells its stake to another sponsor, investors in the fund being taken over, have the option to exit the schemes they have invested in, within a stipulated period, at no exit load. This option is not available to investors in ELSS whose funds are locked in for 3 years.
The facility to nominate a person in whom the units will vest in the event of the death of the investor is a facility that is available only to individual investors in a mutual fund. Non- individual investors, including corporates, HUFs, trusts, societies and partnership firms, can neither nominate nor be a nominee.
Assets under Management (AUM)
The current value of the portfolio of the mutual fund is the AUM of the fund. The fund manager’s fees and fund running expenses are charged to the AUM. Net assets refer to the value that remain after charging such fee.
The limits on investments in a debt instrument are defined in terms of the issuer. Therefore a mutual fund factsheet discloses debt instruments issuer-wise and not instrument-wise, unlike equity shares.
Close ended schemes
Schemes have a pre-specified maturity period and investments in these schemes can be made at the time of the IPO and thereafter at market price through the stock exchange on which the same is listed. The market price is generally at a discount to the NAV depending upon market perception and expectations of the scheme. The Fund may also offer an exit route by offering to repurchase at NAV related prices.
Investments and redemptions are processed at a particular NAV. This NAV is a function of the cutoff times specified by the fund. For example a fund may 10.00 am as the cutoff time in the Liquid Fund for previous day NAV. Investment Applications received after the cutoff time of 10.00 am will get same day NAV, while applications received before 10 am will get previous day NAV, assuming that there are no holidays/Sundays involved in between.
Gilt Funds are those schemes, which as per their offer document can invest only in government securities of different maturities. They offer lower returns as the credit risk is virtually absent and there are no chances of government defaulting on its payment obligations. This effectively reduces the yield on them. They are still subject to the interest rate risk.
The capital gains arising out of selling mutual fund units are taxed at Long Term Capital Gains rate if they are held for more than one year. The Long term capital gains rate can be computed either as 10 % flat or 20 % with indexation benefit. For this the government has specified an index linked to the wholesale price index. The indices of two years (year of purchase and the year of sale) are used for the purpose of computing capital gains tax. The purchase price is multiplied by the index of the year of sale and the product is divided by the index of the year of purchase. This indexed purchase price is deducted from the sale price to calculate the indexed capital gains. The tax rate of 20 % is applied to the indexed capital gains.
Risk Adjusted Returns
For the purpose of comparing returns across schemes involving varying levels of risk, the returns are adjusted for the level of risk before comparison. Such returns (reduced for the level of risk involved) are called risk-adjusted returns.
This is the hypothetical rate of return that, if the fund achieved it over a year's time, would produce the same cumulative total return if the fund performed consistently over the entire period. A total return is expressed in a percentage and tells you how much money you have earned or lost on an investment over time, assuming that all dividends and capital gains are reinvested.
Capital Appreciation Fund
A mutual fund that seeks maximum capital appreciation through the use of investment techniques involving greater than ordinary risk, such as borrowing money in order to provide leverage and high portfolio turnover.
The responsibility of a credit rating agency assigned to rate a debt instrument extends over the life of the bond. If there is any change in the circumstances leading to a change in the credit quality of the bond, the rating of the bond will have to be upgraded or downgraded. The rating assigned to a bond will have to be re-affirmed every year even if there is no change in the rating of the bond.
The capital loss incurred on the sale of mutual fund units can be set-off against capital gains thus reducing the gains that will be subject to tax. Capital loss can be carried forward for eight years and set-off. Short-term capital losses can be set-off against short-term and long-term capital gains. Long-term capital loss can be set-off against only against long-term capital gains. If the long-term capital loss is on the sale of an asset whose long-term capital gains is exempt from tax, such as an equity-oriented mutual fund, there will be no set-off benefits available on this loss.
The returns from a bond fund comprises of both coupon income from the bonds held as well as an increase or decrease in the value of the bond because of a change in interest rates. The contribution of each of these components varies. In situations where interest rates are going down, the gains from an increase in the price will be the greater contributor to total returns while in times of rising interest rates, coupon income will make a positive contribution to total income while the loss from a fall in the value of the bonds erode the total returns.
Interest Rate Risk
The change in the price of a debt security due to changes in the market interest rates is the interest rate risk. For debt oriented mutual fund schemes, this interest rate risk affects the NAV of the fund. A rise in the interest rates leads to a fall in the price of a fixed income security.
The ease with which an investment can be bought or sold. A person should be able to buy or sell a liquid asset quickly with virtually no adverse price impact.
The relationship at a given point in time between yields on fixed-income securities with varying maturities – commonly, treasury bills, notes and bonds. The curve typically slopes upward because longer maturities normally have higher yields, although it can be flat or even “inverted” or downward sloping.