Basic Mutual Fund Terminology
The world of mutual funds is filled with terminology. In order to wade through these waters, an investor needs to be aware of them regardless of whether they make their investments on their own or via a financial advisor or distributor. Let’s take a look at some of the basic terminologies in mutual funds. We have compiled a list of 25 common terms associated with mutual fund investing.
Basic Mutual Fund Terminology
1. Actively Managed Fund:
An actively managed fund or portfolio implies an investment strategy, which tries to outperform its underlying benchmark. It employs a fund management team which continuously monitors financial markets to find suitable opportunities for the fund to invest in. The underlying belief is that an experienced team can beat market returns and outperform peers.
Known as the Jensen’s alpha, this statistic measures the difference between the expected and actual returns of a fund. While a positive alpha signals better than expected performance, a negative alpha measures otherwise. Alpha is considered to be the value added by a fund manager’s stock picking abilities.
AUM is the acronym used for Assets Under Management and represents the total value of investments being managed under a scheme. AUM continues to change based on purchases and sales by investors as well as due to market movement.
4. Asset allocation:
Asset allocation refers to the inclusion of securities across asset classes in an investment portfolio like equities, fixed income, and bullion, among others based on an investor’s investment objective, risk tolerance, and life stage. Including stocks, bonds, non-convertible debentures, bullion, commodities, and funds can get an investor the best of what financial markets have to offer.
5. Balanced fund:
Balanced funds are mutual funds, which provide exposure to both equity and fixed income classes, or bonds, in a sizable measure. They get their name from the ‘balance’ that they try to strike between the two aforementioned asset classes. They typically invest 55-65% of their assets in stocks and the remaining in bonds and money market instruments.
Beta measures the volatility of a fund’s returns as compared to the market. This means that it measures the sensitivity of returns given market movement. A beta of 1 indicates that the fund’s returns move as the market does, i.e., a 5% rise in the market will lead to a similar rise in the fund’s returns. A value of more than 1 indicates higher than market volatility while a value of less than 1 indicates lower volatility.
A benchmark is used in mutual fund terms to represent an index against which the performance of a particular fund is measured or ‘benchmarked.’ Fund management selects a suitable index to benchmark their fund’s performance based on its investment universe and strategy. This is the first among many measures to assess a fund’s performance relative to others.
8. Bond fund:
A bond fund holds fixed income instruments issued by governments, corporates, and municipalities in its portfolio. Unlike equity funds, bond funds focus on income generation. They are also known as debt funds.
9. Close-ended fund:
A close-ended fund allows investment only during the New Fund Offer (NFO) period and comes with a specified lock-in tenure. During this lock-in period, investors cannot redeem their investments like they can in open-ended funds. After the lock-in period ends, the fund becomes open-ended and allows other investors to invest. Existing investors can redeem, switch or continue with their investment.
10. Credit quality:
This term, used in mutual fund factsheets, provides a snapshot of the average credit quality of a fixed income (or debt) fund. The bonds held by such a fund have a credit rating and this is used, weighted by their size in the portfolio, to arrive at average credit quality of a fund. Generally, higher the average credit quality, lower the risk of investment.
Diversification is closely associated with asset allocation. The underlying philosophy of diversification is to spread the risk of a portfolio by investing across asset classes and also within asset classes. For example, if one invests in stocks, one can do so across large, mid and small cap companies as well as across sectors like consumer staples, financials services, materials, and utilities.
12. Equity fund:
An equity fund invests in stocks of the companies listed on the stock market with an objective to offer capital appreciation. It can also invest in equity-related instruments like preferred shares and may also have a small exposure to bonds.
Equity Linked Savings Scheme (ELSS) is an equity-oriented mutual fund scheme, which functions like any other equity fund, except for that it provides tax benefits under section 80C of the Income Tax Act. One can invest a maximum of Rs 1.5 lakh in a year which can be deducted from taxable income.
14. Exit load:
The charge levied on an investor when he redeems his investment from a mutual fund scheme is known as exit load. This is in the form of a percentage and is applicable to the entire amount being liquidated. Earlier, an entry load was also charged to investors in India, but this was done away with in August 2009.
15. Expense ratio:
Also known as total expense ratio, it represents the annual fee levied on the fund. It is provided in fund documents, is in percentage terms and is applied on the AUM of the scheme. It includes fund management and advisory fees, sales commissions, legal and audit fees, fund administration expenses, and marketing expenses, among others. Since this is a cost on the fund, the higher the expense ratio, the lower the returns in the hands of investors.
16. Inception date:
The date on which a mutual fund scheme begins operations and publishes its first NAV is known as its inception date.
17. Index fund:
An index fund is a special type of mutual fund which simply tries to replicate a benchmark index instead of beating it. It comprises of the same securities that its benchmark is made of in the same proportions. The only difference between the returns of an index fund and its benchmark is the cost and exit load, if any.
18. Investment objective and strategy:
All mutual funds lay out an investment objective which describes their chief aim. In order to achieve their objective, they intend to follow a method which is known as their investment strategy. Fund documents also define the investment universe in which they intend to purchase and sell securities.
Net Asset Value (NAV) is possibly the most closely associated term with mutual funds. It represents the price of one unit of a fund. The ‘Net’ in the NAV represents the net of costs value and subtracts the expenses of the fund. Though this is similar to the price of one equity share, unlike stock price, it is calculated once at the end of trading. It is the most basic performance indicator of a fund.
20. Open-ended fund:
An open-ended fund offers units on a continuous basis to investors. Unlike close-ended funds, investors can buy and sell units in such funds at any time they wish to.
21. Passively managed fund:
A passively managed fund is based on an investment strategy which replicates its underlying benchmark; unlike an actively managed fund, it does not try to outperform it. The key performance measure of this strategy is the fund’s tracking error; the lower the tracking error, the better the performance of the fund.
22. Portfolio turnover:
This reflects the rate at which the securities comprising a fund’s portfolio have changed in a year. The more actively a fund is managed, the higher is its portfolio turnover. Frequent churning of a portfolio adds to a fund’s expenses, thereby reducing returns.
23. Rupee cost averaging:
Rupee cost averaging is a strategy in which an investor invests a fixed amount of money at regular intervals. By doing this, he gets more units of a fund when the prices are low and fewer units when prices are high. In this way, the cost of investing in these securities is averaged out.
A Systematic Investment Plan (SIP) helps an investor adopt a disciplined approach to investing by facilitating the investment of a fixed amount in a mutual fund at regular periods. This mechanism is based on the principle of rupee cost averaging.
25. Standard deviation:
This indicator measures the deviation in returns of a fund from its historical average returns. Standard deviation measures the consistency in returns. A higher standard deviation implies more volatility in returns than a lower one.