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What is a mutual fund?
A mutual fund is a trust. It pools money from like-minded
shareholders and invests in diversified portfolio of securities, through
various schemes that address different needs of investors. The pool of money
thus collected is then invested by the Asset Management Company (AMC) in
different types of securities. These could include shares, debentures,
convertibles, bonds, money market instruments or other securities, based on the
investment objective of a particular scheme. Such objective is clearly laid
down in the offer document for that scheme. The fund adds value to the
investment in two ways: income earned and any capital appreciation realised
through sale. This is shared by unit holders in proportion to the number of
units they own.
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What is an Asset Management Company?
An AMC is involved in the daily administration and also acts as
investment advisor for the fund. An asset management company is promoted by a
sponsor which usually is a reputed corporate entity with sound record of
profits. An AMC typically has three departments:
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Fund Management
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Sales & Marketing
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Operations & Accounting
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What are the different types of mutual fund
schemes?
Mutual fund schemes can be classified as follows:
By Structure
Open-ended schemes
Close-ended schemes
Interval schemes
By Investment Objective
Growth schemes
Income schemes
Balance schemes
Money Market schemes
Other types of schemes
Tax Saving schemes
Special schemes
Index schemes
Sector specific schemes
By Structure
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Open-end Funds
An Open-end Fund is one that is available for subscription all
through the year. These do not have a fixed maturity. Investors can
conveniently buy and sell units at Net Asset Value ("NAV") related prices.
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Close-ended Funds
A Close-ended Fund has a stipulated maturity period which
generally ranges from 3 to 15 years. The fund is open for subscription only
during a specified period. Investors can invest in the scheme at the time of
the initial public issue and thereafter they can buy or sell the units of the
scheme on the Stock Exchanges where they are listed.
By Investment Objective
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Growth Funds
The aim of growth funds is to provide capital appreciation over
the medium to long term. Such schemes normally invest a majority of their
corpus in equities. Growth schemes are ideal for investors who have a long term
outlook and are seeking growth over a period of time.
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Income Funds
The aim of Income Funds is to provide regular and steady income
to investors. Such schemes generally invest in fixed income securities such as
bonds, corporate debentures and Government securities. Income Funds are ideal
for capital stability and regular income.
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Balanced Funds
The aim of Balanced Funds is to provide both growth and regular
income. Such schemes periodically distribute a part of their earning and invest
both in equities and fixed income securities in the proportion indicated in
their offer documents. These are ideal for investors looking for a combination
of income and moderate growth.
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Money Market Funds
The aim of Money Market Funds is to provide easy liquidity,
preservation of capital and moderate income. These schemes generally invest in
safer short-term instruments such as Treasury Bills, Certificates of Deposit,
Commercial Paper and Inter-Bank Call Money. Returns on these schemes may
fluctuate depending upon the interest rates prevailing in the market. These are
ideal for corporate and individual investors as a means to park their surplus
funds for short periods.
Other Schemes
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Tax Saving Schemes
These schemes offer tax rebates to the investors under specific
provisions of the Indian Income Tax laws as the Government offers tax
incentives for investment in specified avenues. Investments made in Equity
linked Savings Schemes (ELSS) and Pension Schemes are allowed as deduction
under Section 88 of the Indian Income Tax Act, 1961.
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Index Schemes
Index Funds attempt to replicate the performance of a particular
index such as the BSE Sensex or the NSE S&P CNX 50.
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Sectoral Schemes
Sectoral Funds are those which invest exclusively in a specified
sector(s) such as FMCG, Infotech, Pharmaceuticals, etc. These schemes carry
higher risk as compared to general equity schemes as the portfolio is less
diversified, i.e. restricted to sector(s) / industry (ies).
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What is the difference between an open
ended and close ended scheme?
Open ended funds can issue and redeem units any time during the
life of the scheme. Close ended funds cannot issue new units except through a
bonus or rights issue. Hence, unit capital of open ended funds can fluctuate
daily. Further, new investors to an open ended fund can join the scheme by
directly applying to the mutual fund at applicable Net Asset Value-related
prices. In the case of close ended schemes, new investors can buy units only
from the secondary market.
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What is a Prospectus or Offer Document?
It is a document which an open-end fund, or newly issued
closed-end fund, is required to provide to investors. Funds say that investors
should read it carefully before investing or sending money. A prospectus
contains descriptions of:
Fees, in a standardized format
Investment Objective
Some financial data
Investment methods
Risk factors and description
Investment management and compensation
Dividend and Capital Gain distributions
Other services
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What is the Net Asset Value (NAV)?
The net asset value (NAV) is the market value of the fund's
underlying securities. It is calculated at the end of the trading day. Any
open-end fund buy or sell order received on that day is traded based on the net
asset value calculated at the end of the day. The NAV per units is such Net
Asset Value divided by the number of outstanding units.
| NAV |
= |
Market Value of Assets - Liabilities |
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| Units Outstanding |
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What are Dividends?
A mutual fund may receive dividend or interest income from the
securities it owns; it is required to pay out this income to its investors.
Most open-end funds offer an option to purchase additional shares with the
dividends. Dividends are often made monthly or quarterly, though many funds
make distributions only yearly.
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Are investments in mutual fund units safe?
No stock market related investments can be termed safe with
certainty; they are inherently risky. However, different funds have different
risk profile, which is stated in its objective. Funds which categorize
themselves as low risk, invest generally in debt which is less risky than
equity. Anyway, as mutual funds have access to services of expert fund
managers, they are always safer than direct investment in the stock markets.
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What are the Risks in a mutual fund?
Equity Funds are open to market risk i.e. there is a possibility
that the price of the stocks in which the Fund has invested may decrease. Of
course, the prices may also go up, making it possible for the Fund to earn
profits.
Debts Funds are open to two main risks - Credit Risk and
Interest Rate Risk. Credit Risk refers to the possibility that the company that
has issued the bond or debenture in which the Fund has invested may default on
interest or on principal payments. Debt Fund managers take care of this by
investing in bonds which have good credit rating.
Interest Rate Risk refers to the possibility that the price of
the bond in which the Fund has invested may go down because of an increase in
the interest rates in the economy. In general, it is useful to remember that
this is a "see-saw" relationship - bond prices (and therefore, NAV) goes up
when interest rates drop and drops when interest rates rise.
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What are the benefits of a mutual fund?
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Your money is managed by experienced and skilled professionals
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Your investment is automatically diversified over a large number of companies
and industries, thus reducing the element of risk
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Your money is very liquid, especially in an open-end fund
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The potential to provide a higher return over the medium to long term is better
in a wide range of securities than in any one
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The costs of research and investing directly in the individual securities are
spread over a large corpus and thousands of investors thus minimising
individual share
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There is a high degree of transparency in the operation of a mutual fund, so
you can take investment decisions based on more information
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You have a choice of schemes to suit your needs
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The industry is well regulated with many measures oriented towards investor
protection
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Do mutual funds assure returns?
Some mutual funds have floated "assured" return schemes that
guarantee a certain annual return. At present, there are very few funds who
assure returns as they have realized that it is not possible to assure returns
in a volatile market.
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How do you make money in a mutual fund?
There are three ways in which you can make money in a mutual
fund.
First you can earn a dividend from the Mutual Fund. Most Debt
Funds declare dividends around once in six months in their Dividend Option. If
you do not want the dividend, you can choose to be in the Cumulative Option.
When a dividend is declared, the NAV of the units will fall, since dividend is
paid out of the appreciation in the value of the unit.
Next, you can make a profit by selling the mutual fund units at
a price higher than that at which you bought them. This is capital gain. (If
you sell the units at a lower price, you make a capital loss.)
Finally, the value of the units you hold can appreciate. This is
unrealised capital gain. Dividends and capital gains are treated differently.
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What are the tax
benefits for investing in mutual fund units?
20% rebate on contribution upto Rs 10,000/- under ELSS (equity linked saving
schemes)
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Who should invest in
mutual funds?
Mutual funds can meet the investment objectives of almost all
types of investors. Younger investors who can take some risk while aiming for
substantial growth of capital in the long term will find growth schemes (i.e.
funds which invest in stocks) an ideal option.
Older investors who are risk-averse and prefer a steady income in the medium
term can invest in income schemes (i.e. funds which invest in debt
instruments). Investors in middle age can allocate their savings between income
funds and growth funds and achieve both income and capital growth.
Investors who want to benefit from regular savings, save a small sum every
month, can use the Systematic Investment Plan.
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As mutual fund schemes
invest only in stock markets, are they suitable for small investors?
Mutual funds are meant for small investors. The prime reason is
that successful investments in stock markets require careful analysis which is
not possible for a small investor. Mutual funds are usually equipped to carry
out thorough analysis and can provide superior returns.
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In the budget 2004, an
Education Cess Tax of 2% has been introduced as below :
“AN EDUCATION CESS OF 2 PERCENT ON INCOME TAX, CORPORATE TAX,
EXCISE DUTIES, CUSTOMS DUTIES AND SERVICE TAX TO BE LEVIED”.
Meaning : An education cess tax is levied at 2% on TDS or
advance tax paid, inclusive of surcharge. On the income tax plus surcharge
payable by all categories of taxpayers, there will be an Education Cess at the
rate of 2% thereon of such tax and this new tax is applicable to Excise Duties,
Corporate Tax, Customs Duties and Service Tax.
(A) Example for mutual fund: In the mutual fund context, TDS
is applicable to NRI investors. The following is the calculation of TDS on
short term capital gain including education cess tax.
Assume that the redemption proceeds are 1,00,000/- and Short Term Capital Gains
out of the transaction is Rs. 500/-. TDS would be 30% as per tax slab + 10%
surcharge + 2% education tax (33.66 %) = 500*33.66/100 = 168.30 The amount
payable to investor is 1,00,000.00 – 169.00 = Rs. 99831.00 and the Rs. 169/-
will be remitted to treasury as TDS.
(B) Example - Impact on Income Tax : No change in existing
Income Tax Rate and Surcharge otherwise stated below. An Additional Surcharge @
2% (on aggregate amount of Income tax and existing surcharge) is proposed as
Education Cess. A person having taxable income exceeding Rs one lakh will now
be required to pay in addition to income tax (after rebate under Chapter
VIII-A) an education cess at the rate of two per cent. The tax proposals
also specify that a person having income exceeding Rs 8.5 lakh in this slab
would be required to pay 10 per cent surcharge on the total income tax payable
after the rebate under Chapter VIII-A, and also the education cess at the rate
of 2 per cent.
(C) Example for Interest on NRE, FCNR &
RFC Account : Any interest paid or credited on or after 1st September, 2004 in
respect of deposits in NRE, FCNR and RFC account of an individual shall be
taxable at normal rates of taxation. The bank shall be required to deduct tax
at 33.66% (i.e. Income Tax 30% + Surcharge 10% + Education cess 2%). However,
if such deposits are with an Indian company or bank, which is an Indian Company
not being a private company as defined in the Companies Act, 1956 (1 to 1956),
the rate of TDS shall be 22.44% (i.e. Income Tax 20% + Surcharge 10% +
Education cess 2%). { Disclaimer : This contents above should not be considered
as substitute for specialized professional advice and expert guidance may be
sort before acting upon }
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