Mutual Fund Myths

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A few myths about mutual funds.

Myth 1) While choosing between two MFs one should buy one with lower Net Asset Value(NAV).
NAV of a mutual fund depends on the duration for which the fund has been in existence and its performance. Rather than looking at the NAV one should look at the past performance to compare the funds.

Example: Let us assume two funds Fund A and Fund B. Suppost that Fund A is currently priced at Rs. 50 and Fund B is priced as Rs 20. Suppose you invest Rs 5000 in both funds, you get 100 and 250 units respectively. Assuming Fund A gives 20 % return and Fund B gives 10% return. The unit price of the funds becomes Rs 60 and Rs 22. Now your investment of 5000 in Fund A has now become 60 * 100 = 6000, and invesment in Fund B has become 250 * 22 = 5500. Thus we see the fund that looked expensive gives better return.

Myth 2) It is better to invest in NFO (New Fund Offer) than buying a existing fund.
Buying a mutual fund through a NFO only means that you are investing in a fund with no past performance. It is better to invest in a scheme with a known past performance record.

Myth 3) All mutual funds come with tax benefit.
Not all mutual fund come with tax benefit. If you invest in a Equity Linked Saving Scheme (ELSS), your investment can be shown under 80(c). These mutual funds come with a three year lock-in. If your fund invest more than 60% of the corpus into equity and you hold the fund for more than a year, the return made on the investment is tax free. Income from other mutual funds are treated as regular income for the investor.

Myth 4) NAV of a mutual fund always follows the Sensex.
It is possible that the NAV of a mutual fund falls even if Sensex rises and vise versa. Sensex or any other index track only a fraction of companies. The fund you have invested in can invest in these funds and also in other companies that are not part of the index. So it is very much possible that the index and your fund go in opposite direction. But if your fund is a diversified fund it is should follow the index over a long period of time.

Myth 5) It is better to invest in a mutual fund that gives good dividends.
When a fund gives you dividend the NAV of your fund gets adjusted by the amount. Thus the money that you get gets reduced from your investment. This option is mainly useful in ELSS where dividend received is like getting some of your investment back before the lock-in period expires.

Myth 6) You need a demat account to invest in mutual fund.
You need demat account when investing in stocks not for mutual fund. You can just need to fill up a application form, attach the check of the desired amount and submit the form at the mutual fund office or one of the customer service center.

Loan EMIs and Interest Calculations

Some banks are offering loan at 10% some at 11% and some at 12%. Most people think that this is the percentage of interest calculated yearly. After taking loans they get shocked when they see that two borrowers borrowing at same rate of interest of are paying different Equated Monthly Installments (EMIs). Well that is because of one more factor in calculating EMIs that is called reducing frequency. We will talk about reducing frequency in this article and see how they affect the loan EMIs. In general this article will try to explain how EMIs are actually calculated.

When you take loan from a bank they tell you an interest rate which they would be charging on the loaned money. But there are two ways in which they calculate EMIs - one is flat rate system other is reducing balance system. For example you took a loan of 100000 for 20 years and interest rate charged is 10% per annum. Under flat rate system the EMI is calculated as follows:

Interest each year = 10000
total interest = 10000 x 20 = 200000
principle = 100000
total returned money = principle + total interest = 300000
EMI = total returned money / total months = 300000 / (20 x 12) = 1250

Reducing system can be further divided into many systems based on Reducing Frequency. What is this Reducing Frequency? When you repay your loan as EMIs, it has two parts - an interest part and a principle part. How frequently the principle returned, as part of EMI, is subtracted from the remaining balance is called the Reducing Frequency. Suppose the principle returned is subtracted every month from the remaining balance then then balance keeps on reducing each month and interest is calculated on the remaining amount. In this case the reducing frequency is monthly. If the principle returned is subtract once in a year then the reducing frequency is yearly. In that case you end up paying interest on the amount which you had already returned. The more the reducing frequency for a loan the better it is for you (the borrower). How lets see,

The EMI of this loan is calculated using following formula:

EMI = (principal x period interest) ((1 + period interest) ^n) /(m x ((1 + period interest)^n - 1))

where,
period interest = rate in % for the period divided 100
n = number of periods
m = months in a period

Now suppose the reducing frequency is monthly then
period = month
number of periods (n) in 20 years = 240 (i.e. 20x12)
period interest = (10/100)/12 (since 10% is annual interest rate for a month it will be divided by 12)
EMI = (100000 x 10/1200) ((1 + 10/1200)^240)/(1 x ((1 + 10/1200)^240 - 1))
i.e. EMI = 965

If reducing frequency is yearly then
period = a year
number of periods (n) in 20 years = 20
period interest = (10/100)
EMI = (100000 x 10/100) ((1 + 10/100)^20)/(12 x ((1 + 10/100)^20 - 1))
i.e. EMI = 978

These calculations applies to all kinds of loans whether it is House or Home Loan, Personal Loan, Education Loan or any other Loan.

Mutual Funds - Basics

Maniram once told me:
I have got five thousand rupees lying in my saving account earning a interest of 3-4%. I have heard that stock market gives better returns. I don't have a demat account. I don't know what stock to invest in. What should I do?

Sounds familiar?

Let us look at Maniram's problem. He wants to invest in stock market. If he decides to buy shares of some company, he will need a demat account and will have to spend about 700 to 1000 Rs for that. With the small amount of money that he has he would be able to buy only a few shares of a company. He will also have to decide which company to invest in, which requires a substantial effort.

Lets innumerate his problems
1) Initial expenses for investment.
2) Time needed to study a company.
3) Too small a investment to buy shares of more than one company.
4) Commission that he will have to pay on each transaction.


This is where a Mutual Fund(MF) can help him. Mutual funds take money from a invester and invests in the equity market on his behalf.

Now let us see how Maniram's problems get solved:

1) Initial expenses for investment: You don't need to open a demat or trading account for buying and selling mutual funds. Thus initial expense is zero.

2) Time needed to study a company: You won't need to study any company as you are not investing directly, but the mutual fund is investing on your behalf. They are financial market professionals and this task is best left to them.

3) Too small a investment to buy shares of more than one company: This problem no longer exists as the fund will have a large cumulative investment from many users and can easily diversify its investments in many companies.

4) Commission that you need to pay for each transaction: Most funds charge some fee as entry load. This charge is higher than commission paid while buying shares, but it get waived off if you purchase the units yourself (i.e. without going through a agent).

My suggestion: If you have money lying idle in your bank account, and if you are a medium to long term investor(three years or more). Go ahead and invest in mutul funds.

A few terms that you must understand about mutual funds

1) AUM - Assets Under Management
It the total worth of assets that are being managed by the fund.

2) NAV - Net Asset Value
NAV is the value of each unit that one holds in the mutual fund. NAV is calculated by dividing AUM by total number of units sold by the fund.

3) AMC - Asset Management Company
AMC is the entity that manages a fund for the investors.

More information about mutual funds can be found at http://www.amfiindia.com/

Latest NAV of all the funds can be found at http://www.amfiindia.com/navreport.asp

ULIP vs Mutual Fund

Unit Links Insurance Plan (ULIP) and Mutual Fund (MF) are the two most preferred options for a part time investor to invest into equity. But how do we decide which one should we go for. Though it is very easy to decide, people tend to confuse themselves most of the time. This article talks about some points that you need to consider while deciding which option we want to take.

Mutual Fund are pure investments. ULIP are combination of Insurance and Investment.

First question that we need to answer while buying ULIP is - Do I need to buy insurance?

1) Does the person seeking insurance have any financial liabilities?
2) If something happens to the person, Is there someone who can be in a financial crisis?

If the answer to the above two question is yes, I NEED TO BUY INSURANCE.

Now let us compare ULIP and MF based on certain well known facts:

1) Insurance
ULIPs provide you with insurance cover.
MFs don't provide you with insurance cover.

A point in favor of ULIPs. But let me tell you that you don't get this insurance cover for free. Mortality charges (i.e. the price you pay for the insurance cover) get deducted from your investment.

2) Entry Load
ULIPs generally come with a huge entry load. For different schemes, this can vary between 5 to 40% of the first years premium.
MFs have a small entry load of a maximum of 2.5% which can also be waved off if you apply directly (i.e. not through a agent).

Here MFs have a huge advantage. If we consider a conservative market return of about 10-15% you may get a zero percent return in the first year.

3) Maturity
ULIPs generally come with a maturity of 5 to 20 years. That what ever money you put in, most of it will be locked-in till the maturity.
Tax saving MF ( Popularly called as Equity Linked Saving Scheme or ELSS) come with a lock-in period of 3 years. Other MFs don't have a lock-in period.

Again MFs have advantage over ULIPs. ULIPs do allow you to take money out prematurely but they also put penalties on you for doing that.

4) Compulsion of Investing
ULIPs would generally make you pay at least first three premiums.
MFs don't have any compulsion on future investments.

If you have invested in a MF this year, and in the next year you dont have enough income or money to do investments you can decide not to make any investmets. Also if you notice that the MF that you invested in is not giving good returns as compared to some other Funds scheme, you can decide to invest in some other MF.

5) Tax Saving
Both the ELSS and ULIP come under 80C and can save you tax. Returns in the both form of investments are tax free.

6) Market exposure
ULIPs give you both moderate and aggressive exposure to equity market
Debt and Liquid MF let invest with low risk, but don't give you tax benefit.

ULIPs need not be aggressive in equity exposure. That is ULIPs need not keep more that 60% of their funds in equity market. ULIPS also allow to change your equity market exposure. Thus it can help you time the market and still give you tax savings.
If a MF has a less than 60% exposure to equilty market the returns from it are not tax free. Thus you don't get to take a conservative stand on returns.

7) Flexibility of time of redemption
ULIP will get redeemed on maturing. Premature redemption is allowed with some penalty.
In MF Premature redemption is not allowed. For a open ended scheme one can redeem the MF anytime after maturiry

This is mainly useful if the market is down at the maturity time of the investment. In case of ELSS you can wait till the market comes up again and then redeem them. ULIP scheme won't allow you to wait.

Thus, According to my opinion

1) If you wish to take a agressive exposure to equity market, go ahead any buy MF. ULIP wont be able to give you similar returns.

2) If you think you are not diciplined enough to make regular investments and need a whip to make you invest, invest in ULIP.

3) If you want to take a low exposure to equity market and still get tax free returns, invest in ULIP but make sure that fund you are invested is conservative fund.

4) If you want Insurance cover and also good return on investment. I would suggest that you invest in MFs and take a term plan.

If you find any information wrong or missing feel free to comment on the post.