5 Important terms you must know before investing in Mutual Funds
You must have been investing in Mutual Funds with a mindset to maximise the returns and minimise the risk. But many investors with investment going for years (in some cases for decades) in Mutual Funds, don’t know the basic terminologies which are related to their funds and also don’t know the accurate returns of their invested money. If you don’t know the basic but most important terms of investing in Mutual Funds, it shows that you are not taking right decisions; so don’t go that way. There are not many but 5 most important terms, once you understand these terms you will start taking wise decisions for your investments, let’s discuss them one-by-one in detail-
- NAV: It is Net Asset Value of a Mutual Fund; it is an important term because NAV performance is the Mutual Fund performance. It is calculated by formulae— ((Asset – Liabilities)/no. of units). Here Assets are- AUMe. Asset Under Management means the money collected by Fund house for investment. Liabilities are the redemption requests at one particular time on Fund House. No. of Units is a figure of total units which Fund house wants to allocate. This formula gives the NAV but it is not final; the expense ratio is then adjusted in this figure to get final value of NAV, which you use to see in your investing app or website. The denominator of formula “no. of units” is decided by Fund house, so NAV no. can be anything if Fund house changes the No. of units. For example- Let’s suppose HDFC Mutual fund scheme has AUM of Rs 1000 crore and its redemption requests at a particular time is of Rs. 100 crore and no. if units allocated by Fund house is 10 crore. So NAV= (1000-100)/ 10 = 90, it comes out here 90; if fund makes no. of units 100 crore NAV will become 9. So absolute NAV figure has nothing to do with Mutual Fund performance, it is important when compared with its own past value. NAV lower or higher is not important but the percentage change of NAV over a period of time is important.
- SIP, STP and SWP: SIP is Systematic Investment Plan, through which you invest your money periodically at fixed interval of time. It can be monthly, quarterly or annually. Some schemes provide weekly and daily too. Once you link your bank account with your investment platform through AutoPay and decide amount and frequency of investment, you can start your SIP. Its biggest benefit is that it gives you opportunity to start your investment as low as Rs. 100. SIP is considered as most disciplined and very popular investment method. STP is Systematic Transfer Plan, through STP you can transfer your invested money from one Mutual Fund scheme to another in fixed interval of time. STP can only be done within the schemes of same investment company. If you have invested in Mutual Fund scheme of HDFC Mutual Fund you can use STP only in other scheme of HDFC Mutual Fund. It is not possible for any other company’s scheme like ICICI, Axis, Kotak etc. It is mainly used for taking advantage of overvalued or undervalued market. SWP is Systematic Withdrawal Plan, through SWP you can systematically withdraw your invested money from any scheme to your bank account in fixed interval of time. It is exactly opposite of SIP. SWP is mainly used for retirement plan where you withdraw your money for your daily expenses.
- CAGR: It is Compounded Annual Growth Rate, it is an important parameter to judge the performance of any Mutual Fund scheme. CAGR is mostly confused with absolute returns. Absolute returns are simply returns on invested capital. It is calculated as ((Final value – Initial Value)/ Initial Value) X 100. An absolute return does not consider time, if you have invested 1 lakh and it becomes 2 lakhs, its absolute return is 100% but you don’t know what time it has taken to generate this return. While in CAGR, it gives a rate at which Initial capital would grow Every Year to become that final value. It does not mean that capital has grown with same rate, it may have fallen or risen but if it that capital grows with that rate it would have given this final value. It is calculated by formula of compound interest that you had learned in your school. The formula is Final value= Initial capital (1 + r/100)^n, you don’t have to calculate it, now every investing platform shows the CAGR of every scheme. The important thing to note is that CAGR is significant when you are choosing Mutual Fund for investment. Once you have invested in a Mutual Fund then CAGR of your invested money is not important rather IRR and XIRR should be seen to judge the performance of your portfolio.
- IRR and XIRR: IRR is Internal Rate of Returns and XIRR is Extended Internal Rate of R You would have seen these terms when you have invested money through SIP or otherwise. When you invest in different intervals, all installments do not have the same time duration of investment. You would have redeemed some amount that also impacts your actual returns. All these are taken in consideration through IRR and XIRR. IRR is concept only for annual installment and hence IRR is also not much relevant. But XIRR gives actual returns because it considers all installments with its date of investment and also consider the redemption. XIRR formula is complex; you don’t have to go for it because XIRR is in-built in every investment platform. You would have seen sometimes XIRR is very high or very low, it is because when XIRR is seen for shorter duration like less than12 months (if investment is monthly) it may go abruptly high or low but after one year it gives you clear picture of your investment returns.
- Direct and Regular plans: You have seen in Mutual Fund schemes that have suffix like Direct or Regular plans. For example- SBI Bluechip Direct Plan and SBI Bluechip Regular These DIRECT and REGULAR plans signify the type of scheme. Regular plans are those you have taken through a Mutual Fund Distributor or Agent. That distributor/agent helps you in choosing right fund and does your paper work and in turn charges you around 0.5-1.5% of commission which is added in its expense ratio. You don’t have to pay directly; Fund house pays this commission and charges you in the expense ratio. While in Direct plan you bypass the Agent/Distributor and make your investment decision on your own and invest directly through Mutual Funds investment platforms. Before 2013 there was no concept of Direct plan there was only Regular plan. After the arrival of online investment platforms, the Direct plans have become popular. Both Direct and Regular plans have its pros and cons; you must choose plan according to your risk profile.
Conclusion: When you invest in Mutual Funds, even with the help of a Financial Advisor/Agent/Distributor; you must know the basic terminologies and if you are making your investment on your own that becomes even more important. Understanding these terms will enable you take informed and wise decisions for your investments of your hard earned money. Happy Investing.