Click here: How to earn good returns in mutual funds (Series Post #1)

Click here: How to earn good returns in mutual funds? (Series Post #2) – Mutual Fund Returns Are Variable.

Click here: How to earn good returns in mutual funds (Series Post #3) – Mutual Fund Returns are mostly Capital Gain.

So far, in the “good returns” series, we have covered two important aspects of investing in mutual funds. In this post, we will uncover another important aspect, namely, the sources of return of a mutual fund scheme.

The capital markets regulator SEBI in its document “INVESTMENTS IN MUTUAL FUNDS – FAQs” says “mutual fund is a mechanism for pooling money by issuing units to the investors and investing funds in securities in accordance with objectives as disclosed in offer document.”

A mutual fund scheme’s fund manager will have a wide choice of securities to invest in.  Some of them are:

1. Equity and equity-related securities.
2. Securities issued and guaranteed by the Central and State Governments.
3. Debt obligations of domestic Government agencies and statutory bodies, Indian Government Bond, State Development Loans issued and serviced at the Public Debt Office, Bonds issued by Central, and State Government PSUs guaranteed by Central or State Governments.
4. Corporate debt of both public and private sector undertakings.
5. Term Deposits of banks (both public and private sector) and development financial institutions.
6. Money market instruments permitted by SEBI/RBI.
7. Certificate of Deposits (CDs).
8. Commercial Paper (CPs).
9. Repo of corporate debt securities.
10. Securitized Debt, not including foreign securitized debt.
11. The non-convertible part of convertible securities.
12. Any other domestic fixed income securities as permitted by SEBI / RBI from time to time.
13. Foreign securities including ADR/GDR of Indian or foreign Companies
14. Investment in units of Real Estate Investment Trust (‘REIT’) & Infrastructure Investment Trust (‘InvIT’).
15. Any other instruments/securities, in the opinion of the fund manager, would suit the scheme’s investment objective subject to compliance with extant Regulations.

This is not a complete list and is indicative. The fund manager may decide to invest in some or all of them depending on their suitability and as the financial situation evolves and market conditions change.

Now, the real question to ask is how the NAV of a unit increases that is how the scheme generates a surplus.  This is where the answer becomes multi-layered and nuanced.  Here again, let’s start with the basics.

A typical income statement of a mutual fund scheme will have the following components:

• Dividend
• Interest
• Profit on inter-scheme transfer/sale of investments
• Profit on sale/redemption of investments (other than inter-scheme transfer/sale of investments)
• Profit on derivative transactions
• Foreign exchange gain (Net)
• Other income

Let’s explore some of the sources of income of an equity scheme in detail:

Dividend – Many companies declare dividends to their shareholders from time to time.   A mutual fund scheme, when it invests in an equity share of a company, becomes a shareholder of that company. Therefore, it receives dividends due to the shareholders.

Interest – Coupons received from the fixed income securities held in the portfolio of a scheme.

Corporate Benefits – The companies where a mutual fund scheme invests may declare bonuses and rights shares. All the corporate benefits accrue to a scheme when it holds the shares of the companies declaring such benefits.

Capital Gain –When a mutual fund scheme sells the securities it holds, and the values of securities have risen from their original purchase prices, it will realize a capital gain.

Mark-to-Market Gain – the NAV of a scheme may increase due to an increase in the market valuation of the underlying securities.

The net effect of all the above returns sources is an increase in the value of your investment in a mutual fund scheme.

Reduction in the Gain due to Total Expense Ratio (TER)

So far, we have seen and understood the sources of returns of a mutual fund scheme.  There are some factors that will reduce the returns of a scheme.  Some of these factors are intuitive and inverse to the sources of returns. 

• A company may not declare any dividend
• The issuer of the bond may delay/default in paying the coupons
• Instead of the prices of securities increasing, they may decrease due to the market conditions

Other than the above market-linked factors, there are certain expenses a scheme will incur regularly. 

Total Expense Ratio is the total of ongoing fees and operating expenses charged to the scheme, expressed as a percentage of the scheme’s daily net assets. To the extent of the Total Expense Ratio (TER), the scheme’s (gross) return will get reduced. 

TERs include Investment Management and Advisory Fees charged by the Asset Management Company (AMC), Registrar and Transfer Agents’ (RTA) fees, brokerage/commission paid to the intermediaries and distributors, marketing and selling costs, etc. Such a reduction in NAV will happen even if you do not realize the gains, i.e., you continue to hold the units.

Illustration of impact of expense ratio on scheme’s returns:

The numbers above illustrate the impact of expense ratio on a scheme return and should not be construed as an indicative return of any mutual fund scheme.

Exit Loads

The Mutual Fund House may levy a fee, namely “exit load,” if you exit a scheme partially or wholly within a specific time from the date you have invested.  The details of the applicable exit load and the time will be mentioned in the Scheme Information Document (SID).

Suppose a scheme charges a 1% exit load for redemptions within 365 days from the date of purchase. Suppose you redeem 500 units of a scheme 11 months after the date of purchase. Let us assume that the NAV is Rs 100. The exit load will be = 1% x 500 (number of units) x 100 (NAV) = Rs 500. This amount will be deducted from the redemption proceeds. Therefore, the redemption amount received in your bank account will be Rs.49,500 (Units 500 x NAV Rs 100 – Rs 500 exit load = Rs 49,500.)

A Mutual Fund scheme charges an exit load to discourage investors from redeeming before a specific time. This is done to protect the financial interest of remaining investors in the scheme, the ones who remain invested. The exit load of Rs.500/- deducted from your redemption amount will be added back to the NAV of the scheme to benefit the remaining unit holders.

Therefore, the exit load reduces your returns.

Capital gain tax and the tax on dividends are other outgoes that reduce your returns.  The taxes are dependent on your tax status. The impact of taxes differs from one investor to another, and I will discuss it more elaborately in a separate post.

To sum it up, the fund manager of a scheme has various avenues to earn income and generate capital gains.  These earnings net of expenses is reflected in a scheme’s Net Asset Value (NAV).  Under the growth option, the investor will realize capital gains when the units are sold.  Similarly, the investor will likely receive income and capital distribution if such a plan/option is chosen.

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