Introduction
We learnt some important terms in the last blog
- Benchmark
- Allocation
- Rebalancing
- SIP
- Expense Ratio
In this edition we will learn 5 more terms which will enrich your learnings and financial journey
- Returns
- Volatility
- Risk
- NAV
- Passive Investing
1. Returns of Mutual Funds (XIRR):
Returns refer to the gains or losses made on an investment over a certain period of time. In the context of mutual funds, returns indicate how much your investment has grown or shrunk. Returns are usually expressed as a percentage.
Mutual funds generate returns through two main sources: capital appreciation and dividends. Capital appreciation occurs when the value of the mutual fund’s underlying investments, such as stocks or bonds, increases over time.
The returns of a mutual fund can vary over different time periods, such as daily, monthly, quarterly, or annually. It’s important to consider the performance of a mutual fund over a longer period to get a more accurate understanding of its returns.
XIRR (Extended Internal Rate of Return): XIRR is a method used to calculate the annualized return of an investment, taking into account the timing and amount of cash flows (investments and withdrawals) over the investment period. It helps in evaluating the performance of mutual funds accurately, especially when there are multiple transactions involved at different points in time.
The XIRR calculation considers both the timing and amount of cash flows, making it a more precise measure of investment returns. It takes into account the investment amount, the dates on which investments were made, and the dates on which redemptions or withdrawals were made.
XIRR calculates the annualized return, which means it converts the returns into an annual percentage to facilitate comparison with other investments or benchmarks. It helps investors understand the growth of their investments and make informed decisions.
To calculate XIRR manually, you need to know the cash flows (investments and withdrawals) along with their respective dates. This information is usually available in the account statements or transaction history provided by the mutual fund company. However, most online platforms and mutual fund tracking tools automatically calculate XIRR for you.
In conclusion, returns indicate the growth or decline in the value of your mutual fund investment, usually expressed as a percentage. XIRR is a more precise measure of returns that considers the timing and amount of cash flows, helping you evaluate the performance of your mutual fund investments over time.
2. Volatility
Volatility refers to the fluctuation in the value of an investment over time. It is a key measure of the uncertainty or risk associated with an investment. In the context of mutual funds, volatility indicates how much the fund’s returns can vary from its average return. We will understand this via Debt funds and Equity funds
Debt Funds: Debt funds primarily invest in fixed-income securities such as government bonds, corporate bonds, and other debt instruments. These funds aim to provide relatively stable returns with lower volatility compared to equity funds. Debt instruments typically offer fixed interest payments and have a defined maturity date.
Due to the fixed-income nature of their underlying investments, debt funds generally offer lower returns compared to equity funds. However, they also tend to have lower volatility. This means that the value of your investment in a debt fund is likely to experience fewer ups and downs over time.
Equity Funds: Equity funds invest in shares or stocks of companies. They aim to generate higher returns over the long term by participating in the growth and profitability of the underlying companies. However, equity funds also come with higher volatility compared to debt funds.
Stock prices can fluctuate significantly due to various factors such as economic conditions, company performance, market sentiment, and geopolitical events. These fluctuations can result in higher volatility in the returns of equity funds. While equity funds have the potential for higher returns, they are also exposed to greater short-term price volatility.
Long-Term Holding and Volatility Mitigation: Holding investments in equity funds over a longer period, such as 7-8 years or more, can help mitigate the impact of volatility and potentially provide higher returns. When you invest for the long term, you give your investments more time to recover from short-term market fluctuations and benefit from the overall growth of the market. Hence the advice of time in markets is more important than timing the market.
Over longer periods, the effects of short-term volatility tend to average out, and the potential for higher returns in equity funds can kick in. Historically, equity markets have shown a tendency to deliver better returns compared to other asset classes like debt over extended time horizons.
Additionally, holding equity investments for a longer duration can help provide better protection against inflation. Equities have the potential to deliver returns that outpace inflation over the long run, thus helping to preserve and grow the purchasing power of your investments.
In summary, debt funds offer lower returns with lower volatility, while equity funds have higher volatility but also the potential for higher returns over the long term. Holding equity investments over a longer period, such as 7-8 years, can help mitigate volatility, tap into the potential for higher returns, and provide better protection against inflation.
3. Risk
In mutual funds, risk refers to the uncertainty of achieving the expected returns or the potential for loss of capital. Mutual fund investments come with inherent risks that investors should consider before investing. Some common risks associated with mutual funds include:
- Market Risk: Market risk arises from fluctuations in the overall market conditions, such as economic factors, geopolitical events, or changes in investor sentiment. It affects the value of the securities held by the mutual fund and can result in losses.
- Credit Risk: Credit risk is the potential for default by the issuer of a bond or other fixed-income security held by the mutual fund. If a bond issuer fails to make interest payments or repay the principal, it can negatively impact the fund’s returns.
- Interest Rate Risk: Interest rate risk refers to the impact of changes in interest rates on the value of fixed-income securities held by the mutual fund. When interest rates rise, bond prices generally fall, leading to potential losses for bondholders.
- Liquidity Risk: Liquidity risk arises when there is a difficulty in buying or selling securities at the desired time or price. If a mutual fund holds illiquid assets or faces a high level of redemption requests, it may face challenges in meeting those requests or may need to sell assets at unfavourable prices.
Specific Risks in Debt Mutual Funds: Debt mutual funds primarily invest in fixed-income securities, such as government bonds, corporate bonds, and other debt instruments. Some specific risks associated with debt mutual funds include:
- Default Risk: Debt funds are exposed to the risk of default by the issuer of the underlying bonds. If a bond issuer fails to repay the principal or interest, it can lead to losses for the fund and its investors.
- Credit Rating Risk: Debt funds invest in bonds with different credit ratings. Lower-rated bonds carry higher credit risk, as they are more likely to default. Funds investing in lower-rated bonds tend to have higher potential returns but also higher risk.
- Interest Rate Risk: Debt funds are sensitive to changes in interest rates. When interest rates rise, bond prices fall, which can lead to capital losses for debt fund investors.
Specific Risks in Equity Mutual Funds: Equity mutual funds invest in stocks or shares of companies. Some specific risks associated with equity mutual funds include:
- Market Risk: Equity funds are subject to market fluctuations, and the value of their holdings can be influenced by broader market movements. Adverse market conditions can lead to temporary declines in the fund’s value.
- Company-Specific Risk: Equity funds are exposed to risks associated with individual companies. Factors such as poor financial performance, management issues, or industry-specific risks can affect the value of stocks held by the fund.
- Sectoral Risk: If an equity fund focuses on a specific sector or industry, it becomes vulnerable to sectoral risks. Any adverse developments affecting that sector can impact the fund’s returns.
- Liquidity Risk: In certain situations, liquidity risk can affect equity funds, especially when investing in small-cap or illiquid stocks. If the fund needs to sell such stocks during a market downturn, it may face challenges in finding buyers or may need to sell at lower prices.
- SEBI has mandated all schemes provide a riskometer in terms of this a riskometer which captures risk of capital in specific scheme. A comprehensive list of performance and scheme level riskometer and comparison with benchmark is provided in AMFI here.
4. NAV
NAV stands for Net Asset Value, is a term used to measure the value of a mutual fund. It reflects the consolidated value of investments held by the fund per unit after considering all the buying and selling activities and the current prices of the underlying assets. Understanding NAV is important because it provides a clear reference point for the price of your investments in the fund. Here’s a simple explanation of NAV and its significance:
- What is NAV? NAV represents the total value of all the investments held by a mutual fund divided by the number of units issued. It is calculated by taking into account the current market prices of the stocks, bonds, or other assets owned by the fund.
- Consolidated Value: NAV gives you an idea of how much each unit of the mutual fund is worth at a particular time. It combines the value of all the assets owned by the fund and divides it by the total number of units outstanding.
- Buying and Selling Activities: NAV takes into consideration all the buying and selling activities within the fund. When investors purchase units of the mutual fund, it increases the total value of the fund, thereby impacting the NAV. Similarly, when investors sell units, it reduces the total value and affects the NAV as well.
- Current Underlying Prices: NAV reflects the current market prices of the assets held by the mutual fund. If the prices of the underlying assets rise, it tends to increase the NAV, and if the prices fall, it can lead to a decrease in NAV.
- Price Point for Investments: NAV provides a basis for understanding the price at which you can buy or sell units of the mutual fund. When you invest in a mutual fund, you usually purchase units at the NAV prevailing on that day. Similarly, when you sell your units, you receive the NAV-based price.
- Tracking Fund Performance: NAV is important in tracking the performance of a mutual fund over time. By comparing the NAV at different points in time, you can assess whether the value of your investments has increased or decreased.
- Transparency and Valuation: NAV ensures transparency in mutual fund investments. It provides a fair and standardized way to determine the value of your holdings. It allows you to see the growth or decline in your investment’s value as per the performance of the underlying assets.
Understanding NAV helps investors gauge the value of their investments in a mutual fund and monitor its performance. It serves as a reference point for buying or selling units and offers transparency in assessing the growth of your investment over time. However, it’s essential to remember that NAV alone does not determine the overall performance of a mutual fund. It is crucial to consider other factors like investment objective, risk, and historical performance before making investment decisions.
5. Passive Investing
Passive investing, in the context of Indian mutual fund investments, is a strategy where you aim to achieve returns by tracking a specific market index or benchmark. Here are some key points to help you understand passive investing in Indian mutual funds:
- Absorbing Investment Returns: Passive investing allows you to participate in the overall returns of a specific market or index in India, such as the Nifty 50 or the BSE Sensex. Instead of trying to select individual stocks, you invest in a mutual fund that replicates the performance of that particular index.
- Minimal Effort: As a passive investor, you don’t need to spend significant time and effort researching individual stocks or analyzing market trends. The mutual fund manager of the passive fund takes care of the portfolio composition, ensuring it closely resembles the underlying index.
- Index Funds and ETFs: In India, passive investing is commonly implemented through index funds or exchange-traded funds (ETFs). Index funds aim to replicate the performance of a specific index by holding a portfolio of stocks in the same proportion as the index. ETFs are similar but trade on stock exchanges like individual stocks.
- Lower Charges: Passive mutual funds typically have lower expense ratios compared to actively managed funds. Since the goal is to track the performance of the index rather than actively select stocks, the fund charges lower management fees. This helps preserve more of your investment returns over time.
- Diversification: By investing in an index fund or ETF, you gain exposure to a diversified portfolio of stocks from different sectors and companies in India. This diversification helps spread your investment risk, as the fund holds a basket of securities.
- Long-Term Approach: Passive investing is well-suited for long-term investors. By staying invested in a passive mutual fund over a significant period, you can potentially benefit from the overall growth of the Indian market. It is important to maintain a long-term perspective and avoid making frequent changes based on short-term market fluctuations.
- Efficient Market Hypothesis: Passive investing is based on the belief that markets are generally efficient in India. This means that stock prices reflect all available information, and it can be challenging for active fund managers to consistently outperform the market over the long term. Passive investing embraces the idea of capturing the market returns rather than trying to beat the market.
Passive investing in Indian mutual funds offers a straightforward and cost-effective way to participate in the growth of the Indian market. It can be a suitable for investors who prefer a hands-off approach and are focused on long-term wealth accumulation. Remember to assess your investment goals, risk tolerance, and investment time horizon before choosing the right mutual fund for your needs.
Improving one’s financial literacy by understanding key terms used in mutual funds investment builds a solid foundation in building long term wealth.
Disclaimer:
The information provided in this article is for educational purposes only and should not be considered as financial advice.
It is always recommended to consult with a qualified financial advisor before making any investment decisions.
