Monday, March 31, 2008

What are mutual funds?

We posted an article earlier on Best Mutual Funds. We got a query from one of the readers to explain mutual funds first. So, here it is:

What are Mutual Funds?
Mutual funds are pools of money that are managed by an investment company. The portfolio manager raises money from shareholders and invests it in stocks, bonds, options, commodities etc.

Why opt for mutual funds?
Mutual funds offer a small investor many benefits. For one, they are a tax efficient method of investing in equities. The income earned (dividend) as well as profit earned from selling of mutual fund units after holding them for at least a year are tax free. If you are investing in tax schemes of the mutual fund, you can get tax deduction on the amount invested. Another benefit is that by investing a nominal amount of Rs. 10000, you can diversify your portfolio across various companies and sectors. Finally, you do not have to spend time in studying and analyzing the performance of the companies as mutual funds have professional fund managers who do it for you. You also don’t have to worry about timing the market as it is the fund managers’ task.

What are different options in Mutual Funds?
Mutual funds basically offer two main options: growth and dividend options. Dividend option is further divided into dividend payout and dividend reinvestment options.
Growth: In the growth option, once you make the investment, the number of units you are allotted is constant. There is no dividend paid for this option, but the NAV keeps increasing. So the value of your investment increases without the corresponding increase in number of units.
Dividend payout: In this option, you are paid a dividend whenever the mutual fund declares dividends, in the form of a check or direct credit to your bank account. The NAV for the dividend payout option falls by the value of the dividend. E.g., if the fund declares a dividend of Rs. 100 when the NAV is Rs. 200, the NAV will reduce to Rs. 100 after declaration of dividend.
Dividend reinvestment: Here, the fund uses the dividend to buy more units for you instead of paying it to you. The number of units you hold will increase, but the corresponding NAV will decrease.

How do I choose the right option for myself?
If you are in immediate need of cash, the dividend option is best for you as you can get paid at periodic intervals. But if you want capital appreciation, are saving for a future goal like retirement, or don’t need cash urgently, opt for the growth option. If you don’t want the money but want to buy more units of the fund without having to pay for them from your pocket, go for the dividend reinvestment option. However, remember, if you are choosing dividend payout or reinvestment option for a debt fund, the dividend paid out is levied a 12.24% dividend distribution tax.


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