Mutual Funds
What is a mutual fund?
As in most of the developed and developing countries, the mutual fund cult has been catching on in India. There are various reasons for this happening. Mutual funds make it easy and less costly for investors to satisfy their need for capital growth, income and/or income preservation.
In addition, a mutual fund brings the benefits of diversification and money management to the individual investor, providing an opportunity for financial success, which once was available only to a select few.
Understanding mutual funds is easy as it's a very simple concept. A mutual fund is a company that pools money from many investors – its shareholders – to invest in different securities. The investments may be in stocks, bonds, money market securities or a combination of these. Those securities are professionally managed on behalf of the shareholders, and each investor holds a pro rata share of the portfolio – entitled to any profits when the securities are sold, but subject to any losses in value as well.
For the individual investor, mutual funds provide the benefit of having someone else manage your investments and diversify your money over many different securities that may not be available or affordable to you otherwise. Today, minimum investment requirements on many funds are enabling even the smallest investor to get started in mutual funds.
A mutual fund, by its very nature, is diversified – as its assets are invested in a variety of securities. Beyond that, there are many types of mutual funds with different objectives and levels of growth potential, furthering your chances of diversification.
Why invest in mutual funds?
Investing in mutual funds has various benefits, which make it an ideal investment avenue. Following are some of the primary benefits.
- Professional investment management: The primary benefit of investing in mutual funds is that an investor has access to professional management. A good investment manager is certainly worth the fees you will pay. Good mutual fund managers with an excellent research team can do a better job of monitoring the companies they have chosen to invest in than you can, unless you have time to spend on researching the companies you select for your portfolio. That is because mutual funds hire full-time, high-level investment professionals. Funds can afford to do so as they manage large pools of money. The managers have real-time access to crucial market information and are able to execute trades on a large and a cost-effective scale. When you buy a mutual fund, the primary asset you are buying is the manager, who will be controlling assets that are chosen to meet the funds' stated investment objectives.
- Diversification: A crucial element in investing is asset allocation. This plays a very big part in the success of any portfolio. However, small investors do not have enough money to allocate their assets properly. By pooling your funds with others, you can benefit quickly from greater diversification. Mutual funds invest in a broad range of securities. This limits the investment risk by reducing the effect of a possible decline in the value of any one security. Mutual fund unit-holders can benefit from diversification techniques usually available only to investors wealthy enough to buy significant positions in a wide variety of securities.
- Low cost: A mutual fund lets you participate in a diversified portfolio for as little as Rs.5,000, and sometimes less. And with a no-load fund, you pay little or no sales charges to own them.
- Convenience and flexibility: Investing in mutual funds has its own convenience. While you own just one security rather than many, you still enjoy the benefits of a diversified portfolio and a wide range of services. Fund managers decide which securities to trade, collect the interest payments and see that your dividends on portfolio securities are received and your rights exercised. Mutual funds also use the services of a high-quality custodian and registrar. Another big advantage is that you can move your funds easily from one fund to another within a mutual fund family. This allows you to easily rebalance your portfolio to respond to significant fund management or economic changes.
- Liquidity: In open-ended schemes, you can get your money back promptly at net-asset-value-related prices from the mutual fund itself.
- Transparency: Regulations for mutual funds have made the industry very transparent. You can track the investments that have been made on your behalf and the specific investments made by the mutual fund to see where your money is going. In addition to this, you get regular information on the value of your investment.
- Variety: There is no shortage of variety when investing in mutual funds. You can find a mutual fund that matches just about any investment strategy you select. There are funds that focus on blue-chip stocks, technology stocks, bonds or a mix of stocks and bonds. The greatest challenge can be sorting through the variety and picking the best for you.
What are the types of mutual funds?
Getting a handle on what's under the hood helps you become a better investor and ensures that you put together a successful portfolio. To do this, one must know the different types of funds that cater to investors’ needs, whatever be the age, financial position, risk tolerance or expectation of return. Mutual fund schemes can be classified according to both their investment objective (like income, growth, tax saving) as well as the number of units (if these are unlimited then the fund is an open-ended one while if there are limited units, then the fund is closed-ended).
This section provides descriptions of the characteristics – such as investment objective and potential for volatility of your investment – of various categories of funds. These descriptions are organized by the type of securities purchased by each fund: equities, fixed-income, money market instruments, or some combination of these.
Open-ended schemes
Open-ended schemes do not have a fixed maturity period. Investors can buy or sell units at NAV-related prices from and to the mutual fund on any business day. These schemes have unlimited capitalization and do not have a fixed maturity. There is no cap on the amount you can buy from the fund and the unit capital can keep growing. These funds are not generally listed on any exchange.
Open-ended schemes are preferred for their liquidity. Such funds can issue and redeem units any time during the life of a scheme. Hence, the unit capital of open-ended funds can fluctuate on a daily basis. The advantages of open-ended funds over closed-ended are the options of anytime exit and entry.
Anytime exit option: The issuing company directly takes the responsibility of providing an entry and an exit. This provides ready liquidity to the investors and avoids reliance on transfer deeds, signature verifications and bad deliveries. Anytime entry option: An open-ended fund allows one to enter the fund at any time and even to invest at regular intervals.
Closed-ended schemes
Closed-ended schemes have fixed maturity periods. Investors can buy into these funds during the period when the funds are open. After that such schemes cannot issue new units except in the case of bonus or rights issue. However, after the initial issue, you can buy or sell units of the scheme on the stock exchanges where they are listed. The market price of the units could vary from the NAV of the scheme due to demand and supply factors, investors’ expectations and other market factors
Classification according to investment objectives
Mutual funds can also be classified on the basis of their specific investment objective such as growth of capital, safety of principal, current income or tax-exempt income.
In general, mutual funds fall into three general categories:
- Equity funds – those that invest in shares or equity of companies.
- Fixed-income funds – that invest in government/corporate securities that offer fixed rates of return
- Balanced funds – that invest in a combination of these two.
How do u choose a fund?
A mutual fund is the best investment tool for the retail investor as it offers the twin benefits of good returns and safety as compared with other avenues such as bank deposits or stock investing. Having looked at the various types of mutual funds, one has to now go about selecting a fund suiting your requirements. Choose the wrong fund and you would have been better off keeping money in a bank fixed deposit. Keep in mind the points listed below and you could at least marginalize your investment risk.
Past performance
While past performance is not an indicator of the future, it does throw some light on the investment philosophies of the fund, how it has performed in the past and the kind of returns it is offering to the investor over a period of time. Also check out the two-year and one-year returns for consistency. How did these funds perform in the bull and bear markets of the immediate past? Tracking the performance in the bear market is particularly important because the true test of a portfolio is often revealed in how little it falls in a bad market.
Know your fund manager
The success of a fund to a great extent depends on the fund manager. The same fund managers manage the most successful funds. Ask before investing, has the fund manager or the strategy changed recently? For instance, the portfolio manager who generated the fund’s successful performance may no longer be managing the fund.
Does it suit your risk profile?
Certain sector-specific schemes come with a high-risk high-return tag. Such plans are suspect to crashes if the industry loses the marketmen’s fancy. If the investor is totally risk-averse, he can opt for pure debt schemes with little or no risk. Most prefer the balanced schemes which invest in the equity and debt markets. Growth and pure equity plans give greater returns than pure debt plans but their risk is higher.
Read the prospectus
The prospectus says a lot about the fund. A reading of the fund’s prospectus is a must to learn about its investment strategy and the risk that it will expose you to. Funds with higher rates of return may take risks that are beyond your comfort level and are inconsistent with your financial goals. But remember that all funds carry some level of risk. Just because a fund invests in government bonds or corporate bonds, it does not mean it does not have significant risk. Thinking about your long-term investment strategy and tolerance for risk can help you decide what type of fund is best suited to you.
How will the fund affect the diversification of your portfolio?
When choosing a mutual fund, you should consider how your interest in that fund affects the overall diversification of your investment portfolio. Maintaining a diversified and balanced portfolio is the key to maintaining an acceptable level of risk.
What does it cost you?
A fund with high costs must perform better than a low-cost fund to generate the same returns for you. Even small differences in fees can translate into large differences in returns over time.
Finally, don’t pick a fund simply because it has shown a spurt in value in the current rally. Ferret out information of a fund for at least three years. The one thing to remember while investing in equity funds is that it makes no sense to get in and out of a fund with each turn of the market. Like stocks, the right equity mutual fund will pay off big – if you have the patience. Similarly, it makes little sense to hold on to a fund that lags behind the total market year after year.
What is NAV?
Net asset value (NAV) represents the market value of all assets per unit, held by the fund. To an investor, it simply signifies the current value of his or her investment in the fund. The NAVs of mutual funds are determined at the end of every business day.
The NAV is computed by dividing the fund's net assets by the number of units outstanding on the validation date and is illustrated below:
Market value of the fund's investment + other current assets + deposits - all current liabilities except unit capital, reserves and profit & loss account / Number of units outstanding
Since the value of the various securities keeps changing, the NAV also changes on a daily basis. NAVs are updated daily and are usually available on the fund’s website and from its investor-service centres. You can Subscribe to receive daily navs through e-mail.
Generally, in-person purchase or redemption requests received up to 3 p.m. on any business day will be priced on the basis of the same day's closing NAV. Requests received after 3 p.m. will be treated as having been received on the next business day, and will therefore be priced on the basis of the next business day's NAV.
