Chapter -12
Mutual Fund
Mutual fund
A mutual fund is a company that pools money from many investors and
invests that money IN various places viz. in stocks, bonds, short-term money-
market instruments, other securities or assets. It can also be a combination of
any of these investments. The portfolio of any mutual fund is actually the
combined holdings it owns. Each share or unit of the mutual fund stands for
proportionate ownership of any investor in the mutual fund holding and the
income those holdings generate. There are certain terminologies of the mutual
fund which one needs to know to get a fair idea before investing in these
instruments.
NAV
This is the underlying value of a unit of mutual fund. It is calculated as the
market value of its assets by subtracting its liabilities and then dividing by the
number of units issued by the mutual fund. It is basically the total value of the
portfolio of the fund less its liabilities. The NAV is normally calculated on a daily
basis. The NAV is by and large below the market price because the current value
of the fund’s assets is higher than the historical financial statements which are
normally used for calculating the NAV.
Features of Mutual Funds:
Some of distinctive characteristics of mutual funds include the following:
1. Investors purchase mutual fund shares from the fund itself (or through a
broker) instead of from other investors in a secondary market (in Stock
Exchange)
2. The mutual funds shares are purchased at per share net asset value (NAV) of
the fund. Apart from that price an investor may have to pay any fees that
the fund imposes at the time of purchase in the form of specified entry
loads.
3. Mutual fund shares are "redeemable," means one can sell one’s shares back
to the fund or to a broker for the fund.
4. Mostly Mutual funds are constantly creating and selling new shares to attract
and accommodate new investors.
Benefits of Investing in Mutual Funds
Mutual funds offer several advantages to investors
Affordable:
Almost everyone can buy mutual funds. Mutual Funds generally provide a
opportunity to invest with less funds as compared to other avenues in the capital
market. Even the ancillary fee which one has to pay in the form of brokerages,
custodian etc is lower than other options and is directly linked to the performance
of the scheme.
Professional Management:
For an average investor, it may be quite difficult to decide what to buy,
when to buy, how much to buy and when to sell. Mutual Funds have a skilled
professionals who have years of experience to manages your money. The fund
manager takes these decisions after doing adequate research on the economy,
industries and companies, before buying stocks or bonds. They use intensive
research techniques to analyze each investment option for the potential of
returns.
Diversification:
Investments are less risky as it is spread across a wide cross-section of
industries and sectors. Diversification reduces the risk because all stocks
generally don’t move in the same direction at the same time. A mutual fund is
able to diversify more easily than an average investor across several companies.
Liquidity:
You can afford to withdraw your money from a mutual fund on immediate
basis when compared with other forms of savings like the public provident fund
or National Savings Scheme. You can withdraw or redeem money at the Net
Asset Value related prices in the open-end schemes. In closed-end schemes, the
units can be transacted at the prevailing market price on a stock exchange.
Tax Benefits:
Mutual funds have historically been more efficient from the tax point of
view. A debt fund pays a dividend distribution tax of 12.5 per cent before
distributing dividend to an individual investor or an HUF, whereas it is 20 per cent
for all other entities. There is no dividend tax on dividends from an equity fund for
individual investor.
Potential of returns:
Mutual funds generally offer better than any other option over a given
period of time. Though they are affected by the interest rate risk in general, the
returns generated are more.
Well regulated:
The Mutual Fund industry is very well regulated. All investments have to
be accounted for. SEBI acts as a true watchdog in this case and can impose
penalties on the AMCs at fault. The regulations are also designed to protect the
investors’ interests are also implemented effectively.
Transparency:
As they are under a regulatory framework, they have to disclose their
holdings, investment pattern and all the information that can be considered as
material, before all investors to ensure transparency which is unlike any other
investment option in India where the investor knows nothing as nothing is
disclosed.
Pros and cons
Every investment has advantages and disadvantages. But what is
important to remember is that as the choices and preferences of each investor
vary, the advantage of a particular feature for him will depend on his unique
circumstances. Generally, mutual funds provide quite an attractive investment
choice for investors because they generally offer the following features viz.
Professional Management, Diversification which means spreading your
investments across a wide range of companies and industry sectors, Affordability
in the sense that one can enter in mutual funds even with relatively less invest
able amounts, Liquidity by way ready availability of redemption of you shares at
the extant NAV at any point of time.
But mutual funds also have features that some investors might view as
disadvantages, such as costs as investors pay sales charges, annual fees, and
other ancillary charges irrespective of the fund’s performance and fund giving
negative returns, Lack of control as investors can neither determine the
composition of a fund's portfolio nor can they directly influence the buying
behavior of fund manager, Price uncertainty as unlike with an individual stock,
with a mutual fund, the purchase price or redemption price of the shares will
depend on the fund's NAV.
How Funds Can Earn Money for You
One can earn money from the investment in mutual funds by way of
various ways including Dividend Payments as a fund may interest on the
securities in its portfolio the income earned in the form of dividends. The
shareholders generally get most of that income. Capital Gains as when the fund
sells a security that has increased in price, the capital gain (minus any capital
losses) is distributed to investors at the end of the year. Increased NAV of the
shares of the fund increases if the market value of a fund's portfolio increases
after deduction of expenses and liabilities. The higher NAV reflects the higher
value of investment.
The biggest advantage of mutual funds is that for ordinary investors, who
do not have much knowledge about stock market operations, the professional
management of funds allows them to earn decent returns over a period of time.
However keep in mind that like all stock market investments, mutual funds are
also not free from market risk of adverse price movement of securities where
funds park your money. Hence do your due diligence about the history of funds,
fund managers who would be handling your funds and use the route for medium
and long term investment.
Types of Mutual funds (By Investment objective)
Dividend option
The fund normally earns income from the profit which it makes by
investing in securities. It also earns dividends on those securities. The investors
are normally given the option of earning some of the earnings by way of
dividends by Mutual Fund companies.
Build a reputable Asset Management platform by taking into account
previous investment performances for comparison.
Growth option
As said earlier, a fund earns income from the profit it makes from investing
in securities and also in the form of dividends. In growth option, the investors
leave the earned profits in the mutual fund and allow it to get invested for earning
more returns. A diversified portfolio of stocks normally has capital appreciation as
its primary goal. They invest in companies that reinvest their earnings into
expansion, acquisitions, and research and development. Investors generally get
higher potential growth in these types of funds but there is usually higher risk
associated with them.
Equity Fund
It is a mutual fund that invests in a broad based and well-diversified group
of stocks. The invested funds will either be in cash or stock. Mostly an equity
fund invests its assets in stocks of companies and earns returns in the form of
capital gains (the difference between buying and selling stocks) as well as
dividends earned from these investments. This type of fund is riskier as
compared to balanced funds and debt funds.
Debt Fund/Income Fund
It is also called bond fund as this fund normally invests in mainly
government securities and corporate bonds which bear interest. It may invest in
short-term or long-term bonds and other securitized products, money market
instruments or floating rate debt. It earns returns from interest income on its
investments and profits on trading securities. This fund is the least risky of all the
funds. In other words, the main investing objectives of a debt fund will usually be
preservation of capital and generation of income.
Hybrid Funds
This fund type invests in equity shares of companies as well as debt
securities. It earns income in the form of dividends and interest as well as buying
and selling securities. This is riskier than debt fund and less risky than equity
funds
Some of distinctive characteristics of mutual funds include the following:
1. Investors purchase mutual fund shares from the fund itself (or through a
broker) instead of from other investors in a secondary market (in Stock
Exchange)
2. The mutual funds shares are purchased at per share net asset value (NAV) of
the fund. Apart from that price an investor may have to pay any fees that
the fund imposes at the time of purchase in the form of specified entry
loads.
3. Mutual fund shares are "redeemable," means one can sell one’s shares back
to the fund or to a broker for the fund.
4. Mostly Mutual funds are constantly creating and selling new shares to attract
and accommodate new investors.
Types of Mutual Funds (By Structure)
Open ended fund
In an open-end fund, the units of a mutual fund are bought and sold by the
fund company itself. The price at which you buy this fund is usually higher than
the price at which you can sell the fund to the fund company. In this mutual fund,
there are no restrictions on the amount of shares the fund can or will issue.
Depending upon the demand, the fund continues to issue shares no matter how
many investors there are. In this case, the fund companies also give option to the
investors to buy back their shares when investors wish to sell. Mostly mutual
funds are open-end funds and they are more conservative and provide consistent
returns. Generally, Open-end funds are managed actively and are priced
according to their net asset value.
Closed ended fund
Unlike an open-end fund, where the buying and selling of funds are
conducted by the fund company itself, the units of close-end funds are traded on
a stock exchange. The market price of the shares in closed ended fund is
determined by supply and demand and not by net-asset value (NAV).
Load
This is the total price of buying a unit of a mutual fund. It is actually a kind
of fee or commission charged to an investor when buying or redeeming shares in
a mutual fund. Mostly funds sell units at a premium to its underlying NAV, and
purchase them at NAV. When the fund company charges a load while selling its
units, it is called entry load. When it charges a load at the time of buying the units
back from an investor, it is called exit load. Most mutual funds today carry some
load, since there is always a cost incurred in the operation of the fund and as a
result of numerous shareholder transactions. Sometimes, though this load thing
acts as a burden for investors and is very effective in discouraging them from
trading the mutual fund in short-term or using it for purposes other than
investment. It is also a source of income for the Asset Management Company
which operates the mutual fund.
Individual's Rules for investing in mutual funds
Investing is a quite a complex exercise. But when it comes to the basic
principles, they are amazingly simple. Anyone can become good investor and
reach your goals just by following those simple and easy rules. Here is the list of
few rules for making investment in mutual funds:
Be a long-term investor:
You should have a long term horizon. Short-term trading will make
brokers rich and not investors and the income tax department will also be happy.
Mutual funds are diversified and therefore, their gains and losses are likely to be
lower than what it would be in case you are investing in an individual security.
However, major fluctuations are highly uncommon in mutual funds. So what
make sense is to leave your capital in a mutual fund for a long time and let it
compound. So the key point is Buy and Hold. It also requires to you do a reality
check on yourselves so that you can define your goals and priorities before
entering the market.
Start Early:
When you invest in the market is more important than the market timing.
Always enter the market with long term thinking. Do proper researches before
investing set your priorities and goals, ascertain your risk profile. Also very
importantly you should keep yourself abreast with the daily market news. One
should not do impulsive purchase allowing emotions overpowering the sense of
reason.
Know yourself and then What You Are Buying:
The first step towards achieving your goals would be to know yourself,
your risk appetite and accordingly make the investments. Once you have
discovered yourself, explore the market and find out the kind of funds available in
the market. Firstly, get a hang on the style and strategy followed by a fund by
reading the available material. This will help in diversifying the portfolio and also
in assessing potential risks. In general, large-cap value funds are less risky than
small-cap growth funds.
Be a Disciplined Investor:
Once you've chosen some funds, you may stick with them. It is not
necessary that one should always go with the tide. Even the unpopular groups
tend to outperform in subsequent years. Investing a regular amount of money at
regular intervals may add a good value to your portfolio. Make a systematic
investment plan which in all probability likely to offer reasonable returns.
Know How Much You Pay:
There is one famous saying that Money saved is money earned. So it's
always better to pay less than it is to pay more. Expenses are very important with
your larger-cap, lower-risk funds, and less critical with small-cap funds and other
higher-risk categories.
You can afford to be lenient with the expense of a small-cap or a sector
equity fund. Actually, the strength of the mutual fund lies in its simplicity. Don't
follow the bandwagon.
How to make money from your fund
Examine Sector Weightings and the Fund's Concentration:
The funds that have large stakes in just one or two sectors are expected
be more volatile than the evenly diversified funds. A concentrated portfolio may
also get more successful if its stocks are performing better. You may add a
concentrated fund in your portfolio but mostly the concentration should be in a
diversified fund which is more predictable.
Invest in a few funds and develop a Plan:
But it would not mean you should invest only in one fund. Even though the
funds are diversified, many funds go though a few years of poor performance.
When you invest in only one fund, you might lose heavily. On the other hand,
investing in too many funds may lead to duplication of many securities and a
portfolio with no focus. For the long-term financial goals, equities are the best
option.
Keep It Simple:
To keep the selection of fund simple, you should stick with well diversified
and well established equity funds, an index fund for equity exposure and a
floating-rate bond fund for fixed income exposure. For long term perspective,
equities are the best performing asset class. One should normally stay away
from specialty and sector funds because they have a huge risk associated.
Know Your Portfolio & Ignore the hot stocks and funds:
Avoid going for impulsive purchase. It is wise to invest in a fund that
invests in stocks that make up an index. This way, you will do no worse than the
market. Since, in the long run, markets have a tendency to go up, even your
investment will move the same way. But in case, you are a little more active, you
can go for established `value' funds that invest in undervalued securities.
Invest Regularly:
Investing a little bit of money each month is the surest way to reduce the
risk of investing. Investing on a regular basis is the key to success. Irrespective
of the fund you choose, the reality is that its value will be keep going up and
down. One can expect a reasonable price in the long term by investing on a
regular basis.
Diversification is suitable for many investors:
It is generally true that stocks perform better than any other liquid
investment. So in case of long-term horizon and if you are comfortable with the
risks associated with the stock market, you can think of investing in stock funds.
But in case you are a slightly conservative, you may think of investing in different
asset classes such as stocks, bonds etc. The key challenge is to choose the right
fund.
Assess Performance Appropriately:
Past performance is not necessarily a good indicator of future results and
this fact should be kept in mind every time one consider investing in any fund.
Avoid investing in a concentrated fund and focusing on short-term returns.
Generally while choosing a fund, one should look for above-average
performance over a period of time.