Mutual Fund | Investment | Wealth

Meaning of “ Mutual Fund”

Meaning : 

A mutual fund is a professionally-managed investment scheme, usually run by an asset Under management ( AUM ) company that brings together a group of people and invests their money in stocks, bonds and other securities.

Description:

As an investor, you can buy mutual fund 'units', which basically represent your share of holdings in a particular scheme. These units can be purchased or redeemed as needed at the fund's current net asset value (NAV). These NAVs keep fluctuating, according to the fund's holdings. So, each investor participates proportionally in the gain or loss of the fund.

All the mutual funds are registered with SEBI. They function within the provisions of strict regulation created to protect the interests of the investor.

The biggest advantage of investing through a mutual fund is that it gives small investors access to professionally-managed, diversified portfolios of equities, bonds and other securities, which would be quite difficult to create with a small amount of capital.

It may be as simple as giving your money to a mutual fund to invest in equity stocks but it is good to know some of the technicalities

It is actually quite simple. You give money to a mutual fund, which invests it inequity stocks on your behalf wherein the gains or losses also accrue to you. Of course, there are technicalities involved but this is the crux of investing in equity mutual fund schemes. However, being a prudent long term investor, it helps to know more details about how an equity fund works. So let us see what they are.

Investment Objective: First and foremost, equity funds are not one size fits all. There are a variety of equity funds classified by their investment objective which needs to be mapped to your risk profile. Though the investment objective of all equity funds is capital appreciation, it is the risk taken to achieve this objective that varies. This further depends upon the type of stocks that the fund would invest in.

This could either be based on the market capitalisation of the stock like large cap, mid-cap or small cap wherein the former is relatively less risky (volatile) than mid-cap or small cap. The objective may also be to invest in a mix of stocks across market capitalisation and across sectors termed as diversified equity funds. Another objective may be to save tax – called equity linked savings scheme or it could be to invest in specific sectors or themes say banking (sector) or infrastructure (theme) or invest in international equity.

Investment Strategy or Style: You as an investor also need to know the investment strategy followed by the fund house, meaning the methodology followed for selecting stocks. The key investment strategies or styles include top down strategy, bottom up strategy, value strategy and growth strategy.

A ) Top-down strategy - simply means that the sector is chosen first and then the best stocks within that sector are bought in the portfolio.

B ) Bottom up strategy - means that well-researched stocksare bought irrespective of the sector.

C) Growth Strategy - means that the fund will invest in companies which have a consistent track record of profitability and growth, andare likely to continue on this path in the future.

D) Value Strategy - means that the fund will invest in companies which have a potential to grow exponentially in future and are currently available at a lower value.

Asset Allocation:

 While most equity funds are close to fully invested in equities, there are a few which may have a split allocation between predominantly equity (at least 65%) and the rest in debt or an allocation between domestic and international equity. It is important to look at asset allocation from a tax efficiency perspective because as per the current Income Tax Act, 1961 provisions, equity funds are those which have an annual average of 65% allocation to domestic equity. Hence international equity funds which have a predominant foreign equity allocation are classified as debt funds for income tax purposes.

Expenses:

 Last but not the least, it is important to know that you are also charged for investing in equity mutual funds. While this may be true for investing in any mutual fund scheme, equity mutual fund investors are charged more than those who invest in other asset class. In short, the riskier the asset class, the higher the charges. For example, equity funds will have higher charges vis-à-vis debt funds.

These charges are denoted by a term called ‘Expense Ratio’ which is nothing but the ratio of scheme expenses to its assets under management (AUM). These expenses include cost of running the mutual fund scheme like brokerage cost, administrative cost, marketing and distribution cost, commissions, investment management charges, service tax (if any), investor education charges, among others. You may also note that funds with a similar objective may have different expense ratios depending upon their AUM and actual costs incurred to the run the scheme.

There could be a further variation of expense ratio even within equity funds, depending on whether they are actively or passively managed equity funds. The latter, which replicate an equity index, have a lower expense ratio than actively managed equity funds.

You also ought to know that there are two classes of expense ratios – one for direct plans and the other for regular plans. In the former, commissions and distribution costs are excluded while they are included in the latter. Returns of direct plans are higher than regular plans to the extent of the difference in the expense ratio.

SUMMARY

Simply put, equity mutual fund schemes pool your money and invest in equity stocks after in-depth research. However, it is important to understand the basics of how equity funds work. This includes knowing the objective of the equity fund and mapping it to your risk profile. Next is the asset allocation of the fund followed by the investment strategy. Last but not the least; you also ought to know the expense ratio of the fund as it could impact returns.

Advantages of Investing in Mutual Fund

·         No large investment compulsory

Mutual funds allow you to make an investment, even if you have a very small amount to invest. This advantage makes it more attractive among investors.

·         Investing in a variety of instruments

Imagine ordering a Dish (Plate) at your favourite restaurant where you can eat a variety of different foods in one affordable package! Mutual funds also work in a similar way.

Mutual Funds invest in a wide range of securities. This diversification reduces the risk by limiting the effect of a possible decline in the value of any one security. You achieve this diversification through a Mutual Fund with far less money than you can do on your own.

·         Convenience

You can invest directly with the fund house or through your financial advisor. You get regular information on the value of your investments and portfolios of the schemes.

·         Professional Management

Mutual fund investments are managed by experienced and skilled professionals, who with the help of an investment research team, analyzes the performance & prospects of companies and selects suitable investments to achieve the objective of the scheme.

·         Easy access to your money

In open-ended mutual funds, you can redeem all or part of your units any time you wish. Some schemes do have a lock-in period where an investor cannot return the units until the completion of such a lock-in period. With close-ended schemes, you can sell your units on a stock exchange at the prevailing market price or avail of the facility of repurchase through Mutual Funds at NAV related prices which some close-ended and interval schemes offer you on maturity of scheme or periodically, as the case maybe.

·         Diversification

To diversify is to reduce risk. For example, let’s say you buy milk from one milkman. If someday he falls ill, you won’t have any milk to drink! On the other hand, let’s say you buy milk from two milkmen. If one milkman falls ill, you’ll still have milk from the other milkman. The chance of both the milkmen falling ill at the same time is very low. This is why diversification is so important in investing.

Investing requires in depth research and analysis which usually takes a long period of time. Often, people do not have so much time. Mutual funds are managed by fund managers who invest money in a manner that allows diversification.

The advantage of mutual funds is that diversification is automatically done. Instead of buying shares, bonds, and other investments on your own, you outsource the task to an expert. Thus, your investments are diversified without you having spent too much time and effort.

·         Simplicity

When investing, the availability of information and data is particularly time-consuming. If all information would be easily available, investing would be much simpler.

Investing in mutual funds is much easier and simpler. The research and information collection is done by the mutual funds themselves. All you have to do then is analyse the performance of mutual funds.

Mutual fund dealers allow you to compare the funds based on metrics such as level of risk, return, and price. Because the information is easily accessible, you, the investor, is able to make wise decisions.

·         Liquidity

Of all others, one of the advantages of mutual funds that is often overlooked is liquidity.  In financial jargon, liquidity basically refers to the ability of being able to convert your assets to cash with relative ease.

Consider this: if you own a house and need cash, how long would it take for you to sell the house and get cash in hand? It could take anywhere from a few weeks to a few months.

Mutual funds are considered liquid assets since there is high demand for many of the funds in the marketplace. Since this is the case, you can retrieve money from a mutual fund very quickly. Usually, in about two days.

·          Costs

Mutual funds are one of the best investment options considering the costs involved. If you hire a portfolio management service, you’ll typically be charged 2% to 3% of your total investments per year. They will also take a share from your profits.

Mutual funds are relatively cheaper with 1% to 2% of expense ratios. Debts funds have an even lesser expense. Read more about expense ratio: click here to open in new tab.

Tax Efficiency

Mutual funds are relatively more tax-efficient than other types of investments. Long term capital gain tax on equity mutual funds is zero. That means if you sell your investments one year after purchase, you pay no tax.

For debt funds, long-term capital gains apply when you hold them for 3 years. Understand tax on mutual funds

Match Your Style

If you have more knowledge about certain industries or sectors, but don’t have enough expertise to know which companies to invest in, you can make use of sector mutual funds. By doing so, you are ensuring your money gets invested in a certain industry without having to research which companies to invest in.

Sector mutual funds stick to investing primarily in a certain sector only. Some common types of sector mutual funds are mining funds, energy funds, automobile funds, etc.

Some important features of tax saving funds:

Surrogate route to direct stock markets

Minimum investment is Rs 500 per month

Only 3-year lock-in period

Tax benefits under 80C up to 1.5 lac

The returns are tax-free too

Highest expected returns.

Disadvantages of Mutual Funds

Costs

Surprised to see “Costs” in both advantages and disadvantages of mutual funds?

Some mutual funds have a high cost associated with them. Mutual funds charge for managing the funds, fund managers salary, distribution costs etc. Depending on the fund, these charges can be significant. When you exit from your mutual fund, you might be charged an extra cost as exit load. Do check out exit loads before investing in a fund. Typically, exit loads are applicable if you sell your investments within a specified duration.

Investors should note that different funds have different expense ratios. Passively managed funds like index funds or ETFs (Exchange Traded Funds) have lower expense ratios than actively managed funds. This is only because passively managed funds track the underlying index and do not require a fund manager to take active investment calls.

Lower costs reflect the operational efficiency of a mutual fund house. All the other factors remaining the same, an investor should ideally invest in a scheme which charges a lower expense ratio compared to peers as higher expenses reduce returns of the fund.

 Dilution

This is one of the most prominent of all disadvantages of mutual funds. Diversification has an averaging effect on your investments. While diversification saves you from suffering any major losses, it also prevents you from making any major gains! Thus, major gains get diluted.

This is exactly why it is recommended that you do not invest in too many mutual funds. Mutual funds are themselves diversifying investments. Therefore buying many mutual funds in the name of diversifying only further dilutes your gains.

No Insurance:

Mutual funds, although regulated by the government, are not insured against losses. 

Comparison of Mutual Funds With Other Investment Products

 

As inflation decreases the value of money over time, it becomes important to put your savings in correct channels of investment. An unused amount, if not invested will lose its purchasing power. Right investments at the right time help you tide over financial downs and also provide for retirement. There are ‘n’ number of investment options with different risk and return profiles that cater to the investor’s appetite for the same.

Equities are the highest in the risk and return matrix while savings while postal services are on the lower side of risk and return matrix. You must invest according to the amount of risk you are willing to take. The other option is time horizon: short term, medium term or long term.

Here are comparisons between some common forms of investment and mutual funds:

Mutual Fund Vs Public Provident Fund (PPF)

PPF (Public Provident Fund) is till date one of the most popular options. However, over time, the reduced returns on Public Provident Fund (PPF) have made PPFs less attractive. Also, the low returns come at the expense of liquidity and growth. Public Provident Fund (PPF) has a lock-in period of 15 years.

Mutual Fund Vs Bank Deposits

The returns on bank deposits become negligible after you account for inflation and after paying tax, as compared to a mutual fund in which the dividend/returns received is completely tax exempt (on equity mutual funds, after one year) and the liquidity provided is higher than that of bank deposits.

Mutual Funds Vs Institutional or Corporate Bonds

Although financial institution bonds have high compounded returns, they are unsecured and more prone to interest rate risks as compared to mutual funds. Mutual funds are much more diversified as they invest in a variety of instruments like debt and money market.

Also, investors need to be extremely careful about such investments and must ascertain that the issuing company is credit rated. Corporate bonds also have less liquidity as compared to mutual funds.

Going Into Direct Stocks vs Buying Mutual Funds

Critics of the mutual fund industry argue that fund expenses are too high. They argue that the most effective way for investors to raise the returns they earn from mutual funds is to invest in funds with lower expense ratios. Or invest directly into equities.

Fund managers counter that the fees are determined by a highly competitive market and therefore, reflect the value that investors attribute to the service provided. They also note that fees are clearly disclosed.

Also investing in direct equity involves trading costs. In addition investing in direct equity also needs significant time and understanding of businesses and stock markets.

For Example Watch Videos: 

https://youtu.be/dn1S0Pk2KOs