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What You Must Know About Mutual Funds? Research Team | Posted On Friday, July 29,2011, 05:35 PM

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What You Must Know About Mutual Funds?



Things to know about Mutual Funds:

A Mutual Fund is a trust that pools the savings of a number of investors who share a common financial goal. The money thus collected is invested by the fund manager in different types of securities depending upon the objective of the scheme. These could range from shares to debentures to money market instruments. The income earned through these investments and the capital appreciations realized by the scheme are shared by its unit holders in proportion to the number of units owned by them that is on pro rata basis. Thus a Mutual Fund is the most suitable investment for the common man as it offers an opportunity to invest in a diversified, professionally managed portfolio at a relatively low cost. Anybody with an inventible surplus of as little as a few thousand rupees can invest in Mutual Funds. Each Mutual Fund scheme has a defined investment objective and strategy.

A mutual fund is the ideal investment vehicle for today’s complex and modern financial scenario. Markets for equity shares, bonds and other fixed income instruments, real estate, derivatives and other assets have become mature and information driven. Price changes in these assets are driven by global events occurring in faraway places. A typical individual is unlikely to have the knowledge, skills, inclination and time to keep track of events, understand their implications and act speedily. An individual also finds it difficult to keep track of ownership of his assets, investments, brokerage dues and bank transactions etc.

A mutual fund is the answer to all these situations. It appoints professionally qualified and experienced staff that manages each of these functions on a full time basis. The large pool of money collected in the fund allows it to hire such staff at a very low cost to each investor. In effect, the mutual fund vehicle exploits economies of scale in all three areas - research, investments and transaction processing. While the concept of individuals coming together to invest money collectively is not new, the mutual fund in its present form is a 20th century phenomenon. In fact, mutual funds gained popularity only after the Second World War. Globally, there are thousands of firms offering tens of thousands of mutual funds with different investment objectives. Today, mutual funds collectively manage almost as much as or more money as compared to banks.

See Also: Types of Mutual Funds

Mutual funds can be classified as follow

Open-ended funds:

Investors can buy and sell the units from the fund, at any point of time.

Close-ended funds:

These funds raise money from investors only once. Therefore, after the offer period, fresh investments can not be made into the fund. If the fund is listed on a stocks exchange the units can be traded like stocks (E.g., Morgan Stanley Growth Fund). Recently, most of the New Fund Offers of close-ended funds provided liquidity window on a periodic basis such as monthly or weekly. Redemption of units can be made during specified intervals. Therefore, such funds have relatively low liquidity.

Based on their investment objective:

Equity funds

These funds invest in equities and equity related instruments. With fluctuating share prices, such funds show volatile performance, even losses. However, short term fluctuations in the market, generally smoothens out in the long term, thereby offering higher returns at relatively lower volatility. At the same time, such funds can yield great capital appreciation as, historically, equities have outperformed all asset classes in the long term. Hence, investment in equity funds should be considered for a period of at least 3-5 years. It can be further classified as :

Index funds
In this case a key stock market index, like BSE Sensex or Nifty is tracked. Their portfolio mirrors the benchmark index both in terms of composition and individual stock weightages.

Equity diversified funds
100% of the capital is invested in equities spreading across different sectors and stocks.

Dividend yield funds
It is similar to the equity diversified funds except that they invest in companies offering high dividend yields.

Thematic funds
Invest 100% of the assets in sectors which are related through some theme.
e.g -An infrastructure fund invests in power, construction, cements sectors etc.

Sector funds
Invest 100% of the capital in a specific sector. e.g. - A banking sector fund will invest in banking stocks.

Equity Linked Saving Scheme provides tax benefit to the investors.

Balanced fund

Their investment portfolio includes both debt and equity. As a result, on the risk-return ladder, they fall between equity and debt funds. Balanced funds are the ideal mutual funds vehicle for investors who prefer spreading their risk across various instruments. Following are balanced funds classes:

Debt-oriented funds:
Investment below 65% in equities.

Equity-oriented funds:Invest at least 65% in equities, remaining in debt.

Debt fund

They invest only in debt instruments, and are a good option for investors averse to idea of taking risk associated with equities. Therefore, they invest exclusively in fixed-income instruments like bonds, debentures, Government of India securities; and money market instruments such as certificates of deposit (CD), commercial paper (CP) and call money. Put your money into any of these debt funds depending on your investment horizon and needs.

Liquid funds
These funds invest 100% in money market instruments, a large portion being invested in call money market.

Gilt funds ST:
They invest 100% of their portfolio in government securities of and T-bills.

Floating rate funds:
Invest in short-term debt papers. Floaters invest in debt instruments which have variable coupon rate.

Arbitrage fund:
They generate income through arbitrage opportunities due to mis-pricing between cash market and derivatives market. Funds are allocated to equities, derivatives and money markets. Higher proportion (around 75%) is put in money markets, in the absence of arbitrage opportunities.

Gilt funds LT:
They invest 100% of their portfolio in long-term government securities.

Income funds LT:
Typically, such funds invest a major portion of the portfolio in long-term debt papers.

Monthly Income Plans have an exposure of 70%-90% to debt and an exposure of 10%-30% to equities.

fixed monthly plans invest in debt papers whose maturity is in line with that of the fund.
Reason to chose Mutual Fund

Mutual Funds are the best option to multiply your wealth. You can go for Mutual fund with a minimum of Rs. 500. SIP (Systematic Investment Plan) gives you an opportunity to invest in Mutual Funds with a minimum monthly investment. It allows you to withdraw the money at any time; this helps you in ensuring the liquidity of your money. Why should one buy Mutual Fund? There are many reasons to buy a mutual fund. Below given are the top ten reasons that make Mutual Fund investment a feasible one.

  • Enjoy the advantage of Diversification
  • Gain the service of a professionally qualified Fund Manager
  • Option to choose from a pool of funds
  • Minimum initial investment
  • SIP facility
  • Automatic Reinvestment facility
  • Greater Transparency
  • High Liquidity
  • Audited Track Records
  • Greater convenience

Enjoy the advantage of Diversification

Mutual Funds provide you the facility to diversify your portfolio. Diversification is an effective technique to minimise your risk. If you are investing directly in stock market, you have to buy different stocks of companies from different sectors to diversify your portfolio. The beauty of a mutual fund is that you can buy a mutual fund and has instant access to a hundreds of individual stocks or bonds. Otherwise, in order to diversify your portfolio, you might have to buy individual securities, which exposes you to more potential volatility with very high risk.

See Also: How To Choose Mutual Funds For Beginners?

Gain the service of a professionally qualified Fund Manager

Investing in individual stocks and making profits are not an easy job. It requires detailed study and analysis to find out factors such as, in which stock to invest, how much amount to invest, when to invest, etc. Many investors don’t have the resources or the time to buy individual stocks. If you buy also, you should have a close eye on the stock, according to the market fluctuations you have to rearrange your portfolio. It not only takes resources, but a considerable amount of time also. In contrast, mutual fund managers and analysts wake up each morning dedicating their professional lives to conduct research and analyze current and potential holdings for their mutual fund. This makes Mutual Funds more Productive compared to other means of investments.

Option to choose from a pool of funds

A mutual fund comes in several types and styles. There are different types of Mutual Funds in the market. You can choose the fundas per your need. Mutual funds allow you to invest in the market whether you believe in active portfolio management or passive management. Passively managed funds are those funds with no interference from a manager; these are called as passive funds and index mutual funds. The availability of different types of mutual funds allows you to build a diversified portfolio at low cost and without much complexity. Following are some of the major funds available in the market;

. Asset allocation fund
. Balanced fund
. Bond fund
. Equity fund
. Fund of funds
. Gilt fund
. Growth fund
. Hedge fund
. Income fund
. Index fund
. Money market fund
. Sector fund
. Tax saving fund (ELSS) etc.

Minimum Initial Investment

Normally you can start a Mutual Fund investment with relatively less amount. Through SIP (Systematic Investment Program) you can invest in Mutual Funds by paying the money in installments. Many of the Mutual Fund companies are allowing the investors to start with a minimum investment of Rs. 500.

SIP Facility

It is easy to invest regularly in a mutual fund. Many mutual fund companies allow investors to get started in a mutual fund with as little as Rs. 500. This will help you in taking the advantage of Rupee Cost Averaging. As you are paying the money in installments, it will help you to reduce the risk of market fluctuations. For instance if you are investing a lump sum amount in Mutual Fund, during the time of market crash the value of entire investment will come down. But in case of SIP the units are credited to your account on a monthly basis. So you will be buying the units as per the current market price. This will help in reducing the investment risk.

Automatic Reinvestment facility

In Mutual Funds you might receive dividend on your investments. You can easily and automatically reinvest this dividends and capital gain into your mutual fund. There won’t be any charge or extra fees. This increased investment will help you to gain more returns.

Greater Transparency

Mutual fund holdings are publicly available (with some delays in reporting), which ensures that investors are getting what they pay for.

High Liquidity

Liquidity is an important factor that all people do consider while choosing an investment. Mutual Funds provide you high liquidity, whenever you want to exit from the fund, you can do it where as in investments like ULIPs, PPF, NSC, etc. you have lock-in-period. If you want to sell your mutual fund, the proceeds from the sale are available the day after you sell the mutual fund.

Audited Track Records

Mutual fund companies have to maintain performance records of mutual funds. All these funds must be audited for accuracy. Which helps the investors to trust the mutual fund’s declared returns.

Greater convenience

All the transactions related to mutual funds such as, buying and selling of shares, switching of funds, changing distribution options, and obtaining information can be done very easily by telephone, mail, or online.

Expenses in Mutual Funds

Mutual funds bear expenses similar to other companies. The fee structure of a mutual fund can be divided into two or three main components: management fee and non management expense. All expenses are expressed as a percentage of the average daily net assets of the fund.

Management fees

The management fee for the fund is usually synonymous with the contractual investment advisory fee charged for the management of a fund's investments. Though, as many fund companies include administrative fees in the advisory fee component, when attempting to compare the total management expenses of different funds, it is helpful to define management fee as equal to the contractual advisory fee + the contractual administrator fee. This "levels the playing field" when comparing management fee components across multiple funds.

Contractual advisory fees may be structured as "flat-rate" fees, i.e., a single fee charged to the fund, regardless of the asset size of the fund. Though, many funds have contractual fees which include breakpoints, so that as the value of a fund's assets increases, the advisory fee paid decreases. Another way in which the advisory fees remain competitive is by structuring the fee so that it is based on the value of all of the assets of a group or a complex of funds rather than those of a single fund.

Non-management expenses

Apart from the management fee, there are certain non-management expenses which most funds must pay. Some of the more significant (in terms of amount) non-management expenses are: transfer agent expenses (this is usually the person you get on the other end of the phone line when you want to purchase/sell shares of a fund), custodian expense (the fund's assets are kept in custody by a bank which charges a custody fee), legal/audit expense, fund accounting expense, registration expense (the SEC charges a registration fee when funds file registration statements with it), board of directors/trustees expense (the disinterested members of the board who oversee the fund are usually paid a fee for their time spent at meetings), and printing and postage expense (incurred when printing and delivering shareholder reports).

See Also: How To Choose The Best Mutual Fund?

Investor fees and expenses

Fees and expenses borne by the investor vary based on the arrangement made with the investor's broker. Sales loads (or contingent deferred sales loads (CDSL)) are not included in the fund's total expense ratio (TER) because they do not pass through the statement of operations for the fund. Additionally, funds may charge early redemption fees to discourage investors from swapping money into and out of the fund quickly, which may force the fund to make bad trades to obtain the necessary liquidity. For example, Fidelity Diversified International Fund (FDIVX) charges a 1 percent fee on money removed from the fund in less than 30 days.

Brokerage commissions

An additional expense which does not pass through the statement of operations and cannot be controlled by the investor is brokerage commissions. Brokerage commissions are incorporated into the price of the fund and are reported usually 3 months after the fund's annual report in the statement of additional information. Brokerage commissions are directly related to portfolio turnover (portfolio turnover refers to the number of times the fund's assets are bought and sold over the course of a year). Generally the higher the rate of the portfolio turnover, higher will be the brokerage commissions. The advisors of mutual fund companies are required to achieve "best execution" through brokerage arrangements so that the commissions charged to the fund will not be excessive.

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