Meaning of Mutual Fund
A mutual fund is an investment security type
that enables investors to pool their money together into one professionally
managed investment. Mutual funds can invest in stocks, bonds, cash and/or other
assets.
There are certain key
characteristics of mutual funds:
a.
Mutual Fund Diversification: Most individual
investors are unable to purchase 50 or 60 different issues of stocks. They
typically have to rely on a few selections and hope for the best. An investor
in a mutual fund gets the advantage of being invested in the entire fund’s
portfolio. This helps lower the exposure to problems with any individual issue.
b.
Mutual Fund Professional Management: The fund
employs professionals to manage the fund's investments. Most small investors
can’t possibly spend their days researching individual stocks or bonds and
market trends. By owning a fund, the investors can take advantage of the
abilities of the fund’s management team. The fund charges a management fee to
cover the cost of management.
c.
Mutual Fund Affordability: Investments in
mutual funds can often be opened with small investments. Sometimes the initial
investment may be as low as Rs.100, and subsequent investments into the fund
may be made with similar small amounts.
d.
Mutual Fund Liquidity - Mutual funds are
liquid on every business day. They are sold at their net asset value which is
computed on every business day after the close of the markets. The price you
receive depends on the value of the securities in the fund
Advantages of Mutual Funds for
Investors
1.
Professional Management: Mutual funds offer
investors the opportunity to earn an income or build their wealth through
professional management of their investible funds. There are several aspects to
such professional management viz. investing in line with the investment
objective, investing based on adequate research, and ensuring that prudent
investment processes are followed.
2.
Affordable Portfolio Diversification: Units of
a scheme give investors exposure to a range of securities held in the
investment portfolio of the scheme. Thus, even a small investment of Rs 5,000
in a mutual fund scheme can give investors a diversified investment portfolio.
3.
Economies of Scale: The pooling of large sums
of money from so many investors makes it possible for the mutual fund to engage
professional managers to manage the investment. Individual investors with small
amounts to invest cannot, by themselves, afford to engage such professional
management.
4.
Liquidity: Investors in a mutual fund scheme
can recover the value of the moneys invested, from the mutual fund itself.
Depending on the structure of the mutual fund scheme, this would be possible,
either at any time, or during specific intervals, or only on closure of the
scheme.
5.
Tax Deferral: Mutual funds are not liable to
pay tax on the income they earn. If the same income were to be earned by the
investor directly, then tax may have to be paid in the same financial year.
6.
Tax benefits: Specific schemes of mutual funds
(Equity Linked Savings Schemes) give investors the benefit of deduction
of the amount invested, from their income that is liable to tax. This reduces
their taxable income, and therefore the tax liability.
7.
Convenient Options: The options offered under
a scheme allow investors to structure their investments in line with their
liquidity preference and tax position.
8.
Investment Comfort: Once an investment is made
with a mutual fund, they make it convenient for the investor to make further
purchases with very little documentation. This simplifies subsequent investment
activity.
9.
Regulatory Comfort: The regulator, Securities
& Exchange Board of India (SEBI) has mandated strict checks and balances in
the structure of mutual funds and their activities. These are detailed in the
subsequent units. Mutual fund investors benefit from such protection.
10.
Systematic approach to investments: Mutual
funds also offer facilities that help investor invest amounts regularly through
a Systematic Investment Plan (SIP); or withdraw amounts regularly
through a Systematic Withdrawal Plan (SWP); or move moneys between
different kinds of schemes through a Systematic Transfer Plan (STP).
Such systematic approaches promote an investment discipline, which is useful in
long term wealth creation and protection.
Limitations of a Mutual Fund
1.
Lack of portfolio customization: Mutual fund
unit-holder is just one of several thousand investors in a scheme. Once a
unit-holder has bought into the scheme, investment management is left to the
fund manager. Thus, the unit-holder cannot influence what securities or
investments the scheme would buy.
2.
Choice overload: Over 800 mutual fund schemes
offered by 38 mutual funds – and multiple options within those schemes – make
it difficult for investors to choose between them.
3.
No control over costs: All the investor's
moneys are pooled together in a scheme. Costs incurred for managing the scheme
are shared by all the Unitholders in proportion to their holding of Units in
the scheme. Therefore, an individual investor has no control over the costs in
a scheme.
Types of Funds
1. Open-Ended
Funds, Close-Ended Funds and Interval Funds:
a)
Open-ended funds are open
for investors to enter or exit at any time, even after the NFO.
b)
Close-ended funds have a
fixed maturity. Investors can buy units of a close-ended scheme, from the fund,
only during its NFO.
c)
Interval funds combine
features of both open-ended and close ended schemes. They are largely
close-ended, but become openended at pre-specified intervals.
2. Actively
Managed Funds and Passive Funds
a)
Actively managed funds are funds
where the fund manager has the flexibility to choose the investment portfolio,
within the broad parameters of the investment objective of the scheme. Since
this increases the role of the fund manager, the expenses for running the fund
turn out to be higher.
b)
Passive funds invest on
the basis of a specified index, whose performance it seeks to track. Thus, a
passive fund tracking the BSE Sensex would buy only the shares that are part of
the composition of the BSE Sensex. Such schemes are also called index
schemes. Since the portfolio is determined by the index itself, the fund
manager has no role in deciding on investments. Therefore, these schemes have
low running costs.
3. Debt,
Equity and Hybrid Funds
a)
A scheme might have an investment objective to
invest largely in equity shares and equity-related investments like convertible
debentures. Such schemes are called equity schemes.
b)
Schemes with an investment objective that
limits them to investments in debt securities like Treasury Bills, Government
Securities, Bonds and Debentures are called debt funds.
c)
Hybrid funds have an
investment charter that provides for a reasonable level of investment in both
debt and equity.
Types of Debt Funds
a.
Gilt funds invest in only treasury bills and
government securities, which do not have a credit risk.
b.
Diversified debt funds on the
other hand, invest in a mix of government and non-government debt securities.
c.
Junk bond schemes or high
yield bond schemes invest in companies that are of poor credit quality.
d.
Fixed maturity plans are a kind
of debt fund where the investment portfolio is closely aligned to the maturity
of the scheme.
e.
Floating rate funds invest
largely in floating rate debt securities i.e. debt securities where the
interest rate payable by the issuer changes in line with the market.
f.
Liquid schemes or money
market schemes are a variant of debt schemes that invest only in debt
securities where the moneys will be repaid within 91-days.
Types of Equity Funds
a.
Diversified equity fund is a
category of funds that invest in a diverse mix of securities that cut across
sectors.
b.
Sector funds however
invest in only a specific sector. For example, a banking sector fund will
invest in only shares of banking companies. Gold sector fund will invest in
only shares of gold-related companies.
c.
Thematic funds invest in
line with an investment theme. For example, an infrastructure thematic fund
might invest in shares of companies that are into infrastructure construction,
infrastructure toll-collection, cement, steel, telecom, power etc.
d.
Equity Linked Savings Schemes (ELSS), as
seen earlier, offer tax benefits to investors. However, the investor is
expected to retain the Units for at least 3 years.
e.
Equity Income / Dividend Yield Schemes invest in
securities whose shares fluctuate less, and therefore, dividend represents a
larger proportion of the returns on those shares.
f.
Arbitrage Funds take
contrary positions in different markets / securities, such that the risk is
neutralized, but a return is earned.
Types of Hybrid Funds
a.
Monthly Income Plan seeks to
declare a dividend every month. It therefore invests largely in debt securities.
b.
Capital Protected Schemes are
close-ended schemes, which are structured to ensure that investors get their
principal back, irrespective of what happens to the market.
4. Gold
Funds: These funds invest in gold and gold-related securities. They can be
structured in either of the following formats:
5. Gold
Exchange Traded Fund, which is like an index fund that invests in gold. The
structure of exchange traded funds is discussed later in this unit. The NAV of
such funds moves in line with gold prices in the market.
6. Gold
Sector Funds i.e. the fund will invest in shares of companies engaged in gold
mining and processing. Though gold prices influence these shares, the prices of
these shares are more closely linked to the profitability and gold reserves of
the companies.
7. Real
Estate Funds: They take exposure to real estate. Such funds make it possible
for small investors to take exposure to real estate as an asset class. Although
permitted by law, real estate mutual funds are yet to hit the market in India.
8. Commodity
Funds: The investment objective of commodity funds would specify which of these
commodities it proposes to invest in.
9. International
Funds: These are funds that invest outside the country. For instance, a mutual
fund may offer a scheme to investors in India, with an investment objective to
invest abroad.
10. Fund of
Funds: Such funds invests in another fund. Similarly, funds can be structured
to invest in various other funds, whether in India or abroad. Such funds are
called fund of funds.
11. Exchange
Traded Funds: Exchange Traded funds (ETF) are open-ended index funds
that are traded in a stock exchange.
Role of Mutual Funds Institutions
Mutual
funds Institutions perform different roles for different constituencies:
1.
Wealth Building: Their primary role is to
assist investors in earning an income or building their wealth, by
participating in the opportunities available in various securities and markets.
It is possible for mutual funds to structure a scheme for any kind of
investment objective. Thus, the mutual fund structure, through its various
schemes, makes it possible to tap a large corpus of money from diverse
investors.
2.
Source of Finance for government and
companies: The money that is raised from investors, ultimately benefits
governments, companies or other entities, directly or indirectly, to raise
moneys to invest in various projects or pay for various expenses.
3.
Corporate Governance and ethical standards: As
a large investor, the mutual funds can keep a check on the operations of the
investee company, and their corporate governance and ethical standards.
4.
Project Financing: The projects that are
facilitated through such financing, offer employment to people; the income they
earn helps the employees buy goods and services offered by other companies,
thus supporting projects of these goods and services companies. Thus, overall
economic development is promoted.
5.
Employment creation: The mutual fund industry
itself, offers livelihood to a large number of employees of mutual funds,
distributors, registrars and various other service providers. Higher
employment, income and output in the economy boost the revenue collection of
the government through taxes and other means. When these are spent prudently,
it promotes further economic development and nation building.
6.
Growth of capital market: Mutual funds can
also act as a market stabilizer, in countering large inflows or outflows from
foreign investors. Mutual funds are therefore viewed as a key participant in
the capital market of any economy.
7.
Protection to
Small Investors: A small investor is not safe in share market. In mutual
industry there is no such risk. Mutual funds help to reduce the risk of
investing in stocks by spreading or diversifying investments. Small
investors enjoy the benefit of diversification.
8.
Tax Benefit: Investors in
mutual funds enjoy tax benefits. Dividend received byinvestors is tax free. Tax
exemption is allowed on income received on units of mutual funds and UTI.
9.
Diversification:
Investment in mutual funds enable investors to spread out and minimise the
risks upto certain extent. Mutual fund invests in a diversified portfolio of
securities. This diversification helps to reduce risk since all the stocks do
not fall at same time. Thus investors are assured of average income which is
not possible in other sources.
10.
Arrival of
Foreign Capital: Mutual funds attract foreign capital. Indian Mutual Fund
Industries open offshore funds in various foreign countries and secure safe
investment avenues abroad to domestic savings. These funds enable NRI’s and
foreign investors to participate in Indian Capital Market.