The Basics of Mutual Funds

The Introduction to Mutual Funds

Investment is the keys to the financial success of any individual. Whatever one has earned, spent or saved throughout the earning period of life,the end of the day is whether you are able to multiply your savings or not. Increasing your savings by many folds can never be done by keeping your savings in a bank account. One needs to invest the money at the right place so that it grows by leaps and bounds. Most of the Indians are found to be keeping their money idle in savings accounts instead of investing because of the potential risk in investing. Well, the risk involving in investing can never be overlooked.

If you are one of them who don’t want to take the market risks and still interested in investing money for a good return then the solution is Mutual Funds. Before you jump start investing in mutual funds, let us first understand what are mutual fund and how they are claimed to be risk free investment.

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What is a Mutual Fund?

A mutual fund is a trust which is managed by professionals that invest the savings of many investors on behalf of the investors. A mutual fund pools the investment of the investors who lack time or knowledge to have a research on market and take risks of investing. A mutual fund collects the investment of various investors and invests the same amount with a proper market study to earn maximum profit. The investments done by the mutual fund is well diversified to offset potential losses. Fund managers of mutual fund make sure that the investment is done on different platforms such as securities like stocks, bonds, short-term money market instruments and commodities such as precious metals. By investing your money in a mutual fund, you permit the portfolio manager or the fund manager to make those essential decisions on behalf of you. Whatever profit one will earn by capital appreciation realized will be shared by its unit holders or the investors with the mutual fund trust. A mutual fund is the most suitable investment scope for common people as it offers an opportunity to invest in a diversified, professionally managed mixed bag of securities at a relatively lower cost.

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How is a Mutual Fund set up?

A mutual fund is set up by consisting of different bodies who have their own set of functions to be done. All the bodies of a typical mutual fund work towards the same goal of bagging more and more returns on the investment.

Here is how a typical mutual fund is structured.

Sponsor

A sponsor of a mutual fund is either a single person or in association with another corporate body forms a mutual fund. The person or the body who establishes the mutual fund must contribute at least 40% of the net worth of the investment managed. The sponsor of the mutual fund must be formed in such way that it qualifies the eligibility criteria prescribed by the Securities and Exchange Board of India (SEBI) Regulations, 1996. The sponsor of a mutual fund is never responsible for any loss happen over any kind of investments done by the trust.

Trust

The sponsor of the mutual fund forms a trust in accordance with the provisions of the Indian Trusts Act, 1882. The trust deed of the mutual fund is registered under the Indian Registration Act, 1908.

Trustee

The trustee of a mutual fund is a corporate body or a Board of Trustees. The main function of this board of trustees is to safeguard the interest of the investors or the unitholders. The trustees keep an eye on the functioning of the AMC (Asset Management Company). They make sure that AMC is in accordance with the regulations of SEBI.  At least 2/3rd of the trustee members should not be directly or indirectly be associated with the sponsor/s.

Asset Management Company (AMC)

The trustees of a mutual fund appoint the AMC. The AMC is responsible for the investment/divestment decisions for the mutual fund, and manages the assets of the mutual fund. They decide where to invest based on in-house research and data analytics. Sometimes, asset management company even works according to the public recommendations from sell-side firms. The AMC of must be registered with the Securities and Exchange Board of India (SEBI). Minimum of half of the directors of AMC should be independent ones and should not be associated with sponsors.

Custodian

A custodian of a mutual fund is a bank or a trust company which is registered with SEBI and the same is responsible for holding and safeguarding the securities owned within a mutual fund. The Custodians maintains a mutual fund’s assets, including its portfolio of securities or some record of them.

Registrar and Transfer Agent

Just as trustees appoint the AMC, AMCs appoint the registrar and transfer agent to the mutual fund. The prime function of these agents is to maintain the detailed records of the transactions of unitholders on a professional basis. The registrar and transfer agents contribute to saving cost and time involved in keeping detailed records. The team of the registrar and transfer agents also handles communication with investors and updates investor records.

What is NAV of a Mutual Fund?

The abbreviation NAV stands for Net Asset Value. The Net Asset Value is the total asset value per unit of the fund. The NAV is calculated by the AMC at the end of every market day after checking the closing market prices of the securities that the fund or scheme holds. The NAV is calculated by taking the current market value of the assets that the fund owns after subtracting the liabilities (if any) and then divided by the number of shares outstanding.

Here is the formula of finding NAV–

The Different Types of Mutual Funds

Mutual funds are actually of many kinds and the variety of the mutual funds is the primary reason for getting confused about where to invest. Here are different kinds of mutual funds with a clear definition.

Based on the Maturity Period

Open-ended Funds

If you want to invest your money but afraid of being in a lock-in period than an Open-ended Fund will work best. Such funds are best for enjoying maximum liquidity. An open-ended mutual fund can be subscribed and redeemed at any time of the year. One can buy and sell units at NAV related prices.

Close-ended Funds

A closed-ended fund has a fixed maturity period. A close-ended fund can be purchased only at the launching time and the fund will come back to the investor with the profit only after the maturity.  Generally, the of a closed-ended mutual fund gets matured within 3 to 6 years.

Interval Funds

Interval funds are the combination of open-ended and close-ended funds. Interval funds are open for sale or redemption during pre-determined intervals on the prevailing NAV.

Based on the asset class

According to the asset class in which the asset management company invests the pooled money, mutual funds are divided into three parts

1) Equity Mutual Fund

2) Debt Mutual Fund

3) Hybrid Mutual Fund

Equity Mutual Fund

Equity mutual funds are the funds that invest principally in stocks. Such investments can be actively or passively managed by the AMC. Stock mutual funds principally invest in the equities of various companies. Equity mutual funds carry the highest risk as well these are the best return mutual funds.  Equity mutual funds are further divided into different categories. Before we dive deep into the different kinds of Mutual funds we need to understand the ‘Market Capitalisation’.

The market capitalisation of a company makes us understand how big is  a company. According to the market capitalisation, companies are divided into three parts- Large cap company, Mid cap company and small cap company. The companies which market capitalisation is below 5000 crores are called small cap companies. The companies with a market value of 5000 to 100000 crores are considered as mid cap companies and the companies with the market value of more than 100000 crores is called large cap companies. There are no fixed criteria for this market capitalisation of the companies. Along with the changing time, the value of the company which make it stand in any particular category can be altered. For example, until a few years back, the companies with a value of 50,000 crores was considered as large cap companies but at present time these companies fall in mid cap category.

i) Large-cap Funds

The funds which are invested in large cap companies are known as large cap fund. The large cap companies are generally the leader of their own sector and have an influential presence in the market. Investing in such fund has a low risk but the returns are also low as the company is already in its best position and there is no much scope to go further.

ii) Mid-cap Funds

The fund which is invested in medium sized companies are known as mid cap funds. Investing in this type of fund is a bit risky as such companies may or may not succeed in future and as we all know the ratio of failed companies are always more. If they succeed, one may earn a high profit if not there are chances of facing the loss too.

iii) Small-cap Funds

When the investment is done in small companies with the market value of less than 5000 crores, it is called as small cap funds. Investing in such funds can be extremely risky as there is not much information available. However, if your luck is in your side you may earn a phenomenal return. this type of investment is suitable for the ones who are ready to take a risk with their investment.

iv) Sector Funds

Sector funds are the funds that invest in one specific sector or industry. The returns of this type of investment depend on the performance of that particular industry. For example, Reliance Entertainment and Media fund is a sector fund which invests only in the media sector only. Another example of a sector fund is SBI pharma fund which invests only in the pharma sector. Investing in sector fund has some risk involved as the performance of a particular industry is concerned here. To invest in sector fund one must have sound knowledge of that particular industry.

v) Diversified Equity Funds

Diversified equity funds are the funds are the fund that is invested in different schemes and different market capitalisation companies. The profit in such type of investment is entirely dependent on the market research and knowledge of the fund manager. such investments are less risky than mid cap and small cap investment but riskier than large cap funds.

vi) Dividend Yield Funds

Dividend yield funds are the kind of fund where the companies share a part of its profit with its investors. The part of the profit which is shared with the shareholders is called dividends. Whether a company will give dividends to its shareholders or not, depends on the board of directors of the company. Dividend yield funds invest in the companies which are stable, safe, consistent and low volatile.

vii) ELSS

ELSS ( Equity Linked Savings Schemes) is the tax saving equity schemes. This is a closed fund where your investments are locked for a minimum of 3 years. This scheme is beneficial for the ones who want to save tax. The investment and the income through the capital appreciation are beyond the taxable income. One can claim for a tax rebate of 1.5 lakhs under income tax act 80C.

viii) Thematic Funds

Thematic funds invest in themes. It can be any stocks related to that particular theme. For example infrastructure, manufacturing or MNC are all themes. Hence a thematic fund is more diversified than a sector fund. An example of a thematic fund is ‘HDFC Housing Opportunity Fund’. This fund invests only in housing theme and buys stocks of related companies such as bricks, cement, paints etc.

Debt Funds

Debt funds are mutual funds that invest in Treasury Bills, Government Securities, Corporate Bonds, Money Market instruments and other debt instruments. The investment time horizons are different in different classes of debt mutual funds. Most large corporates use debt funds to manage their surplus funds efficiently.  Debt funds are mostly used as a substitute to Bank Deposits.

A debt mutual fund as the word suggests is nothing but a loan or credit.  The mutual fund that gives away a loan to other companies or government which they return with an interest is called debt fund. When the government borrows money from AMCs it issues bonds and Treasury bills. Treasury bills are issued for less duration investments such as a year or less whereas bonds are issued when the investment is done for longer durations. When a loan is issued to businesses, it issues corporate bonds and commercial papers. While a loan to financial institutions comes with the certificate of deposit and debentures.  

The first classification of debt mutual fund is done on the basis of i) Time & ii) Risk

Based on Time

i) Money Market/ Liquid Funds

Money market funds are the funds when your time horizon is 0 to 90 days. This type of mutual funds invests in treasury bills which are nothing but short-term government securities. Whenever you have some extra fund in your savings account you can invest the same in liquid funds which generally gives a return of 7% to 8% yearly.

ii) Ultra Short Term Funds

Ultra short terms funds are best if your investment horizon is 3 to 6 months. It generally fetches a return of 7% to 8% annually. These funds generally invest in treasury bills which are short term government security and the commercial papers which are short-term securities issued by companies.

iii) Short Term Funds

Whenever your investment horizon is six to twelve months. These funds invest into commercial papers which are short-term securities issued by companies. These commercial papers have the maturity of less than one year. These funds have given returns with about 7.5 to 8.5 on an annual basis in past five to ten years.

iv) Medium Term Funds

Whenever your investment horizon is one to three years these are the funds for you.  These funds invest into medium-term corporate bonds which are issued by companies and medium-term debentures which are issued by financial institutions.

v) Long Term Funds

Whenever your investment horizon is more than three years these are the funds for you. These funds invest into long-term government securities issued by state and central government and long-term corporate deposits issued by companies. The long-term funds give returns of about 8% to 9%on an annual basis in the past five to ten years.

Based on the Risk Factor

i) Gilt Funds (Low-risk Funds)

Gilt funds invest only in government securities. As the securities are issued by governments, they do not have the default risk. Such type of mutual funds can be of short term or long term. However, they are highly vulnerable to the changes in interest rates and other economic factors.

ii) Junk Bond Scheme (High-risk Funds)

The bonds according to their credit rating are categorised into different parts. Bonds with a high credit rating are known as investment-grade bonds whereas Bonds that are likely to default are called speculative or non-investment grade bonds. Such low-grade bonds are likely to be released by companies without long track records or with questionable ability to meet their debt obligations. As most of the investors don’t invest in these low-grade bonds, they are known as junk bonds. However, because of the very high interest rates these bonds can yield high interest rate and fetch a handsome profit. Because of this feature junk bonds are also referred to as high-yield bonds.

iii) Fixed Maturity Plan (No Risk Fund)

Fixed Maturity Plans (FMPs) are a kind of closed ended mutual funds where you can not sell your funds before the maturity period. Fixed Maturity funds have a specific maturity date which is generally of three years. Fixed Maturity plans are managed and invested by the portfolio manager on behalf of the investor. The fund manager buys and holds the debt securities for the entire duration of the product. FMPs are best for the investors who are risk averse. Such investments attract more returns than a bank’s fixed deposits and this type of investment is tax efficient too.

Hybrid Mutual Funds

As per he had discussed above, mutual funds invest in equities which gives more profit with more risk or in debt funds which gives less profit with a low risk. But if you want an investment which has low risk but more profit that the answer is- Hybrid funds.  According to many experts of mutual funds this type is the best mutual fund to invest. The hybrid schemes invest in two or more asset categories so that the investor can avail the benefit of profit and less exposure to being defaulted. There are various types of hybrid funds in the Indian Mutual Fund industry. Here are the major parts Hybrid funds-

i) Monthly Income plans/ debt oriented funds

ii) Balanced fund/ equity oriented funds

iii) Arbitraged Fund

i) Monthly Income Funds

In monthly income funds, 60% to 90% of the investment is done in debt assets while the rest is done in equities.  In this type of plan, most of the investment is done in debt funds which makes it less exposure to potential risk whereas the investment in the equity is meant for fetching the profit. But this kind of investment can never be claimed to be as risk free as debt funds.

ii)Balanced Funds

In a balanced fund investment 60% to 80% investment is done in Equity and the rest is done at debt funds. Equity helps to bring a good return whereas investment in debt minimises the risk.

iii) Arbitrage Funds

This is a type of Mutual Fund which takes advantage of the differences in the price of securities in the cash market and derivatives market. The difference between both the prices is used to earn the profit or generate a return. The returns of this type of fund are generally 6% to 10%.  In terms of taxation, arbitrage funds are considered as equity funds. So the ones who are in the highest tax bracket and looking to park money for a short period, an arbitrage fund works best for them.

The Benefits of Investing in Mutual Funds

• Professional Management

The first benefit of investing in the mutual fund is that our financial portfolio is managed by professionals. The persons who are lacking time or skill to manage their portfolio can invest in mutual funds. The fund managers who handle our funds are highly skilled and make the best decisions on our investments. Availing such professional services for an individual investor will be a costly deal.

• Diversification

As we have seen above that a mutual fund provides the benefit of diversification across different sectors and companies. One can invest in various industries and asset classes. The diversified investment portfolio is best for earning more and more profit with less risk intake.

• Liquidity

Liquidity of a mutual fund is one of the reasons which make a mutual fund first choice for many investors. Unless you have invested in the fund which comes with a pre-specified lock-in period. Most of the mutual funds are integrated with the bank account of the investors hence the money directly goes to your bank account.

• Flexibility

while investing in mutual funds, one can enjoy the flexibility and convenience offered by mutual funds to invest in a wide range of schemes. The open-ended funds give the convenience of systematic (at regular intervals) investment and withdrawal which is much beneficial.

• Low Transaction Cost 

The transaction cost of mutual funds is much lower than the cost which one needed to invest while getting into the share market individually. The benefits which can be enjoyed by a mutual fund investor, may not be enjoyed by an individual who enters the market directly.

• Transparency

The investors of a mutual fund get all updates on their investment by different means. The AMC provides investors with updates on the investments by factsheets, offer documents, annual reports etc.

• Well Regulated

The mutual fund companies in India are regulated and monitored by SEBI (Securities and Exchange Board of India). The SEBI protects the interest of the investors which makes the mutual funds safe place for investment for the general public. Mutual funds have to report SEBI time to time. The SEBI makes sure that mutual funds provide investors with standard information about their investments which ensures cent per cent transparency.

Disadvantages of Investing in Mutual Funds

• Active Management

The management of your portfolio can sometimes be full of uncertainty as many investors doubt if the fund manager is taking a right decision on your investment. In the cases like a wrong management decision on investment can make you bear the loss on investment.

• Costs and Fees

Running a mutual fund is a costly business as Creating, distributing, managing the company, the salary of fund managers etc needs lots of money. Those expenses are passed on to the investors only. Moreover, the fees and charges vary widely from fund to fund so if you are not concerned about this you may end up by paying much more in with the name of fees and charges.  

• Dilution

Though it is true that diversification of mutual fund investment brings the risk lower but the same can make your incomes to lower. It is possible that you may get poor returns just because of too much diversification. You may have a high return from a few investments while low return from some other investments which often don’t make much difference on the overall return.

• Fund Evaluation

The fund evaluation in mutuals funds in a tricky task. Many investors find it difficult to evaluate the value of the fund.  To find out the mutual fund’s net asset value (NAV), the investor needs to study various parameters such as the Sharpe ratio and standard deviation among others to ascertain the same. To find out all the data and evaluate the same can be difficult for many investors.

What are The Things You Should Know in Advance?

Though we have learnt many things about mutual funds still there are few more things which one must know before investing in mutual funds.

• The first thing that one must know before investing in the mutual fund is the asset location. Every investor must know is what kind of product or fund he or she wants to put their money on. The way how one invests money in different investments with the proper mix of various asset classes is known as asset location.
• The second rule of a mutual fund is that the proportion of the proportion of his portfolio in debt instruments should be equivalent to his age. Let’s  Take an example, A investor or 25 years should have 25% in the debt market and the rest should be in equity. Along with increasing age, one should take the lesser risk.
• Prior to investing in mutual funds, one must be assured of the financial needs and for the objective of investing the money. One must have a clear idea on the time frame when he/she may need the return. If your goals are far then you can invest in long-term investments. Otherwise, if the investor is in the situation when he may be in need of liquid fund, he/she should better invest in money market funds for better liquidity.
• Along with the time frame, one must be certain about the amount of money he/she is going to need. One may be saving for buying a car whereas some others may like to invest in the child’s education. According to the purpose of saving, the amount changes. One must invest while keeping these things in consideration.
• It is well known that ‘ mutual funds are subject to market risk’. Knowing this fact one must be prepared to face both situations. The trade has a significant amount of exposure to market risks which is unavoidable. One must gear himself up for ups and downs of the prices of the stocks and hold it on with patience for good returns.

The Bottom Line

Investing in the mutual fund is like taking a calculated risk which is almost certain to bring handsome profit in a long run. The earlier you start investing the more you can earn as returns. An investor in his 20s or 30s can take the benefit of rolling returns while investing money for a longer period of time in mutual fund schemes. The variety for schemes are mend for every kind of investor of mutual funds. So, take an informed decision and maximise your returns.