Mutual funds combine the savings of a large number of investors and manage it as a single pool of money. Instead of investors worrying about which stock or bond or commodity to invest in, professional fund managers do the job.
Simply put, mutual fund is a financial intermediary, set up with an objective to professionally manage the money pooled from investors at large. By pooling money together in a mutual fund, investors can enjoy economies of scale. Mutual funds are set up as Trusts and they appoint Asset Management Companies (AMC) to manage the funds. Each AMC operates a number of schemes suited to different types of investment needs.
For the individual investor who does not have much time to study and research investments himself, mutual funds are one of the best option for reaping the benefits of different types of investments with minimum effort and at a lower cost. In most funds, it is possible to start investing with as little as a thousand rupees or even less. Also, unlike many other investments, mutual fund investments are highly ‘liquid’. ‘Liquid’ means an investment can generally be withdrawn without much delay. When an investor wants to withdraw money from a mutual fund, it is generally possible to do so at short notice and receive the redemption proceeds within a few business days.
Many Types of Funds
There are many types of funds with a wide range of risk levels, profit potential, and type of fund management. Funds that invest in equity have the potential to provide higher returns but with a higher risk. At the other extreme, there are funds that invest in short-term bonds having a potential to give relatively lower returns than equity funds but at a much lower risk. There are plenty of intermediate funds as well, which offer varying degrees of risk and returns. For example, hybrid funds, as the name indicates, are a mix of equity and bonds. They combine some of the characteristics of both.
Then there are gold funds, which are a way of investing in gold without having to buy physical gold. They allot mutual fund units which hold physical gold as the underlying security. These funds give almost the same returns as physical gold would have fetched but without the hassles of storage, purity checks, liquidity risk, etc. There are also international funds that invest in foreign securities without investors having to contribute in foreign currency. As per the mechanism, domestic mutual fund companies either invest in foreign securities directly or invest in an overseas mutual fund which further invests in these securities. Investors need to keep an eye on the track-record of individual funds, their fund managers and the fund companies, to make the right decision.
Benefits of Mutual Funds
Instant and easy diversification: One of the basics of safe investing is to spread your money across different investments. Mutual funds are an easy way to do this. Mutual funds help to spread the money across a large number of investments – not just across different companies but also across different sectors and sizes of companies, thus providing safety.
Professional research and investment management: Investing is a lot of work. There are hundreds of companies to track and their prospects could change without warning. While you could do it all yourself, you may not have the time or the resources to spare. Mutual funds employ professional, whole-time investment managers and research staff. Their cost and effort gets shared among all the investors in a fund thus providing economies of scale.
Variety: There are mutual funds available for every kind of risk level and suitable for every kind of time horizon. No matter what kind of investment you want, there is likely to be a variety of fund that suits you.
Convenience: You can easily invest as well as withdraw from mutual funds. Investments can be made by filling up a simple form or even online with direct debit from your bank account. Similarly, redemption proceeds can be credited directly into your bank account within a few business days. If you go directly to buy shares to have a diversified set, you will need a lot of money to do so. However, through a mutual fund, you can invest in a diversified set of stocks for as little as a few thousand rupees. And what’s more, you can invest (or redeem) in small batches as well. Same is the case with international stocks which would be very expensive and complex to purchase at an individual level.
Tax efficiency: When you buy or sell any investment, you have to pay tax on the profit you make. However this does not happen when that buying and selling is being done on your behalf by a mutual fund. To maximise profits, the fund manager could keep buying and selling stocks as needed. MFs pay transaction taxes when they buy or sell stocks. As per current tax laws, you have to pay tax if applicable, only when you redeem your investments from the fund.
Transparent, well-regulated industry: Mutual funds are obligated by law to release comprehensive data about their operations and investments. All funds release NAVs (Net Asset Value) daily and their complete portfolio every month. SEBI regulates the fund industry very closely and is constantly refining the applicable rules to protect investors better.
Open Vs Closed
Apart from the different types of investments they make, mutual funds differ in another fundamental way. They can be closed-end and open-ended. Closed-ended funds have a defined period over which they exist after which they are wound up. Investors are allowed to invest only at the beginning, when the fund is launched. Investors can withdraw their money from the fund only at the time when the fund is finally closed (maturity date). It must be noted that closed-end funds are listed like shares in the stock markets but the trading volumes for these funds is very low causing illiquidity in most cases.
In contrast, open-ended schemes are perpetual. Investors can come in and invest at any point of time. They can also redeem their money from the fund at any time as the scheme never closes.
As per SEBI rules, all mutual funds must offer liquidity. However, liquidity depends on whether a fund is open-ended or closed-ended. Open-ended funds are perpetual funds that are always available for investment or redemption with the AMC. In case of open-ended funds, the AMC will redeem the money at the prevailing NAV in 10 business day. Closed-ended funds are launched for a Fixed period (generally less than one year and upto 5 years) and you can invest in them only at the time of the initial offer. For closed-ended funds, the AMCs get the fund listed on a stock exchange so that you can sell your units like a stock through a stock broker. However, this is not a great option because the trading volumes on the stock-exchange are very low and may lead to illiquidity in most cases. Further, the sale is not at NAV but at market price which may even be below the NAV. In practice, you should consider closed-ended funds only if you agree to the lock-in period. Tax-saving Equity Linked Saving Schemes (ELSS) too have a three-year lock-in. These funds save you tax under Section 80C of the Income Tax Act, 1961. You cannot redeem for three years if you propose to claim tax benefits.
Mutual Fund Rating or Rankings
Technically, mutual fund schemes are ranked and not rated as rating is usually provided by Credit Rating agencies to debt securities. The latter is published by fund houses for all rated debt securities in their monthly portfolios disclosures on the respective websites. Some mutual fund debt portfolios are also rated by credit rating agencies at an aggregate level.
Mutual funds are ranked by rating agencies as well as by independent research houses. These are either denoted as star ranks or cluster ranks. The rankings are the representation of a composite score for various schemes in a category across various parameters of risk, return and portfolio attributes. Rankings are available at a defined frequency (typically quarterly) on the websites of these agencies. SEBI has banned publishing of fund rankings in any publicity material distributed by fund houses.
There are two types of loads Exit Load and Entry Load. Exit Load is a small percentage of the NAV (Net Asset Value) that can be deducted by the AMC at the time of redemption. Exit Load percentages may range from 0 to 3-4 per cent. The actual percentage depends on the type of fund and the period of investment. For example, there could be a load of 1% if you redeem within a year of investment and no load after that
Entry Load was charged at the time of investment till SEBI abolished the same post August 2009.
There is a specific type of fund, known as ELSS fund which is a permissible investment under Section 80C of the Income Tax Act, 1961 and provides tax benefits upto Rs.1 lakh of investment per year. ELSS funds have a lock-in period of three years. Apart from this, some fund houses have a pension fund which is eligible for the same tax benefit. Other types of mutual funds also have tax efficiencies depending on what type of asset class they invest in. For example, when you redeem an equity fund after a year or more, the capital gains are tax-free as per current tax laws. This makes equity funds a great long-term investment. Debt funds on the other hand are allowed to claim indexation benefits for a holding period of more than one year. Indexation allows the purchase price of units to be adjusted for inflation which may reduce the capital gains (sale price less adjusted cost price) proportionately.
Mutual funds are an easy way for investors to gain benefits of investing without having to do much research or analysis. Mutual funds also offer diversification, convenience, tax efficiency as well as many other benefits. There are mutual funds available for a wide variety of investing needs. For the investor who does not have much time to study and research investments himself, mutual funds are the best option to reap the benefits of different types of investments.