What are Mutual Funds?
A mutual fund is a trust that pools the savings of a number of investors who share a common investment objective. The money thus collected is invested in capital market instruments such as shares, debentures, and other securities. The combined holdings the mutual fund owns are known as its portfolio. Each unit represents an investor’s proportionate ownership of the fund’s holdings and the income those holdings generate.
The income earned through these investments is shared by its unit holders in proportion to the number of units owned by them. 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 basket of securities at a relatively low cost.
Investments in securities are spread across a wide cross section of industries and sectors and thereby reduce the risk. Asset Management Companies (AMCs) normally come out with a number of schemes with different investment objectives from time to time. A mutual fund is required to be registered with the Securities and Exchange Board of India (SEBI), which regulates securities markets before it can collect funds from the public.
Structure of Mutual Funds in India:
In India, mutual funds function as trust created under the Indian Trust Act, 1882. There are three layers of mutual fund in India as follows:
- Sponsor: The sponsor is a person who establishes a mutual fund and gets it registered with Sebi. The sponsor forms the Trust, appoints the Board of Trustees, and has the right to appoint the Asset Management Company (AMC) or the fund manager.
- Trustees: The mutual fund is managed by a Board of Trustees. The trustees act as a protector of unit holders’ interests. They do not directly manage the portfolio of securities and appoint an AMC (with approval of Sebi) for fund management. If an AMC wishes to float additional or different schemes, it will need to be approved by the trustees. Trustees play a critical role in ensuring full compliance with Sebi’s requirements.
- Asset Management Company: The AMC is appointed by trustees for managing fund schemes and corpus. An AMC functions under the supervision of its own board of directors and also under the directions of trustees and Sebi. The market regulator has mandated the limit of independent directors to ensure independence in AMC workings.
The other constituents are:
- Custodian and depositories: The fund management includes buying and selling of securities in large volumes. Therefore, keeping a track of such transactions is a specialist function. The custodian is appointed by trustees for safekeeping of physical securities while dematerialised securities holdings are held in a depository through a depository participant. The custodian and depositories work under the instructions of the AMC, although under the overall direction of trustees.
- Registrar and transfer agents: These are responsible for issuing and redeeming units of the mutual fund as well as providing other related services, such as preparation of transfer documents and updating investor records. A fund can carry out these activities in-house or can outsource them. If it is done internally, the fund may charge the scheme for the service at a competitive market rate.
Advantages of Mutual Funds:
Mutual funds hire full-time, high-level investment professionals. Funds can afford to do so as they manage large pools of money. Mutual funds are managed by fund managers generally with knowledge and experience whose time is solely devoted to tracking and updating the portfolio. They have real-time access to crucial market information and are able to execute trades on the largest and most cost-effective scale. Thus investment in a mutual fund not only saves time and effort for the investor but is also likely to produce better results.
Diversified investment improves the risk return profile of the portfolio. Optimal diversification has limitations due to low liquidity among small investors. The large corpus of a mutual fund as compared to individual investments makes optimal diversification possible. Due to the pooling of capital, individual investors can derive benefits of diversification.
Low Transaction Costs:
Mutual fund transactions are generally very large. These large volumes attract lower brokerage commissions and other costs as compared to smaller volumes of the transactions that individual investors enter into.
Choice of products & assets:
There are four basic types of mutual funds based on the asset class they invest in: equity, bond, hybrid and money market. Further, within each asset class there are further choices of products. For any investment objective of any investor, the choice of the products available are many.
Liquidating a portfolio is not often easy and you have to rely on the market liquidity for the security. A mutual fund house stands ready to buy and sell its units at any point of time. Thus it is easier to liquidate holdings in a Mutual Fund as compared to direct investment in securities. There are however also products like close-ended funds or intervals funds which have restrictions on the buy and sell transactions.
In India dividend received by investors is tax-free. This enhances the yield on mutual funds marginally as compared to income from other investment options. Also in case of long-term capital gains, the investor benefits from indexation and lower capital gain tax. Investments in the ELSS schemes qualifies under the section 80 C.
There are many flexibilities available in terms of payment and credit modes, investing, swtiching and withdrawing from the portfolio like SIP, SWP, STP and Switch with different frequency options. The schemes also offer flexibilities in the nature of plan – with dividend payout, reinvestment and growth options. There are virtually no restictions on the amount, period, product type, plan choices you can make.
Well Regulated & Transparent:
All mutual funds are registered with SEBI and they function within the provisions of strict regulations designed to protect the interest of investors. The SEBI regularly monitors the operations of an AMC. There is high degree of disclosures and transparency also. You get regular information on the value of your investment in addition to disclosure on the specific investments made by the mutual fund scheme. You can also track your investments on a daily basis.
Operationally, there is a lot of convenience and ease in transacting with mutual funds. All your holdings and fund accounting is managed by high quality custodians and registrars. You may make use of auto-debit mandates, ECS, etc. to make & schedule investments. The redemption proceeds, dividends can be automatically credited into your accounts within few days of the transaction. Mutual funds are also available on the stock exchange and you can do transactions through online and other modes in a paper-less manner.
Open to everyone:
Any rich or poor person can invest in mutual funds. Often you can even start a SIP with amount as low as Rs.500/-. There is no upper limit on the amoun of investment you can make. Most other government backed investment products in the market have these restrictions. Any person – be it individual, trusts, firms or companies can invest in mutual funds.
Different Types of Funds:
Schemes according to Maturity Period:
- Open-ended Fund/ Scheme: An open-ended fund or scheme is one that is available for subscription and repurchase on a continuous basis. These schemes do not have a fixed maturity period. Investors can conveniently buy and sell units at Net Asset Value (NAV) related prices which are declared on a daily basis. The key feature of open-end schemes is liquidity.
- Close-ended Fund/ Scheme: A close-ended fund or scheme has a stipulated maturity period e.g. 5-7 years. The fund is open for subscription only during a specified period at the time of launch of the scheme. Investors can invest in the scheme at the time of the initial public issue and thereafter they can buy or sell the units of the scheme on the stock exchanges where the units are listed. In order to provide an exit route to the investors, some close-ended funds give an option of selling back the units to the mutual fund through periodic repurchase at NAV related prices. SEBI Regulations stipulate that at least one of the two exit routes is provided to the investor i.e. either repurchase facility or through listing on stock exchanges. These mutual funds schemes disclose NAV generally on weekly basis.
- Interval – Operating as a combination of open and closed ended schemes, it allows investors to trade units at pre-defined intervals.
Schemes according to Investment Objective:
- Growth / Equity Oriented Scheme: The aim is to provide capital appreciation over the medium to long- term. Such schemes normally invest a major part of their corpus in equities and have comparatively high risks. These schemes provide different options to the investors like dividend option, capital appreciation, etc. and the investors may choose an option depending on their preferences. These schemes are good for investors having a long-term outlook seeking appreciation over a period of time.
- Income / Debt Oriented Scheme: The aim of income funds is to provide regular and steady income to investors. Such schemes generally invest in fixed income securities such as bonds, corporate debentures, government securities and money market instruments. Such funds are less risky compared to equity schemes and are not affected because of fluctuations in equity markets. However, opportunities of capital appreciation are also limited in such funds. The NAVs of such funds are affected because of change in interest rates in the country. If the interest rates fall, NAVs of such funds are likely to increase in the short run and vice versa. However, long term investors may not bother about these fluctuations.
- Money Market or Liquid Fund: These funds are also income funds and their aim is to provide easy liquidity, preservation of capital and moderate income. These schemes invest exclusively in safer short-term instruments such as treasury bills, certificates of deposit, commercial paper and inter-bank call money, government securities, etc. Returns on these schemes fluctuate much less compared to other funds. These funds are appropriate for corporate and individual investors as a means to park their surplus funds for short periods.
- Hybrid / Balanced Funds: The aim of balanced funds is to provide both growth and regular income as such schemes invest both in equities and fixed income securities in the proportion indicated in their offer documents. These are appropriate for investors looking for moderate growth. They generally invest 40-60% in equity and debt instruments. These funds are also affected because of fluctuations in share prices in the stock markets. However, NAVs of such funds are likely to be less volatile compared to pure equity funds. There are also MIP products which invest anywhere between 5% to 20% of the portfolio into equities.
Some specific type of funds based on underlying asset class /security choices:
- Gilt Fund: These funds invest exclusively in government securities. Government securities have no default risk. NAVs of these schemes also fluctuate due to change in interest rates and other economic factors as is the case with income or debt oriented schemes.
- Index Funds: Index Funds replicate the portfolio of a particular index such as the BSE Sensitive index, S&P NSE 50 index (Nifty), etc. These schemes invest in the securities in the same weightage comprising of an index. NAVs of such schemes would rise or fall in accordance with the rise or fall in the index, though not exactly by the same percentage due to some factors known as “tracking error” in technical terms. There are also exchange traded index funds launched by the mutual funds which are traded on the stock exchanges.
- Sector specific funds/schemes: These are the funds/schemes which invest in the securities of only those sectors or industries as specified in the offer documents. e.g. Pharmaceuticals, Software, Fast Moving Consumer Goods (FMCG), Petroleum stocks, etc. While these funds may give higher returns, they are more risky compared to diversified funds. Investors need to keep a watch on the performance of those sectors/industries and must exit at an appropriate time. They may also seek advice of an expert.
- Fund of Funds (FoF) scheme: A scheme that invests primarily in other schemes of the same mutual fund or other mutual funds is known as a FoF scheme. An FoF scheme enables the investors to achieve greater diversification through one scheme. It spreads risks across a greater universe.
- Capital Protection: The primary objective of this scheme is to safeguard the principal amount while trying to deliver reasonable returns. These invest in high-quality fixed income securities with marginal exposure to equities and mature along with the maturity period of the scheme.
- Fixed Maturity Plans (FMPs): FMPs, as the name suggests, are mutual fund schemes with a defined maturity period. These schemes normally comprise of debt instruments which mature in line with the maturity of the scheme, thereby earning through the interest component (also called coupons) of the securities in the portfolio. FMPs are normally passively managed, i.e. there is no active trading of debt instruments in the portfolio. The expenses which are charged to the scheme, are hence, generally lower than actively managed schemes.
- Tax Saving – As the name suggests, this scheme offers tax benefits to its investors. The funds are invested in equities thereby offering long-term growth opportunities. Tax saving mutual funds, called Equity Linked Savings Schemes – ELSS has a 3-year lock-in period.