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Mutual Fund
Mutual fund is a vehicle to mobilize money from investors, to invest in different markets and securities, in line with the investment objectives agreed upon, between the mutual fund and the investors. In other words, through investment in a mutual fund, an investor can get access to Stock markets that may otherwise be unavailable to them and avail of the professional fund management services offered by an asset management company.
Role of Mutual Funds
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. The mutual fund structure, through its various schemes, makes it possible to tap a large corpus of money from investors with diverse goals/objectives.
Therefore, mutual funds offer different kinds of schemes to cater to the need of diverse investors. Various categories of schemes are called “funds”.
The money that is raised from investors, ultimately benefits governments, companies and other entities, directly or indirectly, to raise money for investing in various projects or paying for various expenses.
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.
Higher employment, income and output in the economy boosts the revenue collection of the government through taxes and other means. When these are spent prudently, it promotes further economic development and nation building.
Why are there different kinds of Mutual Fund Schemes?
Mutual funds seek to mobilize money from all possible investors. Various investors have different investment preferences and needs. In order to accommodate these preferences, mutual funds mobilize different pools of money. Each such pool of money is called a mutual fund scheme.
Every scheme has a pre-announced investment objective. Investors invest in a mutual fund scheme whose investment objective reflects their own needs and preference.
How do Mutual Fund Schemes Operate?
Mutual fund schemes announce their investment objective and seek investments from the investor. Depending on how the scheme is structured, it may be open to accept money from investors, either during a limited period only, or at any time.
The investment that an investor makes in a scheme is translated into a certain number of ‘Units’ in the scheme. Thus, an investor in a scheme is issued units of the scheme.
Typically, every unit has a face value of Rs. 10. (However, older schemes in the market may have a different face value). The face value is relevant from an accounting perspective. The number of units issued by a scheme multiplied by its face value (Rs. 10) is the capital of the scheme – its Unit Capital.
The scheme earns interest income or dividend income on the investments it holds. Further, when it purchases and sells investments, it earns capital gains or incurs capital losses. These are called realized capital gains or realized capital losses as the case may be.
When the investment activity is profitable, the true worth of a unit increases; when there are losses, the true worth of a unit decreases. The true worth of a unit of the scheme is otherwise called Net Asset Value (NAV) of the scheme.
The money mobilized from investors is invested by the scheme in a portfolio of securities as per the stated investment objective. Profits or losses, as the case might be, belong to the investors or unitholders.
The relative size of mutual fund companies is assessed by their assets under management (AUM). When a scheme is first launched, assets under management is the amount mobilized from investors. Thereafter, if the scheme has a positive profitability metric, its AUM goes up; a negative profitability metric will pull it down.
Advantages of Mutual Funds for Investors
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.
Affordable Portfolio Diversification
Investing in the units of a scheme provide investors the exposure to a range of securities held in the investment portfolio of the scheme in proportion to their holding in the scheme. Thus, even a small investment of Rs. 500 in a mutual fund scheme can give investors proportionate ownership in a diversified investment portfolio.
Economies of Scale
Pooling of large sum of money from many investors makes it possible for the mutual fund to engage professional managers for managing investments. Individual investors with small amounts to invest cannot, by themselves, afford to engage such professional management.
Liquidity
At times, investors in financial markets are stuck with a security for which they can’t find a buyer – worse, at times they can’t find the company they invested in! Such investments, whose value the investor cannot easily realize in the market, are technically called illiquid investments and may result in losses for the investor.
Investors in a mutual fund scheme can recover the current value of the money invested, from the mutual fund itself.
Tax Deferral
Mutual funds are not liable to pay tax on the income they earn. Mutual funds offer options, whereby the investor can let the money grow in the scheme for several years. By selecting such options, it is possible for the investor to defer the tax liability. This helps investors to legally build their wealth faster than would have been the case, if they were to pay tax on the income each year.
Tax benefits
Specific schemes of mutual funds (Equity Linked Savings Schemes) give investors the benefit of deduction of the amount subscribed (upto Rs. 150,000 in a financial year), from their income that is liable to tax. This reduces their taxable income, and therefore the tax liability.
Dividends received from mutual fund schemes are tax-free in the hands of the investors. However, dividends from certain categories of schemes are subject to dividend distribution tax, which is paid by the scheme before the dividend is distributed to the investor. Long term capital gains arising out of sale of some categories of schemes are subject to long term capital gains tax, which may be taxed at a different (and often lower) rate of tax or even entirely tax exempt.
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.
Regulatory Comfort
The regulator, Securities and Exchange Board of India (SEBI), has mandated strict checks and balances in the structure of mutual funds and their activities. Mutual fund investors benefit from such protection.
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 money between different kinds of schemes through a Systematic Transfer Plan (STP). Such systematic approaches promote investment discipline, which is useful in long-term wealth creation and protection. SWPs allow the investor to structure a regular cash flow from the investment account.
Limitations of a Mutual Fund
Choice overload
Over 2000 mutual fund schemes offered by 47 mutual funds – and multiple options within those schemes – make it difficult for investors to choose between them.
No control over costs
All the investor’s money is pooled together in a scheme. Costs incurred for managing the scheme are shared by all the Unit-holders in proportion to their holding of Units in the scheme. Therefore, an individual investor has no control over the costs in a scheme. SEBI has however imposed certain limits on the expenses that can be charged to any scheme.
Types of Funds
Equity
Equity represents ownership in the company that has issued the shares to the extent of shares held. Shareholders participate in the management of the company by exercising the voting rights associated with the shares held. They also participate in the residual profits of the company i.e. the profits remaining after all the dues and claims against the company have been met in the form of dividends. In periods of high revenues and profits, the shareholders benefit from high dividends that may be paid to them. However, there is no assurance given to equity holders either that a dividend will be paid or the amount of dividend. A company may not pay a dividend to its shareholders even if there are distributable profits if the management decides to use the profits for expansion plans, paying off debt and other financial activities that is expected to increase the value of the shares of the company. Apart from dividends, equity investors benefit from the appreciation in the value of the shares.
Investment in equity is investment in a growth-oriented asset. The primary source of return to the investor is from the appreciation in the value of the investment. Dividends are declared by the company when there are adequate profits and provide periodic income to the shareholders.
Debt
Debt represents the borrowings of the issuer. Debt as an asset class represents an income-oriented asset. The major source of return from a debt instrument is regular income in the form of interest. The interest is typically known at the time of issue and may be guaranteed either by an undertaking of the government or by security created on the physical assets of the issuer.
The terms of the issue will determine the conditions such as the coupon or interest payable on the debt, the tenor of the borrowing after which the borrower/issuer has to return the principal to the lenders/investors, the security against the assets of the borrower offered as collateral, if any, and other.
Types of Equity Funds
Equity funds invest in equity instruments issued by companies. The funds target long-term appreciation in the value of the portfolio from the gains in the value of the securities held and the dividends earned on it. The securities in the portfolio are typically listed on the stock exchange, and the changes in the price of the securities are reflected in the volatile returns from the portfolio. These funds can be categorized based on the type of equity shares that are included in the portfolio and the strategy or style adopted by the fund manager to pick the securities and manage the portfolio.
Diversified equity fund is a category of funds that invest in a diverse mix of securities that cut across sectors and market capitalization. The risk of the fund’s performance being significantly affected by the poor performance of one sector or segment is low.
Market Segment based funds invest in companies of a particular market size. Equity stocks may be segmented based on market capitalization as large- cap, mid-cap and small-cap stocks.
- Large- cap funds invest in stocks of large, liquid blue-chip companies with stable performance and returns.
- Mid-cap funds invest in mid-cap companies that have the potential for faster growth and higher returns. These companies are more susceptible to economic downturns. Therefore, evaluating and selecting the right companies becomes important. Funds that invest in such companies have a higher risk, since the selected e companies may not being able to withstand the slowdown in revenues and profits. Similarly, the price of the stocks also fall more when markets fall.
- Small-cap funds invest in companies with small market capitalization with intent of benefiting from the higher gains in the price of stocks. The risks are also higher.
Sector funds 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. The performance of such funds can see periods of under-performance and out-performance as it is linked to the performance of the sector, which tends to be cyclical. Entry and exit into these funds need to be timed well so that the investor does not invest when the sector has peaked and exit when the sector performance falls. This makes the scheme more risky than a diversified equity scheme.
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. The investment is thus more broad-based than a sector fund; but narrower than a diversified equity fund and still has the risk of concentration.
Equity Linked Savings Schemes (ELSS) are diversified equity funds that offer tax benefits to investors under section 80 C of the Income Tax Act up to an investment limit of Rs. 150,000 a year. ELSS are required to hold at least 80 percent of its portfolio in equity instruments. The investment is subject to lock-in for a period of 3 years during which it cannot be redeemed, transferred or pledged. However, this is subject to change in case there are any amendments in the ELSS Guidelines with respect to the lock-in period.
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