Mutual funds are investment companies that pool money from investors at large, and offer to sell and buy back its shares on a continuous basis. The capital raised is then used to invest in securities of different companies.
A Brief of How Mutual Funds Work
Mutual funds can be either or both of open ended and closed ended investment companies depending on their fund management pattern. An open-end fund offers to sell its shares (units) continuously to investors, either in retail or in bulk without a limit on the number, as opposed to a closed-end fund. Closed-end funds have a limited number of shares.
Mutual funds have diversified investments spread in calculated proportions amongst securities of various economic sectors. Mutual funds get their earnings in two ways. First is the most organic way, which is the dividend they get on the securities they hold. Second is by the redemption of their shares by investors will be at a discount to the current NAVs (net asset values).
Worldwide, the Mutual Fund, or Unit Trust as it is called in some parts of the world, has a long and successful history. The popularity of the Mutual Fund has increased a lot. In developed financial markets like the United States, Mutual Funds have almost overtaken bank deposits and total assets of insurance funds. As of date, there are over 5,000 Mutual Funds in the US alone, with total assets of over US $ 3 trillion (Rs. 100 lakh crores). In India, the Mutual Fund industry started with the setting up of Unit Trust of India in 1964. Public sector banks and financial institutions began to establish Mutual Funds in 1987. The private sector and foreign institutions were allowed to set up Mutual Funds in 1993. Today, there are 36 Mutual Funds and over 200 schemes with total assets of approximately Rs. 81,000 crores. This fast-growing industry is regulated by the Securities and Exchange Board of India (SEBI).
A Mutual Fund is a trust that pools the savings of a number of investors who share a common financial goal. Anybody with an investable surplus of as little as a few thousand rupees can invest in Mutual Funds. These investors buy units of a particular Mutual Fund scheme that has a defined investment objective and strategy. The money thus collected is then invested by the fund manager in different types of securities. These could range from shares to debentures to money market instruments, depending on the scheme's stated objectives. The income earned through these investments, and the capital appreciations realized by the scheme are 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.
There are a wide variety of Mutual Fund schemes that cater to your needs, like your financial position, risk tolerance and return expectations. Whether as the foundation of your investment program or as a supplement, Mutual Fund schemes can help you meet your financial goals.
(A) By Structure
These do not have a fixed maturity. You deal directly with the Mutual Fund for your investments and redemptions. The key feature is liquidity. You can conveniently buy and sell your units at net asset value (NAV) related prices.
Schemes that have a stipulated maturity period (ranging from 2 to 15 years) are called close-ended schemes. You can invest directly in the scheme at the time of the initial issue and thereafter, you can buy or sell the units of the scheme on the stock exchanges where they are listed. The market price at the stock exchange could vary from the scheme's NAV on depending on the demand and supply, unit holders' expectations and other market factors. One of the characteristics of the close-ended schemes is that they are generally traded at a discount to NAV, but closer to maturity, the discount narrows. Some close-ended schemes give you an additional option of selling your units directly to the Mutual Fund through periodic repurchase at NAV-related prices. SEBI Regulations ensure that at least one of the two exit routes is provided to the investor.
These combine the features of open-ended and close-ended schemes. They may be traded on the stock exchange or may be open for sale or redemption during pre-determined intervals at NAV-related prices.
(B) By Investment Objective
Aim to provide capital appreciation over the medium to long term. These schemes normally invest a majority of their funds in equities and are willing to bear short-term decline in value for possible future appreciation. These schemes are not for investors seeking regular income or needing their money back in the short-term. Ideal for investors in their prime earning years and investors seeking growth over the long-term.
Aim to provide regular and steady income to investors. These schemes generally invest in fixed income securities, such as bonds and corporate debentures. Capital appreciation in such schemes may be limited. Ideal for retired people, investors with the need for capital stability & regular income, and investors who need some income to supplement their earnings.
Aim to provide both growth and income by periodically distributing a part of the income and capital gains they earn. They invest in both shares and fixed income securities in the proportion indicated in their offer documents. In a rising stock market, the NAV of these schemes may not normally keep pace, or fall equally when the market falls. Ideal for investors looking for a combination of income and moderate growth.
Money Market Schemes
Aim to provide easy liquidity, preservation of capital and moderate income. These schemes generally invest in safer, short-term instruments, such as treasury bills, certificates of deposit, commercial paper and inter-bank call money. Returns on these schemes may fluctuate, depending on the interest rates prevailing in the market. Ideal for corporate and individual investors as a means to park their surplus funds for short periods, or for investors awaiting a more favourable investment alternative.
Tax Saving Schemes
These schemes offer tax rebates to the investors under tax laws as prescribed from time to time. This is made possible because the Government offers tax incentives for investments in specified avenues like Equity Linked Savings Schemes (ELSS) and Pension Schemes. Recent amendments to the Income Tax Act provide further opportunities to investors for saving capital gains by investing in Mutual Funds. The details of such tax savings are provided in the relevant offer documents. Ideal for investors seeking tax rebates.
This category includes index schemes that attempt to replicate the performance of a particular index, such as the BSE Sensex or the NSE 50, or industry-specific schemes (which invest in specific industries) or sectoral schemes (which invest exclusively in segments such as 'A' Group shares or initial public offerings). Index fund schemes are ideal for investors who are satisfied with a return approximately equal to that of an index. Sectoral fund schemes are ideal for investors who have already decided to invest in a particular sector or segment. Keep in mind that any one scheme may not meet all your requirements at the same time. You need to place your money judiciously in different schemes to be able to get the combination of growth, income and stability that is right for you. Remember, as always: higher the return you seek, higher the risk you should be prepared to take. A few frequently used terms are explained here below:
Net Asset Value (NAV)
Net Asset Value is the market value of the assets of the scheme, minus its liabilities. The per unit NAV is the net asset value of the scheme divided by the number of units outstanding on the Valuation Date.
Sale Price Is the price you pay when you invest in a scheme. It is also called Offer Price. It may include a sales load.
Repurchase Price Is the price at which a close-ended scheme repurchases its units and may include a back-end load. This is also called Bid Price.
Redemption Price is the price at which open-ended schemes repurchase their units and close-ended schemes redeem their units on maturity. Such prices are NAV-related.
Sales Load is a charge collected by a scheme when it sells the units. It is also called 'Front-end' load. Schemes that do not charge a load are called 'No Load' schemes.
Repurchase or 'Back-end' Load is a charge collected by a scheme when it buys back the units from the unit holders.
The advantages of investing in a Mutual Fund are:
Professional Management - You avail of the services of experienced and skilled professionals who are backed by a dedicated investment research team, which analyses the performance and prospects of companies and selects suitable investments to achieve the objectives of the scheme.
Diversification - Mutual Funds invest in a number of companies across a broad cross-section of industries and sectors. This diversification reduces the risk, because seldom do all stocks declare at the same time and in the same proportion. You achieve this diversification through a Mutual Fund with far less money than you can do on your own.
Convenient Administration - Investing in a Mutual Fund reduces paperwork and helps you avoid many problems such as bad deliveries, delayed payments and unnecessary follow up with brokers and companies. Mutual Funds save your time and make investing easy and convenient.
Return Potential - Over a medium to long-term, Mutual Funds have the potential to provide a higher return as they invest in a diversified basket of selected securities.
Low Costs - Mutual Funds are a relatively less expensive way to invest compared to directly investing in the capital markets because the benefits of scale in brokerage, custodial and other fees translate into lower costs for investors.
Liquidity - In open-ended schemes, you can get your money back promptly at net asset value related prices from the Mutual Fund itself. With close-ended schemes, you can sell your units on a stock exchange at the prevailing market price or avail the facility of direct repurchase at NAV related prices that some close-ended and interval schemes offer you periodically.
Transparency - You get regular information on the value of your investment in addition to disclosure on the specific investments made by your scheme, the proportion invested in each class of assets and the fund manager's investment strategy and outlook.
Flexibility - Through features such as regular investment plans, regular withdrawal plans and dividend reinvestment plans, you can systematically invest or withdraw funds according to your needs and convenience.
Choice of Schemes – Mutual Funds offer a family of schemes to suit your varying needs over a lifetime.
Well Regulated. All Mutual Funds are registered with SEBI and they function within the provisions of strict regulations designed to protect the interests of investors. The operations of Mutual Funds are regularly monitored by SEBI.
All investments, whether in shares, debentures or deposits involve risk; share value may go down depending on the performance of the company, the industry, state of capital markets and the economy. Generally, however, the longer the term, lesser the risk; companies may default in payment of interest/ principal on their debentures/bonds/deposits; the rate of interest on an investment may fall short of the rate of inflation, thereby reducing the purchasing power. While the risk factor cannot be eliminated, skillful management can minimize it. Mutual Funds help to reduce risk through diversification and professional management. The experience and expertise of Mutual Fund managers in selecting fundamentally sound securities and timing their purchases and sales help them build a diversified portfolio that Minimizes risk and maximizes returns.
Step One - Identify your investment needs.
Your financial goals will vary, based on your age, lifestyle, financial independence, family commitments, level of income and expenses, among many other factors. Therefore, the first step is to assess your needs. Begin by asking yourself these questions:
What are my investment objectives and needs?
Probable Answers: I need regular income, or need to buy a home, or finance a wedding, or educate my children, or a combination of all these needs.
How much risk am I willing to take?
Probable Answers: I can only take a minimum amount of risk, or I am willing to accept the fact that my investment value may fluctuat,e or that there may be a short-term loss in order to achieve a long-term potential gain.
What are my cash flow requirements?
Probable Answers: I need a regular cash flow, or I need a lump sum amount to meet a specific need after a certain period, or I don't require a current cash flow but I want to build my assets for the future. By going through such an exercise, you will know what you want out of your investment and can set the foundation for a sound Mutual Fund investment strategy.
Step Two - Choose the right Mutual Fund.
Once you have a clear strategy in mind, you now have to choose which Mutual Fund and scheme you want to invest in. The offer document of the scheme tells you its objectives and provides supplementary details like the track record of other schemes managed by the same Fund Manager. Some factors to evaluate before choosing a particular Mutual Fund are: the track record of performance over the last few years in relation to the appropriate yardstick and similar funds in the same category, how well the Mutual Fund is organized to provide efficient, prompt and personalized service and the degree of transparency as reflected in frequency and quality of their communications.
Step Three - Select the ideal mix of Schemes.
Investing in just one Mutual Fund scheme may not meet all your investment needs. You may consider investing in a combination of schemes to achieve your specific goals. The charts could prove useful in selecting a combination of schemes that satisfy your needs.
Step Four - Invest regularly
For most of us, the approach that works best is to invest a fixed amount at specific intervals, say every month. By investing a fixed sum each month, you buy fewer units when the price is higher and more units when the price is low, thus bringing down your average cost per unit. This is called rupee cost averaging, which is a disciplined investment strategy followed by investors all over the world. With many open-ended schemes offering systematic investment plans, this regular investing habit is made easy for you.
Step Five - Keep your taxes in mind
If you are in a high tax bracket and have utilized fully the exemptions under Section 80L of the Income Tax Act, investing in growth funds that do not pay dividends might be more tax efficient and improve your post-tax return. If you are in a low tax bracket and have not fully utilized the exemption available under Section 80L, selecting funds paying regular income could be more tax-efficient. Further, there are other benefits available for investment in Mutual Funds under the provisions of the prevailing tax laws. You may therefore consult your tax advisor or Chartered Accountant for specific advice.
Step Six - Start early
It is desirable to start investing early and sticking to a regular investment plan. If you start now, you will make more than if you wait and invest later. The power of compounding lets you earn income on income and your money multiplies at a compounded rate of return.
Step Seven - The final step
All you need to do now is to get in touch with a Mutual Fund or your agent/broker and start investing. Reap the rewards in the years to come. Mutual Funds are suitable for every kind of investor, whether starting a career or retiring, conservative or risk taking, growth oriented or income seeking.
As a unit holder in a Mutual Fund scheme coming under the SEBI (Mutual Funds) Regulations, ("Regulations") you are entitled to:
Receive unit certificates or statements of accounts confirming your title within 6 weeks from the date of closure of the subscription, or within 6 weeks from the date your request for a unit certificate received by the Mutual Fund;
Receive information about the investment policies, investment objectives, financial position and general affairs of the scheme;
Receive dividend within 42 days of their declaration and receive the redemption or repurchase proceeds within 10 days from the date of redemption or repurchase;
Vote in accordance with the Regulations to:
Either approve or disapprove any change in the fundamental investment policies of the scheme which are likely to modify the scheme or affect your interest in the Mutual Fund (as a dissenting unit holder, you would have a right to redeem your investments);
Change the asset management company;
Wind up the schemes.
Inspect the documents of the Mutual Funds specified in the scheme's offer document. In addition to your rights, you can expect the following from Mutual Funds:
To publish their NAV in accordance with the regulations: daily, in case of most open-ended schemes and periodically, in case of close-ended schemes;
To disclose your schemes' portfolio holdings, expenses, policy on asset allocation, the Report of the Trustees on the operations of your schemes and their future outlook through periodic newsletters, half- yearly and annual accounts;
To adhere to a Code of Ethics which require that investment decisions are taken in the best interests of the unit holders.