I hope that you could manage to go through last week’s post about investment avenues. If you really did, you are highly likely to find this post interesting.
Let me tell you, rather bluntly, that what you will be seeing in the lines below, may sound little academic, rather class-room types, but trust me, sometimes it’s indispensable. On that note, wish you a happy reading!
Mutual funds came to public attention only in the late 1980’s or so, when fund investments touched new highs and their returns sky-rocketed. Just as other great inventions, the mutual fund (hereafter, MF) has had rather humble beginnings. People often cite the birth of the first MF in Netherlands, at the hands of a Dutch merchant Adriaan van Ketwich in 1774. You will be surprised to know that Ketwich named his fund ‘Eendragt Maakt Magt’, which translates to ‘unity created strength’ in English. You will soon see why.
What are Mutual Funds?
Mutual Funds represent a collection of small savings of several different investors that are invested together by a professional mutual fund manager. This means that while the money or the saving is yours, you don’t get to choose where to invest directly, primarily because of lack of time or expertise or both on your part. This lacuna is overcome by the appointment of an investment expert (called the MF Manager) who shall decide where to invest the total pool of funds, in a manner that generates the maximum return on the amount invested. Whatever is earned is passed on to investors, after deducting some amount for the manager’s fee and other fund expenses. Simple.
Are all Mutual Funds the same?
No, they are not.
Every fund has its own stated objective (mentioned clearly on its offer document, also called the Prospectus), which its manager is expected to pursue. For instance, some funds may aspire to achieve growth, while others may look for periodic cash returns etc.
Given that different funds have different investment objectives and strategies, every investor has a great variety to choose from, in terms of his own risk preferences and investment objective.
Advantages of Mutual Funds:
Personally speaking, I believe that MFs are the way forward for almost every economy of the world today, given their massive potential to tap into small household savings and meaningful, professional investment.
Some advantages of MFs can be summed up as under:
1. Professional management: Most small investors comprising people like you and me, lack the expertise to identify safe and viable investment options. This is addressed by MFs through their hiring of professional fund managers, who are expected to choose the best investment options, keeping the broad investment objective of the fund in mind. In fact, not only are funds expected to disclose the names of their fund managers in their reports to investors, past performance of other funds managed by the same manager can also be found. This can act as an important factor in deciding whether one’s money is in safe hands. Also, one should, as far as possible, stay away from funds that have had frequent changes in their fund manager over time.
2.Economies of scale: Just as in case of any other investment, MF investment too entails several costs, such as entry and exit loads, transaction costs on purchase and sale of securities etc. The pooling from a large pool of investors has the effect of dividing these costs over all of them, thereby reducing investment costs per person, compared to investing on one’s own.
3.Diversification: Has anyone ever told you to “not put all your eggs in the same basket?” If not, let me tell you that today. By putting all our eggs (think of your savings) in the same basket (think of a particular share or bond), we risk losing everything if something goes wrong with that one avenue of ours. MFs allow you to invest in a variety of securities in different sectors and industries, thereby insulating you from excess exposure to a particular stock or sector. Even if one sector does badly, some other sector may end up doing well, guaranteeing you your average expected return. This is called ‘diversification’.
4.Liquidity: Just like a savings bank accounts, most MFs provide almost hundred percent liquidity, allowing you to withdraw your money from the fund, at any point of time.
5.Simplicity: Once entered into, MFs are easy to track and review. Periodic statements from funds come in handy in deciding whether to continue with the fund or exit.
6.Regularity in savings: Most people believe that only the rich, or those with large amounts of savings can invest in MFs. This is, however, only a myth. Most MFs provide you the option of a Systematic Investment Plan (SIP) that enables you to invest an amount as small as Rs. 500 every month to the fund. This encourages regularity in savings, without hurting the pocket.
7.Tax benefits: Certain MFs, also called Equity-Linked Savings Schemes (ELSS) provide tax benefits on sums invested in funds under section 80C of the Income Tax Act, 1961.
Disadvantages of Mutual Funds:
1.Agency problem: This stems out of the fact that sometimes, the fund manager may not work in the best interest of the investors, whose money he is managing. He may feel that despite poor fund performance, he may continue to be paid his fees. This creates adverse incentives. However, choosing funds managed by reputed managers may alleviate this concern considerably.
2.High costs: Maintaining and running a MF is a costly affair. Everything, ranging from the manager’s fee to the cost of printing periodic fund performance statements entail costs, which is ultimately passed on to the investors.
Types of Mutual Funds:
While there are a hundred varieties of these funds, it may be helpful to understand the broad classes of funds:
A.Based on investment strategy:
1.Equity funds: These is the most common fund type, representing those that invest their entire corpus of funds into buying shares (also called stocks) of other companies. These can further have sub-types such as index funds, specialty funds etc., discussed in subsequent sections.
2.Fixed-income funds: Remember debt instruments from the previous post? To help you recall, Debt comprises instruments such as corporate bonds and debentures that help generate periodic interest payments, without significant risk to the principal amount invested. These funds invest their entire corpus in fixed-income or debt securities, thereby assuring their investors of fixed cash inflows (through interest) and low risk to the amount invested. Given the certain cash flows, these are often preferred by the retired population or pensioners.
However, here too there’s a catch. Please remember that not all bonds are safe! There are also bonds that represent money-raising by highly risky companies who may not be able to even return your capital, forget the promised interest. Such high-risk bonds are often referred to as ‘junk’ bonds. Good name, right?
3.Money Market funds: These involve investing in very short term debt instruments such as Treasury bills. Without much damage to your brain cells, simply try to remember that Treasury bills are certificates issued by the Government, making them almost hundred percent safe, in terms of expected recovery of both principal and interest. These funds therefore, offer you safety of your money, albeit with comparatively low returns (does this ring a bell? Remember the risk-return trade-off?).
4.Hybrid funds: This in itself is no category. It simply implies an investment strategy in more than one category mentioned above. For instance, think of a fund that invests 70% of its money in equity and the balance in debt. That’s what a ‘hybrid’ fund is.
B.Based on investment focus:
1.International fund: As the name suggests, these funds focus only on investing in stocks of foreign companies. They must, however, be distinguished from Global funds, which invest in any part of the globe, including your own country. Some people are of the view that such types of funds are more risky than domestic funds, given the political risks associated with different economies.
2.Regional funds: While these may sound similar to International funds, they have a uniqueness of their own. These represent funds with a particular geographical focus, such as investment in only the Latin American region or say, the western parts of Germany etc.
3.Sector funds: These invest only in particular sectors of the economy, such as banking, automobile, financial services, manufacturing etc. Given their narrow focus on particular sectors, their performance depends directly on that of their respective sectors, making them highly risky and volatile.
4.Socially-responsible funds: Also known as ‘ethical’ funds, these try to strike a balance between profitability and ethical standards, by choosing not to invest in specific industries such as tobacco, nuclear power and alcoholic beverages.
C.Based on liquidity:
1.Open-end funds: This is the most common category of funds. These, being the most liquid, allow an investor to ‘cash-out’ at any time, i.e. withdraw his funds by returning the units held to the fund, at any point of time, at the Net Asset Value (NAV, explained later).
2.Closed-end funds: Unlike open-end funds, these issue units only once through an Initial Public Offering (IPO). While you can enter only at the time of the IPO, you can ‘cash-out’ only when you have been able to identify a buyer for your units. This means that you can transfer your units to another person and not to the fund itself.
3. Exchange-traded funds (ETFs): These combine the features of open-end and closed-end funds, representing funds whose units are listed (just like shares) on an exchange. Listing ensures high liquidity – you are almost always sure of finding yourself a buyer when you wish to sell and a buyer when you with to enter the fund.
I have used this residual category to include funds which, I felt, did not fit in any of the categories above:
1.Index Funds: These represent funds that have a rather simple and clearly-stated investment objective – to beat a particular market benchmark, such as the Dow Jones Industrial Average (DJIA) or the SENSEX. Given this, the investment manager simply attempts to replicate the market index. These funds are often associated with low fund fees.
2.Balanced funds: These typically fall in the category of ‘hybrid’ funds, as they combine the high-return feature of Equity with the safety feature of Debt. A typical fund of this class may divide its assets between Equity and Debt Instruments in a 60:40 ratio.
Some terms you may want to know:
Just like every other subject, the MF business has its own terminology. While it may run into several pages, let me talk to you about only two of them, which I deem to be most crucial:
1.Net Asset Value (NAV): This is a metric used to evaluate the financial health of a fund over time, or simply to compare several funds. It refers to the difference between the market value of the assets of the fund and its liabilities (hence the term NET assets), divided by the number of unites of the fund outstanding . Note that units of a fund represent something very similar to shares of a company. Investors park money in a fund through purchase of its units. Every unit-holder is a part-owner in the fund.
2.The Expense Ratio (TER): Just like the NAV for performance measurement, the TER helps an investor understand how costly the operations of a fund are. It usually comprises expenses such as manager’s fee, administrative costs, marketing costs of the fund etc. Higher the TER, lower the returns to the investor.
As we end:
MFs are a powerful tool, offering something for everyone. All one needs is clarity of investment objectives and scepticism in selecting the right product for oneself, to be able to gradually advance towards a more secure future.
Once again, I apologise for the humongous size of the document, but you know it’s difficult to keep shut, particular when you know that omission of an important concept may inhibit understanding for the reader. Also, with this post, I think that the Personal Financial Management series is gradually drawing to a close with may be another couple of posts on say taxation and budgeting.
I would love to hear from you – any suggestions and feedback is welcome!
Thank you for reading. See you next week.
Image taken from Google images.