Basics of Mutual Fund
To many people, Mutual Funds can seem complicated or intimidating. We are going to try and simplify it for you at its very basic level. Essentially, the money pooled in by a large number of people (or investors) is what makes up a Mutual Fund. This fund is managed by a professional fund manager.
It is a trust that collects money from a number of investors who share a common investment objective. Then, it invests the money in equities, bonds, money market instruments and/or other securities. Each investor owns units, which represent a portion of the holdings of the fund. The income/gains generated from this collective investment is distributed proportionately amongst the investors after deducting certain expenses, by calculating a scheme’s “Net Asset Value or NAV. Simply put, a Mutual Fund is one of the most viable investment options for the common man as it offers an opportunity to invest in a diversified, professionally managed basket of securities at a relatively low cost.
Many of us dread the thought of managing our own investments. With a professional fund management company, people are put in charge of various functions based on their education, experience and skills.
As an investor, you can either manage your finances yourself, or hire a professional firm. You opt for the latter when:
1.You do not know how to do the job best – many of us hire someone to file our income tax returns, or almost all of us get an architect to do our house.
2.You do not have enough time or inclination. It’s like hiring drivers even though we know how to drive.
3.When you are likely to save money by outsourcing the job instead of doing it yourself. Like going on a journey driving your own vehicle is far costlier than taking a train.
4.You can spend your time for other activities of your choice / liking
Professional fund management is one of the best benefits of Mutual Funds. The infographic on the left highlights all the others. Given these benefits, there is no reason why one should look at any other investment avenue.
Several questions rest in a potential investor’s mind regarding the ideal amount to invest. People consider Mutual Funds as just another investment avenue. Is it really the case? Is a Mutual Fund just another investment avenue like a fixed deposit, debenture or shares of companies?
A Mutual Fund is not an investment avenue, but a vehicle to access various investment avenues.
Think of it this way. When you go to a restaurant, you have a choice to order a la carte or buffet/thali or a full meal.
Compare the full thali or the meal with a Mutual Fund, whereas individual items you order are the stocks, bonds, etc. A thali makes the choice easy, saves time and also some money.
The important thing is to start investment early, even if small, and gradually add on to your investments as your earnings increase. This gives you better prospects of better returns in the long run.
There is a beautiful Chinese proverb, “The best time to plant a tree was 20 years ago. The second best time is now.”
There is no reason why one should delay one’s investments, except, of course, when there is no money to invest. Within that, it is always better to use Mutual Funds than to do-it-oneself.
There is no minimum age when one can start investing. The moment one starts earning and saving, one can start investing in Mutual Funds. In fact, even kids can open their investment accounts with Mutual Funds out of the money they receive once in a while in form of gifts during their birthdays or festivals. Similarly, there is no upper age for investing in Mutual Funds.
Mutual Funds have many different schemes suitable for different purposes. Some are suitable for growth over long periods, whereas some may be for those in need of safety with regular income, and some provide liquidity in the short term, too.
You see, whatever stage of life one is in, or whatever one’s requirements, Mutual Funds may have solutions for each one.
Invest for long term – an advice routinely given by many Mutual Fund distributors and investment advisors. This is especially true in case of certain Mutual Funds – such as equity and balanced funds.
Let us understand why the professionals give such advice. What really happens in the long term? Is there a benefit of staying invested for long term?
Consider your Mutual Fund investment as a good quality batsman. Every good quality batsman has a certain style of batting. However, each good quality batsman would be able to accumulate lots of runs, if he continues to play for years.
We are talking about the record of a “good quality” batsman. Every good batsman would go through some good and poor performances. On average the record would be impressive.
Similarly, a good Mutual Fund would also go through some ups and downs – often due to factors beyond the control of the fund manager. An investor would benefit if one stays invested through these funds for long periods of time.
So, as long as you can afford, stay invested for long periods of time – especially in equity and balanced funds.
Imagine a 50-overs cricket match in which #6 batsman walks in to bat only in the 5th over. His job is to first ensure he does not lose the wicket, and then focus on scoring runs.
While saving is a must for investing, it is important to save one’s wicket in order to be able to score later. One can save the wicket by playing defensive cricket and avoiding all sorts of shots. But that would result in a very low score. He would need to hit some boundaries by taking certain risks like lofted shots or drives between fielders or cuts and nudges.
Similarly, in order to accumulate large sums to meet one’s financial goals, in order to beat inflation, one must take certain investment risks. Investing is all about taking calculated risks and managing the same, not avoiding the risks altogether.
At the same time, in the cricket analogy, in order to stay at the crease as well as score runs, one must take calculated risks and not play rash shots. Taking unnecessary risks is a bad strategy.
So while saving is necessary, investing is very important to achieve long term.
More about Mutual Funds
Imagine asking a travel agent, “How should I choose my mode of transport?” The first thing he/she will say is, “Depends on where you want to go.” If I were to travel to a distance of 5 kms, an auto rickshaw might be the best option, while for a journey from New Delhi to Kochi, a flight might be the best. A flight would not be available for a short distance and an auto rickshaw would be highly uncomfortable and slow for a long-distance journey.
In Mutual Funds too, the starting point must be- What are your requirements?
It begins with your financial goals and risk appetite.
You’ve got to identify your financial goals, first. Some Mutual Fund schemes are suitable for short term requirements or goals, whereas some might be better for long term goals.
Next comes your risk appetite. Different people would have different risk appetite. Even husband and wife may have joint finances but different risk profiles. Some are comfortable with high risk products, whereas some are just not.
You can get help from financial planners or investment advisers or Mutual Fund distributors to assess your risk appetite.
We have all heard: “Mutual Fund investments are subject to market risks.” Ever wondered what are these risks?
The image on the left talks about the various types of risks.
Not all risks impact all the fund schemes. The Scheme Information Document (SID) helps understand which risks apply to your selected scheme.
So how does the fund management team manage these risks?
It all depends on what type of investments the Mutual Fund has invested in. Certain securities are more sensitive to certain risks and some are exposed to some other.
Professional help, diversification and SEBI’s regulations help mitigate risks in Mutual Funds.
Finally, and the most important question that many investors have asked: Can a Mutual Fund company run away with my money? This is just not possible given the structure of Mutual Funds as well as the strong regulations.
Every individual investor is unique. Not only with regards to investment objectives but even in approach and view of risk. This is what makes Risk Profiling absolutely crucial before investing.
A Risk Profiler is essentially a questionnaire that seeks an investor’s answers to questions about both “ability” and “willingness”.
It is highly recommended that investors contact their Mutual Fund distributor or an investment advisor to complete this task and get to know their Risk Profile.
Risks could be controlled. And Mutual Funds can be rewarding!
When we say “RISK” in investments, a few questions immediately arise in the mind of the investor… “Is my money safe?” ”How much return will I get?” “Will I get my money back when I want it?”… While, all these are very valid questions, let’s look at them from three angles to understand Mutual Funds better
Professional Fund Management – Mutual funds are managed by professional fund managers and as an investor, you benefit from their research and expertise. While this may not completely eliminate risk, it certainly lowers it.
Diversification – Mutual Funds invest in a basket of securities. Diversification helps in minimizing the risk from a specific security’s under-performance.
Select a Scheme In Line With Your Investment Objective – If the time horizon of the investment is in sync with the fund selected, you protect yourself from very short term fluctuations. For example, if you have invested in an Equity Fund, you may be affected by short term fluctuations, but over a longer term, you would be more likely to get the long term returns associated with equities.
Most people believe that Mutual Funds are risky possibly because of the standard disclaimer they come across in the Mutual Fund advertisements. It’s important to remember that the stringent regulations that ensure investor protection, professional fund management and diversification mitigate it to a large extent.
You’ve lent 5 lakhs to your friend who owns a start-up @8% interest (higher than current bank rate of 7%). Even though you’ve known him for years, you still run the risk that he may not return your money on time or may fail to pay back. Also, the bank rate may rise to 8.5% while you are stuck with 8%.
Likewise, Debt Funds invests your money in an interest-bearing securities like bonds and money market instruments. These securities promise to make regular interest payments to these funds. Hence Debt Funds are prone to three major risks like you when you lend money to friends.
- Firstly, since these funds invest in interest-bearing securities, their NAVs fluctuate with changing interest rates (interest rate risk). Prices of these funds fall when interest rates rise and vice-versa.
- Secondly, these funds are subject to credit risk i.e. the risk of not receiving the regular payments from the underlying securities (e.g. bonds) they have invested in.
- In the worst-case scenario, these funds can face default risk where the bond issuer fails to make the promised payment. When a bond in the underlying portfolio of a Debt Funds defaults in its payments, this impacts the interest income component of the fund thereby adversely affecting your total return from the fund.
Type of Funds
Various types of Mutual Funds exist to cater to different needs of different people. Largely, they are of three types.
- These invest predominantly in equities i.e. shares of companies
- The primary objective is wealth creation or capital appreciation.
- They have the potential to generate higher return and are best for long term investments.
- Examples would be
- “Large Cap” funds which invest predominantly in companies that run large established business
- “Mid Cap” funds which invest in mid-sized companies.
- “Small Cap” funds that invest in small sized companies
- “Multi Cap” funds that invest in a mix of large, mid and small sized companies.
- “Sector” funds that invest in companies that are related to one type of business. For e.g. Technology funds that invest only in technology companies
- “Thematic” funds that invest in a common theme. For e.g. Infrastructure funds that invest in companies that will benefit from the growth in the infrastructure segment
- Tax-Saving Funds
2. Income or Bond or Fixed Income Funds
- These invest in Fixed Income Securities, like Government Securities or Bonds, Commercial Papers and Debentures, Bank Certificates of Deposits and Money Market instruments like Treasury Bills, Commercial Paper, etc.
- These are relatively safer investmentsand are suitable for Income Generation.
- Examples would be Liquid, Short Term, Floating Rate, Corporate Debt, Dynamic Bond, Gilt Funds, etc.
3. Hybrid Funds
- These invest in both Equities and Fixed Income, thus offering the best of both, Growth Potential as well as Income Generation.
- Examples would be Aggressive Balanced Funds, Conservative Balanced Funds, Pension Plans, Child Plans and Monthly Income Plans, etc.