A guide for understanding mutual funds in a simple manner

Every human being has certain needs and many desires. A major part of a human's life is spent in fulfilling these needs, desires as well as few objectives. Unlike animals, food and shelter alone is not sufficient for us. We look for means of comfort and entertainment; and then there are some important objectives too that everyone wishes to achieve, for e.g. a good education for the children, their marriage, etc. Humans work for the fulfillment of these things. Earlier, after spending money on the basic necessities, a person would put rest of it in the savings with a view to use it in the future for the fulfillment of some objective, need or in case of some emergency. We Indians are particularly known in the world for our habit of savings.

But the world has changed a lot since those days when life was very simple, resources were in abundance and needs were few. In the modern times, where the balance between demand and supply often changes and with local economy closely linked with global economic ups and downs, savings is of little value. With the inflation rate of 8 %, the 100 rupee note in the savings would lose its value by 8 % next year. In other words, a person would have to spend more next year than today to procure the same product. Clearly it is not wise to put all the money left after expenses into savings, but to invest it somewhere. There are plenty of investment avenues in the market today. We will be discussing one of the most effective options of them – mutual funds.

What are mutual funds?

As we can see, mutual fund consists of two words – mutual and fund. Mutual means common or shared and fund refers to a pool of money to be used for a specific objective. So basically mutual fund refers to a common reservoir of fund i.e. it has been created by pooling investments from different parties. Now a basic question arises – what is the need of any such pool of funds? Let's assume that a person is able to save 1000 rupees every month (or 12,000 per annum). Now he wishes to invest this money and get suitable returns over a period of time. The problem is that 12,000 is too little a sum to get a good return if not invested for a pretty long period. Let's assume that there are 100 such persons with an annual saving of 12,000. If they pool in their funds, the total sum for the investment would be 12,000 x 100 = 12, 00,000. If this huge amount is invested somewhere, then it has a capability of earning a great return and every person will have a share in it as per his investment. Mutual funds work the same way. The money is collected from the different investors and then the whole fund is invested in different financial instruments capable of generating high returns in the future. Each investor has a share in the return depending upon the investment he has made.

Mutual funds in India

Before gaining further knowledge about mutual funds, it is imperative to know the present situation of the mutual fund industry. The industry was relatively unknown to the investor fraternity till the entry of the private players in 1993 (mutual funds had begun in India in 1963). The industry slowly gained foothold in India and had gathered momentum by mid 2000s. But the recession of 2008 and subsequent economic conditions globally and in India had a negative impact on mutual funds in India. The industry had not matured before the crisis and so it is still weathering the adversities. But here blaming the economic conditions and AMCs alone would be wrong. The average Indian investor too needs to take some blame for that.

Indian investor is generally very conservative in nature. For long he has preferred investing in the safer schemes. The situation has changed since 90s but still a large population avoids taking any sort of risk. Mutual funds by nature are moderately risky as the returns are not guaranteed in it like a FD. Naturally people are averse to putting money in any such scheme where there is a risk of losing some part of principal. What they forget is that there are no great returns without taking small amount of risk.

There is another set of investors who think of getting richer overnight. There is no magic wand that may double one's money in the matter of few days. Stock market is capable of giving high returns in smaller duration, but it is also highly risky and one can end up losing a huge chunk of his investment even in a single day. The investors willing to get rich quickly are the most skeptical as well and have a very short term vision too. They are the first ones to pull out their money or stop investing in mutual funds even if there is a small hiccup in the market.

An investor needs to understand that each investment avenue works in a particular fashion and it needs time. In mutual funds too sometimes returns take some time to come, but often the returns are much more than generated by the traditional investment schemes. One should not get deterred by the minor fluctuations and cyclic changes in the market. Remember patience is as important in investment as the choosing the correct scheme to invest.

How mutual funds work?

We had a general idea about mutual funds above. Now the next step is to understand how the mutual fund works? The very first word that comes to our mind upon mentioning mutual fund is AMC i.e. Asset Management Company. The mutual fund houses are also known as AMC. So ICICI Prudential AMC is in fact a mutual fund house. Mutual fund houses are the ones who design the products (mutual fund schemes) and make all the investment related decisions. The fund manager, who is responsible for portfolio making and managing funds, is appointed by the AMCs.

Now how does an investor invest money? He can either go to the AMC directly, or can invest through the distributor channel of it. A distributor of a mutual fund house may be a bank, like HDFC Bank is a distributor of ICICI Prudential AMC, or can be one of the many IFA i.e. Independent Financial Advisor. An investor can obtain all the relevant information from them before deciding upon where to invest.

One of the important parties between an investor and an AMC is the custodian. Each AMC has a custodian which acts as a third party in the transaction between an investor and an AMC. It is important to note that the flow of funds is through custodian only and AMC has no role to play in it. It is concerned with making important decisions about the fund only. The role of custodian is to safeguard the investors' interest and assure them that their money is not being misused.

Now, when an investor invests in a mutual fund scheme, it is translated into a certain no. of units in the scheme. So, the investor gets the units depending on the investment made. Whenever a new scheme is launched, each unit of the scheme is worth Rs. 10. So if a person is investing Rs. 1000 in the scheme, he will get (1000/10) = 100 units. This value 10 is known as net asset value. We will read about it further.

Fund classification

Mutual funds can be classified in on the basis of various factors. Let's have a look at them one by one –

A. Fund classification on the basis of maturity and freedom of entry/exit to the subscribers.

1. Open-ended fund – These funds don't have any maturity date. Investors can make an entry into the fund or the exit from it anytime i.e. it is 'open' for investment as well as withdrawal anytime. Most of the mutual fund schemes fall into this category.

2. Closed-ended fund – These funds have a fixed maturity. Investors can buy units of a close-ended scheme only during its NFO i.e. New Fund Offering. Once it is over, investors can no longer put money in it. It is 'closed' for any further investment.

3. Interval funds – It combines features of both open-ended and close-ended schemes. They are largely close-ended but become open-ended at pre specified intervals.

B. Fund classification on the basis of flexibility enjoyed by the fund manager

1. Actively managed funds – The fund manager has the flexibility in these funds to choose the investment portfolio. Moreover, these funds needs constant attention and a fund manager needs to 'actively monitor' them and bring changes in the portfolio as and when required.

2. Passive funds – In these funds, investment is made on the basis of a specified index, whose performance it seeks to track. So it tends to mirror the performance of the concerned index. Fund manager don't have much active role to play in the passive funds.

C. Classification on the basis of investment objective

The money collected from the investors can be invested in the variety of financial instruments. They can be divided into three – debt, equity and hybrid.

1. Debt fund – In these funds, the investment is predominantly made in the debt instruments like commercial papers, certificate of deposits, Treasury bills etc. A debt fund can be a pure debt fund or can have a small percentage of equity shares as well. The purpose of inclusion of equity is to give the 'leverage' or that extra mile to the investor so that he can earn than what a traditional investor through buying individual debt instruments.

2. Equity funds – In it, the investment to a large basis (65% and more) is made in the equity. Debt instruments make up the rest of the portfolio. They make the scheme little less risky by creating a diversified portfolio.

3. Hybrid funds – It provides for a reasonable level of investment in both equity and debt. The investment is not necessarily in equal ratio, but each of them is given due importance in the portfolio.

Mutual funds terminology

New investors often become confounded by the terminology used in the mutual fund schemes. Abbreviations like NAV, AUM, and SIP etc. often confuse them. So here I am discussing few important terms used in the mutual funds.

1. AUM – Assets under management refer to the total value of the assets being managed by an AMC. The relative size of an AMC is measured by the AUM under it. For e.g. HDFC mutual fund is the top mutual fund house in the country with an AUM of around 93 thousand crores.

2. NAV – Net asset value refers to the value of each unit of the scheme. It is calculated by dividing unit holders' funds in the scheme by the no. of units. When a scheme comes out with an NFO, the NAV by default is 10. As the time goes on and additions and withdrawals from the fund take place, the NAV keeps on changing. That's why all the AMCs in the country declare the NAV of their different schemes daily. A person investing in a continuing open ended fund will get the no. of units based on the NAV that day. Similarly a person withdrawing his money from the scheme shall be given a return based on the NAV of that particular day.

3. CAGR – Compounded annual growth rate is a business and investing specific term for the smoothed annualized gain of an investment over a given time period. The year to year based returns are often inaccurate and misleading. A CAGR is a more correct measure of the returns given by any scheme. The fact sheets of AMCs give CAGR of each scheme since inception along with returns on the yearly basis to facilitate the correct investment decision.

4. SIP – Systematic investment plan is something similar to the recurring deposits of banks. It is an investment strategy wherein an investor invests a fixed amount of money every month.

5. Growth, dividend and dividend reinvestment – Any investor putting money in the mutual funds has three options at his disposal – growth, dividend and dividend reinvestment. Growth option is conducive for the people seeking wealth creation. The money keeps on growing in the funds and after a time deemed suitable by the investor, he can pull out his principal with return. In dividend option, the investor is paid some dividend every month. The objective of wealth creation takes a back seat here as the investor is being paid on regular intervals. In the last option, the dividend declared is invested back into the scheme, instead of paying it to the investor, thus dividend reinvestment.

Investment strategy

Money can be invested in two ways in most of the mutual fund schemes. Either a lumpsum investment can be made or a systematic investment can be made at regular intervals. Lumpsum investment is better for those who have a significant amount of money to invest. Close ended schemes are conducive for this mode of investment because it ceases to accept money once NFO closes. But the majority of the retail investors in India don't have that kind of luxury. Often they don't have money in bulk to invest. The systematic mode of investment or Systematic Investment Plan, often used in its abbreviated for SIP, is the best way to go for the retail investors.

SIP is not just a suitable mode of investment but much more than that. The primary motive of SIP is to provide the investor with a flexibility to invest, but equally important is the fact that it averages purchasing cost. It is particularly handy for equity schemes. In equity market it can happen that a year later market index, after frequent ups and downs whole year, ends up near about the same point where the investor had invested money. So, even after a year the investor won't be able to earn anything on his investment. But a person investing through SIP in a mutual fund will earn even in this case too. This is because of rupee cost averaging. Let's try to understand it.

When the market is down, things are cheaper and vice-versa. Same goes with the equity funds. When market is up, the fixed money that you are investing will be able to get you few units but in the bearish market, the same amount would fetch you more units. This averaging ultimately proves beneficial for the investor as the accumulated units give him decent returns even if the equity market wouldn't have given significant return in past one year. So we can see how SIP is advantageous to an average retail investor.

Advantages and disadvantages of mutual funds

Now let's us have a look at the various advantages and disadvantages related to the mutual funds.

Advantages

1. The funds are professionally managed in case of mutual funds. The decision of investment lies with the fund manager whose only job is to keep an eye on the market and analyze the data regularly to decide where and how to invest the money pooled in from the investors. With many years of experience behind them and a thorough research with an access to all kinds of information helps fund managers to make a prudent decision on the behalf of all the investors. A single investor, who has various other commitments in life, can't be expected to

2. Portfolio diversification is the second biggest advantage with the mutual funds. There is an old saying that all the eggs shouldn't be placed in one basket. There is always the danger of losing all of them. Portfolio diversification ensures that the investor doesn't lose all of his money even in the most conditions. It is because the money is invested in equity and debt, and even in equity the investment is done across various sectors and different companies. A retail investor, with a trifle amount of money in his hands, won't have this kind of luxury.

3. Investors in a mutual fund scheme can recover the value of the money invested, from the mutual fund, either at any time, or during specific intervals. Except for the schemes like FMP which have a fixed maturity period, where the money can be redeemed only after the time period, investors can pull out money whenever they wish to after paying a small charge (no charge if the investment has been for more than a year).

4. The mutual fund industry is regulated by Securities and Exchange Board of India (SEBI). All the AMCs work under the guidelines of SEBI and so the investors needn't worry that their money might have fallen into the wrong hands.

5. Another great advantage that mutual funds offer to the retail investors is that they can invest their money in the systematic manner. Systematic Investment Plan or SIP is the way through which an investor can regularly invest money over a long period of time. Systematic Withdrawal Plan and Systematic Transfer Plan allow the investor to pull out his money at anytime or move the money from the present scheme to some other scheme anytime.

6. Mutual funds offer schemes that have taxation benefits associated with them. So it is beneficial as a tax saving tool too.

Disadvantages

There are two major disadvantages associated with the mutual funds. Let's have a look at them

1. Mutual funds are moderately risky and most of the schemes carry higher risk than many of the traditional investment schemes like post office schemes, fixed deposits, recurring deposits etc.

2. There are many types of mutual fund schemes in the market, which is good, but in the hindsight it is also very confusing for the investors. An average retail investor finds it very difficult to understand the investment objective and horizon associated with different types of the schemes. Also there are many technical terms associated with mutual funds and the fact sheet given by the AMCs is often very scary to even give a glance for the average investor. This has one of the main reasons that mutual fund industry has not been able to really click in India.

How to decide in which mutual fund scheme to invest

Now that we have understood what is mutual fund, what are different types of funds and different advantages and disadvantages associated with the mutual funds, it is time to move towards the most important question – how to decide in which investment scheme one should invest?

There are plethora of AMCs with different mutual fund schemes. Many of them have been performing well, but the money to be invested is limited in most of the cases for the retail investors. The trouble is where to invest and how long to invest? This is the most crucial aspect of investment in mutual funds. If one is not clear about it then he won't be able to reap any benefits from the investment in mutual funds. Two important concepts come in here – investment objective and investment horizon.

Investment objective refers to why one is investing in the first place? An investment is driven by a no. of factors like wealth creation, regular income, a fixed income after a period of time or tax benefits. Different mutual fund schemes cater to different investment objectives. An investor should be very clear about his investment objective and go for the mutual fund scheme accordingly. If he is interested in getting a decent return post a fixed time period then he shouldn't invest in equity based schemes.

Investment horizon is equally important. It refers to the time period of the investment. Each mutual fund scheme has an indicated investment horizon over which it is expected to give a good return. A person, who can invest his money for a small time period only, say less than a year, should not go for a scheme with an investment horizon of more than a year.

I have not included investment risk level involved here as mutual funds schemes, in general, are moderately risky with equity schemes on little higher side of the risk for the obvious reasons. The risk level is useful while comparing mutual funds with other investment avenues available.

Let's now discuss few types of mutual fund schemes on the basis of investment objective and investment horizon.

Equity schemes are suitable for the persons seeking wealth creation over a long period of time i.e. 3 years and more. Though the dividend option is available with the investor, it is advisable that one should go for growth option. Even in equity schemes, there is investment in growth based funds and value based funds. The value based funds require a little more investment horizon. A person who can't park his money for long term should not go for these schemes.

For the persons seeking a risk free decent return after a fixed time period should go for Fixed Maturity Plans (FMP) offered by different mutual fund houses. This one is a closed fund with a fixed maturity period. The NFO is opened for few days and after the date now new investor is allowed to invest in the fund. The scheme then invests in various debt instruments. The investor gets the return post maturity. The investment horizon varies in it and might be 3 months to little more than a year.

There is a category of investors who invest with a primary motive of getting tax benefits. Mutual funds houses have schemes that cater to this need of the investors as well. In many of these schemes though the money is locked in for a particular period and so the investors should invest keeping in mind that they won't need the money in the near future.

And then there is a category of investors who like getting income every month in the form of dividend. Though most of the mutual fund schemes offer the option of dividend along with the growth to the investors, there is a category of mutual funds which has been designed for this very purpose. MIP or Monthly Income Plans are conducive for the persons interested in a regular income. A word of caution needs to be given here though; like other mutual fund schemes, there is no guarantee of return or regular dividend payment to the investors. So an investor should be ready to bear this kind of risk before investing in it.

Few investors have substantial money at their disposal for a small time period and they wish to invest it to get returns in a very short time period. Liquid funds have been designed for the same purpose. They are basically low risk pure debt fund and have a very small investment horizon, generally given in the form of average maturity period.

I hope the above article would have given an insight into the mutual funds to the newbie investors as well as helped clearing doubts of people who view mutual funds as highly risky.