Beginners Guide to Mutual Funds

Wealthy individuals invest huge amounts in stock market with the help of a financial advisor. The small investors who wish to enter the stock market are hit in the process without the professional advice. Mutual Funds come to the rescue of such investors who have just stepped into the world of stock market and are unaware of the nuances of the trade. Here is a basic guide to help the small investors who have just entered the market to have an overview of this option of investment.

What is a mutual fund?

Mutual fund is basically a financial intermediary that pools the money of its investors to invest in various types of shares, bonds and other securities with a predetermined investment objective. Each investor is the owner of certain number of assets in proportion to their contribution to the entire portfolio. The value of share in the mutual fund is calculated based on the total value of the fund divided by the number of shares held and this is termed as Net Asset Value ( NAV).

Process flow of a mutual fund

Investors pool their funds in a common pool which is in custody of a fund manager. He in turn, invests the funds in different type of securities depending on the nature of the fund. These securities generate returns in the form of capital appreciation, dividends from shares and interest from bonds etc. The returns are passed on to the investor as per his needs.
Mutual Fund Process Flow

Why should people invest in mutual fund?

Mutual Fund is the best investment vehicle ever created for small scale investors. Any individual with surplus money available for investment can invest in mutual funds to gain better than the most common form of investment, fixed deposits. Advantages of investing in a mutual fund are:

Professional management

Professionals invest the money of investors with a lot of analysis and research and the returns are thus, much better than one can invest on their own. A skilled team analyses the financials of every company and the future prospects of each company before investing in the shares of that company. A small investors thus gains from investment through research which would otherwise not be possible for him.

Diversified investment

Investment in mutual funds has investment in diversified assets and industries which reduces risk of loss from one particular security. A wide cross section of industries and sectors are tapped by the fund house to invest the money of the investors. Investors gain by investing small amounts in such variety of industries which would be very difficult if investment were to be done individually.

Cost effectiveness

Entry amount in a diversified portfolio is very less and small amounts can be invested at regular intervals with no or very little trading costs vis-à-vis stock trading which involves very high commissions. Minimum SIP amounts start from Rs.500/- and this is a golden opportunity for an investor to invest in variety of stocks with such low investments and lower costs due to benefits of scale in commission costs, broker costs and other related costs .

Security of funds

The mutual fund regulations have made holdings and transactions transparent. All funds are registered with SEBI who has a regulatory control on them to protect the interest of its investors.

Liquidity

Open ended schemes allow liquidity at net asset value at any time by selling the investment to the fund house. Investors can buy and sell their holdings at NAV at any time during business hours. Closed ended schemes have fixed maturity period and investors buy these funds when they are floated in the market and returns are credited after the end of the tenure of the fund. However, they can sell these investments in the stock market at prevailing market price in close ended schemes.

Different types of mutual funds

The mutual funds are categorized as per their structure and also as per their investment objectives.
Mutual Fund categories

As per structure

Open ended funds

These funds have no maturity period and are open for subscription by investors at any time. Investors can buy and sell units at any time of the tenure of the fund at the prevailing NAV at the end of that day.

Closed ended funds

These funds have a fixed tenure at which the fund will be open for subscription and a specific date when the fund will get closed. The maturity proceeds will be credited to the investor at the end of the tenure.The tenure of the fund may range from 3 to 15 years. However, some fund houses provide an option to the investors to buy/sell their securities to the fund house at NAV at periodic intervals.

As per their investment objective

Growth funds

These are funds with prime focus on capital appreciation. Dividend is not the main criteria. Stocks with low price to earnings ratio usually announce lower dividends. Capital gains are higher in these funds than dividend.

Based on company size, the growth funds are further categorised into:
Large cap funds: Investment is done in large blue chip companies with low debt to equity ratio and a sound financial condition;
Mid cap funds: Investment is done in medium sized companies with a market capitalization of generally Rs500 crores to Rs1000 crores.
Small cap funds: Investment is done in small sized companies with a market capitalization of generally upto Rs500 crores.
Small and mid-cap funds: Investment is done in companies with immense growth potential but operating with a small base and whose shares generally trade at a discount. This is a high risk-high return investment.
Multi cap funds: Investment is done in a combination of large, mid and small sized concerns as per ratio already stated in the offer document.

Growth and income funds

These are funds which seek long term growth as well as current income. Investment is into combination of growth stocks and income stocks which yield high dividends.

Fixed income funds

These are funds which seek capital preservation with consistent current income. Investment is mainly in corporate bonds/government securities. Such schemes are suitable for investors looking for safe capital and high incomes from their investments.

Balanced funds

These are funds which provide both growth and income. They invest in shares and fixed income securities in proportion as indicated by them in their offer document. Though the value of these investments may not be at par with market movements, it is an ideal option for investors looking for moderate growth with regular income.

Money market funds

These funds invest in Government securities, treasury bills, banks and other corporations maturing within a very short term generally within one year. They provide high stability of principal with moderate to high returns with high liquidity and become one of the safest options as compared to other types of mutual funds. Very ideal for corporate and high net worth individuals who want to get nearest by parking their funds for a short term.

Other schemes

Tax funds

These funds invest in shares as specified by the Government o that the investor can avail tax benefits under Section 80C of the Income Tax Act,1961. The main condition in tax funds is that funds are locked for a period of three years and the amount cannot be withdrawn or switched over before the maturity of three years.

Index funds

These funds are invested in shares of such companies in specified allocation so that the value of mutual fund on any day matches the value of the index on the stock market.

Sectoral funds

These funds invest in shares of a specific industry or sector such as healthcare, infrastructure etc. The NAV of these funds moves in tandem with the market movements of that particular sector. A good news can increase the value of shares and a bad news can bring it down.

Fund of funds

These are funds which invest in other mutual funds rather than directly in shares, bonds and debentures. The investors gain from investment in multiple mutual funds at the same time.

Risk of investment in mutual fund

One thumb rule of investment is “higher the risks, higher the returns". Investing in mutual fund does not mean sure shot profits. The returns depend on the volatility in the market. Risks in mutual funds include
Market risk,
Inflation risk,
Credit risk,
Interest rate risk,
Exchange rate risk and
Changes in Government policies.

Choice of the right mutual fund

The investment objective of every fund is the main deciding factor for an investor to decide on the fund to be invested. The objectives of the investors should be in tandem with the returns expected from the fund like some prefer monthly interest, some prefer only capital appreciation and soon. The hope that the value of the fund will rise over a period of time is one way of earning profit from the fund. Apart from this, the fund managers keep buying and selling stocks of the companies in which they had invested in the process incur a capital gain. This gain is generally passed on to the investors annually at the discretion of the fund house. Similarly, if the money is invested in bonds/ debentures, the interest or dividend earned is also distributed among the investors in a pro-rata manner in proportion of their holdings. The amount of capital gain/ interest/ dividend may be either credited to the investors account or re-invested in the market to purchase more units as per the fund objective. These are the ways in which the value of a fund appreciates over time.
Mutual funds do provide good returns and safety but choice of a wrong fund brings down all the money to a loss.

The factors to be kept in mind while selecting a mutual fund are :

Risk profile of an investor

Risk profile of a person is the main factor in choosing a fund. There are three types of risk levels of an investor - high risk, medium tolerance and low risk. A risk averse investor shall invest in money market/balanced funds. An investor who can take risks invests in growth funds.Basically, the risk profile of the investor should match with the fund's investment goals.

Past performance

Though not a very great indicator, it gives a general idea of how the fund has fared in the past. The study of historical performance when the markets had been down gives a better idea of how good the fund can withstand market volatility. Past performance is an indicator of how well the fund had been managed. A benchmark study should be done of funds within the same category to gauge its past performance in a better way.

Fund Managers

Fund Managers play a great role in managing the fund as they are responsible for taking decisions on investment of funds. The ability of the fund manager in choosing the right portfolio determines a lot about the success of its goals.

Size and cost of the fund

The expense ratio of funds should be compared with funds in the same category. If the maintenance cost of the fund is higher, the returns would be comparatively lower. The size of the fund should also be optimum as a huge fund can have fund deployment problems and small size of a fund may lead to higher maintenance costs.

Conclusion

Investment in mutual funds should ideally be in a diversified portfolio combining funds from all asset classes. The combination of best funds from all categories gives the maximum returns and losses set off. SEBI has allowed mutual funds to be held in dematerialized form. Online investment in mutual funds is thus, the order of the day. However, to have a comfortable online experience in investment, selection of a proper broker, the charges/commission charged by the financial institution, types of online facilities available, time taken to credit funds are to be considered.

Investments done in an informed manner always add value to it and returns are commensurate to the hard work and efforts put in that investment.Having made the investment, continuous monitoring of the fund performance to check if the fund goals are being met and gains are uniform is mandatory for every mutual fund investor.