Let’s talk money for a change. Part of a series of reviews on various topics in the financial sector, covering both theoretical and practical aspects, this is a review on why investing in mutual funds is better for a common investor than investing in shares.
When we talk about money, an issue facing most investors relates to the choice of instruments, because returns and risk will differ based on this choice. This factor is very crucial when the final return is not known at the time of making the investment(unlike bank deposits or bonds). The issue takes different forms depending upon the kind of investment selected.
A Mutual Fund is a fund(registered as a trust) that pools the savings of a number of small investors. The fund manager(appointed by the trust) invests the money thus collected in different types of securities ranging from shares to debentures to money market instruments depending upon the objective of the scheme. The income earned and the capital appreciation are shared by the members in the proportion of their contribution to the corpus(pro rata).
The mutual fund in its present form is a 20th century phenomenon. There are thousands of firms offering tens of thousands of mutual funds with different investment objectives. Today, globally, mutual funds collectively manage almost as much as or more money as compared to banks(maybe only after the insurance companies).
Mutual Fund is the most ideal investment for the common man who do not understand the nuances of the stock market, as it offers an opportunity to invest in a diversified, professionally managed portfolio at a relatively low cost and more importantly at a relatively low risk. Anybody with an investible surplus of as little as a few thousand rupees can invest in Mutual Funds. Each Mutual Fund scheme has a defined investment objective and strategy.
A mutual fund is the ideal investment for today’s complex and dynamic financial sector with so many scams and frauds being reported every other day. Markets for shares, bonds, real estate, derivatives and other assets have become mature and information driven. Price changes are driven by global events occurring in faraway places. A typical individual is unlikely to have the knowledge, skills, inclination and time to keep track of events, understand their implications and act speedily.
Mutual Funds are the answer to all these. A mutual fund appoints professionally qualified and experienced staff that manages the investment and portfolio management on a full time basis. The money collected in the fund allows it to hire such staff at a very low cost to each investor. The mutual fund also exploits economies of scale in three areas – research(identification of investment opportunities), investments(managing the investment) and transaction processing(buying and selling of shares).
Return from a mutual fund depends upon the kind of portfolio it holds. In the case of a share, prevailing market sentiment can send its price zooming or crashing. Whereas a mutual fund face only an indirect effect of the share price movement depending upon the fund’s portfolio management.
As mentioned earlier mutual funds are of various types. The various schemes may be summarised on the basis of its structure and its investment objective as mentioned below.
On the basis of structure:
Open-ended Fund - is a fund, which is available for subscription throughout the year. They do not have a fixed maturity. It basically goes on and on. Investors can conveniently buy and sell units at Net Asset Value(’NAV’) related prices, which is the market equivalent of the portfolio of the fund. The key feature of open-end scheme is the liquidity it offers to a common investor.
Closed-ended Fund – is a fund that has a specified maturity period ranging from 3 to 15 years. The fund is open for subscription only during specified periods. Investors can either invest in the scheme at the time of their initial public issue or subsequently on the stock exchanges where they are listed.
Interval Funds - combines the features of open-ended and close-ended schemes. They are open for sale or redemption during pre-determined intervals at NAV related prices.
On the basis of its investment objective:
Growth Funds – tries to provide the investors capital appreciation over the medium to long- term and not on regular income. These funds normally invest in equities of fundamentally strong companies(like the Bluechip companies in India).
Income Funds – tries to provide the investors regular and steady income to investors. These funds generally invest in fixed income securities such as bonds, corporate debentures and Government securities and in shares of companies with high dividend payout ratios. The income earned is generally distributed among the members at periodic intervals.
Balanced Funds – tries to provide the investors both growth and regular income. These funds combines both the features of growth and income funds.
Money Market Funds – tries to provide the investors easy liquidity, preservation of capital and moderate income. These funds generally invest in safer short-term instruments such as treasury bills, certificates of deposit, commercial paper and inter-bank call money. Returns on these funds are low as the interest rates on the above investments are lower. These are ideal for corporate and individual investors as a means to park their surplus funds for short periods, with the liquidity of the money retained.
There are also a few additional schemes like:
Tax Saving Schemes - offer tax relief to the investors under the Indian Income Tax laws by investing in those avenues where tax incentives are available.
Special Schemes - like Industry Specific Schemes(base the portfolio on any specific industry like IT, pharma, FMCG, telecom, etc), Index Schemes(link the fund to any index like Sensex, Nasdaq index, etc)
The Indian mutual fund industry till now was dominated by the Unit Trust of India which has a total corpus of Rs.700bn collected from more than 20 million investors. But lately new mutual funds, particularly, in the private sector and foreign companies, is really taking the investors money away from the banks and UTI.
Hence, it is always beneficial for a small investor who wants to invest in the stock market but does not possess the expertise of a professional portfolio manager to invest in mutual funds than in individual stocks.