A mutual fund is just the connecting bridge or a financial intermediary that allows a group of investors to pool their money together with a predetermined investment objective. The mutual fund will have a fund manager who is responsible for investing the gathered money into specific securities (stocks or bonds). When you invest in a mutual fund, you are buying units or portions of the mutual fund and thus on investing becomes a shareholder or unit holder of the fund.
Mutual funds are considered as one of the best available investments as compare to others they are very cost efficient and also easy to invest in, thus by pooling money together in a mutual fund, investors can purchase stocks or bonds with much lower trading costs than if they tried to do it on their own. But the biggest advantage to mutual funds is diversification, by minimizing risk & maximizing returns.
MFs emerged in the USA many years' back because of the inefficiency of the banking system there. Banks would take money at deposit rates and lend it out to various corporate investors. But there was a huge gap between the rates at which they were willing to take money from individual investors and the rates at which they would lend to huge corporate borrowers. In such a situation a lot of retail investors were willing to go out and lend directly to corporate borrowers. They figured the risk was acceptable. Lots of corporate borrowers also felt that rather than borrow from banks at preposterous rates, they would do much better to access individual investors directly. The catch was that the ticket size of individual investors was very small. For a corporate borrower to transact directly with individual investors would mean running up a towering transaction bill.
This was when the concept of a mutual fund emerged, whereby an entity with very high levels of efficiency, no capital adequacy ratio's, extremely low costs and not maintaining any priority sector lendings or government bonds etc, could pool everybody's money together and lend it out to a AAA company. Of course, in such an eventuality the concept of getting a return guaranteed became endangered. Because individual investors in the mutual fund would then have to risk a portfolio that some anonymous mutual fund manager put together. This brought in a new requirement for diclosures. Investors who took such a risk wanted a very high level of transparency. They wanted disclosures at any given point in time. They wanted to know where their money was being invested.
The mutual fund industry in India started in 1963 with the formation of Unit Trust of India, at the initiative of the Government of India and Reserve Bank . The history of mutual funds in India can be broadly divided into four distinct phases
First Phase – 1964-87
Unit Trust of India (UTI) was established on 1963 by an Act of Parliament. It was set up by the Reserve Bank of India and functioned under the Regulatory and administrative control of the Reserve Bank of India. In 1978 UTI was de-linked from the RBI and the Industrial Development Bank of India (IDBI) took over the regulatory and administrative control in place of RBI. The first scheme launched by UTI was Unit Scheme 1964. At the end of 1988 UTI had Rs.6,700 crores of assets under management.
Second Phase – 1987-93 (Entry of Public Sector Funds)
1987 marked the entry of non- UTI, public sector mutual funds set up by public sector banks and Life Insurance Corporation of India (LIC) and General Insurance Corporation of India (GIC). SBI Mutual Fund was the first non- UTI Mutual Fund established in June 1987 followed by Canbank Mutual Fund (Dec 87), Punjab National Bank Mutual Fund (Aug 89), Indian Bank Mutual Fund (Nov 89), Bank of India (Jun 90), Bank of Baroda Mutual Fund (Oct 92). LIC established its mutual fund in June 1989 while GIC had set up its mutual fund in December 1990. At the end of 1993, the mutual fund industry had assets under management of Rs.47,004 crores.
Third Phase – 1993-2003 (Entry of Private Sector Funds)
With the entry of private sector funds in 1993, a new era started in the Indian mutual fund industry, giving the Indian investors a wider choice of fund families. Also, 1993 was the year in which the first Mutual Fund Regulations came into being, under which all mutual funds, except UTI were to be registered and governed. The erstwhile Kothari Pioneer (now merged with Franklin Templeton) was the first private sector mutual fund registered in July 1993. The 1993 SEBI (Mutual Fund) Regulations were substituted by a more comprehensive and revised Mutual Fund Regulations in 1996. The industry now functions under the SEBI (Mutual Fund) Regulations 1996. The number of mutual fund houses went on increasing, with many foreign mutual funds setting up funds in India and also the industry has witnessed several mergers and acquisitions. As at the end of January 2003, there were 33 mutual funds with total assets of Rs. 1,21,805 crores. The Unit Trust of India with Rs.44,541 crores of assets under management was way ahead of other mutual funds.
Fourth Phase – since February 2003
In February 2003, following the repeal of the Unit Trust of India Act 1963 UTI was bifurcated into two separate entities. One is the Specified Undertaking of the Unit Trust of India with assets under management of Rs.29,835 crores as at the end of January 2003, representing broadly, the assets of US 64 scheme, assured return and certain other schemes. The Specified Undertaking of Unit Trust of India, functioning under an administrator and under the rules framed by Government of India and does not come under the purview of the Mutual Fund Regulations. The second is the UTI Mutual Fund Ltd, sponsored by SBI, PNB, BOB and LIC. It is registered with SEBI and functions under the Mutual Fund Regulations. With the bifurcation of the erstwhile UTI which had in March 2000 more than Rs.76,000 crores of assets under management and with the setting up of a UTI Mutual Fund, conforming to the SEBI Mutual Fund Regulations, and with recent mergers taking place among different private sector funds, the mutual fund industry has entered its current phase of consolidation and growth. As at the end of March 2009, there were 35 mutual funds, which managed assets of Rs. 4,17,300crores under 1,001 schemes
This fast growing industry is regulated by the Securities and Exchange Board of India (SEBI).
In February 2003, following the repeal of the Unit Trust of India Act 1963 UTI was bifurcated into two separate entities. One is the Specified Undertaking of the Unit Trust of India with assets under management of Rs.29,835 crores as at the end of January 2003, representing broadly, the assets of US 64 scheme, assured return and certain other schemes. The Specified Undertaking of Unit Trust of India, functioning under an administrator and under the rules framed by Government of India and does not come under the purview of the Mutual Fund Regulations.
The second is the UTI Mutual Fund Ltd, sponsored by SBI, PNB, BOB and LIC. It is registered with SEBI and functions under the Mutual Fund Regulations. With the bifurcation of the erstwhile UTI which had in March 2000 more than Rs.76,000 crores of assets under management and with the setting up of a UTI Mutual Fund, conforming to the SEBI Mutual Fund Regulations, and with recent mergers taking place among different private sector funds, the mutual fund industry has entered its current phase of consolidation and growth. As at the end of March 2009, there were 35 mutual funds, which managed assets of Rs. 4,17,300crores under 1,001 schemes
Portfolio Diversification:
Mutual funds normally invest in a well – diversified portfolio or securities. Each investor in a fund is a part owner of all the fund’s assets. This enables him to hold a diversified investment portfolio even with a small amount of investment that would otherwise require big capital.
Professional Management
Even if an investor has a big amount of capital available to him, he benefits from professional management skills brought in by the fund in the management of the investor’s portfolio. The investment management skills, along with the needed research into available investment options ensure much better return than what an investor can manage his own. Few investors have the skills and resources of their own to succeed in today’s fast-moving, global and sophisticated markets,
Reduction / Diversification of risk
An investor in a mutual fund acquires a diversified portfolio, no matter how small his investment. Diversification reduces the risk of loss, as compared to investing directly in one or two shares or debentures or other instruments. When an investor invests directly, all the risk of potential loss is all his own. A fund investor also reduces his risk in another way. While investing in the pool of funds with other investors, any loss on one or two securities is also shared with other investors. This risk reduction is one of the most important benefits of a collective investment vehicle like the mutual fund.
Reduction of transaction costs
What is true of risk is also true of the transaction costs. A direct investor bears all the costs of investing such a brokerage or custody of securities. When going through a fund, he has the benefit of economies of scale; the funds pay lesser costs because of larger volumes, a benefit passed on to its investors.
Liquidity
Often, investors hold shares or bonds they cannot directly, easily and quickly sell. Investment in Mutual Fund, on the other hand, is more liquid. An investor can liquidate the investment, by selling the units to the fund if open-end, or selling them in the market if the fund is closed-end, and collect funds at the end of a period specified by the mutual funds or the stock market.
Convenience & Flexibility
Mutual fund management companies offer many investor services that a direct market investor cannot get. Investors can easily transfer their holdings from one scheme to the other; get updated market information and so on. Moreover, Mutual Funds offer multiple schemes allow investors to switch easily between various schemes. This flexibility gives the investor a convenient way to change the mix of his portfolio over time.
Affordability
A mutual fund invests in a portfolio of assets, i.e. bonds, shares, etc. depending upon the investment objective of the scheme. An investor can buy in to a portfolio of equities, which would otherwise be extremely expensive. Each unit holder thus gets an exposure to such portfolios with an investment as modest as Rs.500/-. This amount today would get you less than quarter of an Infosys share! Thus it would be affordable for an investor to build a portfolio of investments through a mutual fund rather than investing directly in the stock market.
Disadvantage of Mutual Funds:
1. No control over cost
2. Tailor made portfolios
A mutual fund invests in a portfolio of assets, i.e. bonds, shares, etc. depending upon the investment objective of the scheme. An investor can buy in to a portfolio of equities, which would otherwise be extremely expensive. Each unit holder thus gets an exposure to such portfolios with an investment as modest as Rs.500/-. This amount today would get you less than quarter of an Infosys share! Thus it would be affordable for an investor to build a portfolio of investments through a mutual fund rather than investing directly in the stock market.
Bank Fixed deposits are similar to company fixed deposits excepting that the Bank FD’s are more safe and chances of default are very less. Banks operate under stringent requirements regarding Statutory Liquidity Ration (SLR) and Cash Reserve Ratio (CRR). Further, Deposit Insurance and Credit Guarantee Corporation (DICGC) protect bank deposits.
1. Credit rating of a bond is an indication of the inherent default risk in the investment. However unlike fixed deposits, bonds and debentures are transferable securities.
2. If security does not get traded in the market, then the liquidity remains on paper. In this respect an open-end mutual fund scheme offering continuous sale / repurchase option is superior.
3. There could be capital gain / capital loss to investor incase of an early exit, because the investment is subject to market risk. This is normally less in Mutual fund as the investment is made in basket of funds and hence your investment gets diversified.
1. It is not possible for a common man to lay his hands on all that information needed to make an equity investment. Mutual fund handled by professionals make prudent investment decisions.
2. Mutual fund investment offers diversification irrespective of the size of investment. Individual investor investing in equity scheme may not have this advantage especially if he does not have that sort of investible funds.
1. Life insurance is hedge against risk – and not really an investment option.
2. But occasionally, on account of mis-pricing of products in India, life insurance products have offered a return that is higher than a comparable “safe” fixed return security – thus, you are effectively paid for getting insured.
The SEBI (Mutual Funds) Regulations 1993 define a mutual fund (MF) as a fund established in the form of a trust by a sponsor to raise monies by the Trustees through the sale of units to the public under one or more schemes for investing in securities in accordance with these regulations.
These regulations have since been replaced by the SEBI (Mutual Funds) Regulations, 1996. The structure indicated by the new regulations is indicated as under.
A mutual fund comprises four separate entities, namely sponsor, mutual fund trust, AMC and custodian. The sponsor establishes the mutual fund and gets it registered with SEBI.
The mutual fund needs to be constituted in the form of a trust and the instrument of the trust should be in the form of a deed registered under the provisions of the Indian Registration Act, 1908.
The sponsor is required to contribute at least 40% of the minimum net worth (Rs. 10 crore) of the asset management company. The board of trustees manages the MF and the sponsor executes the trust deeds in favour of the trustees. It is the job of the MF trustees to see that schemes floated and managed by the AMC appointed by the trustees are in accordance with the trust deed and SEBI guidelines.
Mutual Fund schemes can be classified into different categories and subcategories based on their investment objectives or their maturity periods.
Classification based on maturity period: Mutual Fund schemes can be classified into three categories based on their maturity periods.
These are mutual fund schemes which offer units for purchase and redemption subscription on a continuous basis. In other words, the units of these schemes can be purchased or redeemed at any point of time at Net Asset Value (NAV) based prices. Also, these schemes do not have a fixed maturity period and an investor can redeem his units anytime.
These are mutual fund schemes which have a defined maturity period e.g. 1 year / 5 years etc. The units of close ended scheme can be bought only during a specified period at the time of initial launch. SEBI stipulates that all close-ended schemes should provide for a liquidity window to its investors. These schemes are either required to be listed on a recognized stock exchange or provide periodic repurchase facility to investors.
These schemes are a cross between an open-ended and a close-ended structure. These schemes are open for both purchase and redemption during pre-specified intervals (viz. monthly, quarterly, annually etc.) at the prevailing NAV based prices. Interval funds are very similar to close-ended funds, but differ on the following points.
• They are not required to be listed on the stock exchanges, as they have an in-built redemption window.
• They can make fresh issue of units during the specified interval period, at the prevailing NAV based prices.
• Maturity period is not defined.
Classification based on investment objective
Apart from the above classification, mutual fund schemes can also be classified based on their investment objectives:
Growth/ Equity oriented schemes are those schemes which predominantly invest in equity and equity related instruments. The objective of such schemes is to provide capital appreciation over the medium to long term. These types of schemes are generally meant for investors with a long-term outlook and with a higher risk appetite.
The main objective of debt-oriented funds is to provide regular and steady income to investors. These schemes mainly invest in fixed income securities such as Bonds, Money Market Instruments, Corporate Debentures, Government Securities (Gilts) etc. Debt-oriented schemes are suitable for investors whose main objective is safety of capital along with modest growth. These funds are not affected because of fluctuations in equity markets. However, the NAV of such funds is affected because of change in the interest rate in the country.
Balanced Funds provide the best of both worlds i.e. equity and debt. The aim of the balanced funds is to provide both capital appreciation and stability of income in the long run. The proportion of investment made into equities and fixed income securities is pre-defined and mentioned in the offer document of the scheme. This type of scheme is a good alternative for pure equity-oriented products and provides an effective asset allocation tool. These schemes are suitable for investors looking for moderate growth. NAVs of such funds are generally less volatile in nature compared to pure equity funds.
These Funds invest exclusively in the dated securities issued by the government. These funds carry a very minimal risk because they are free of any default or credit risk. However, they do carry an interest rate risk as is the case with other debt products.
These are predominantly debt-oriented schemes, whose main objective is preservation of capital, easy liquidity and moderate income. To achieve this objective, liquid funds invest predominantly in safer short-term instruments like Commercial Papers, Certificate of Deposits, Treasury Bills, G-Secs etc..
These schemes are used mainly by institutions and individuals to park their surplus funds for short periods of time. These funds are more or less insulated from changes in the interest rate in the economy and capture the current yields prevailing in the market.
Fund of Funds (FoF) as the name suggests are schemes which invest in other mutual fund schemes. The concept is popular in markets where there are number of mutual fund offerings and choosing a suitable scheme according to one’s objective is tough. Just as a mutual fund scheme invests in a portfolio of securities such as equity, debt etc, the underlying investments for a FoF is the units of other mutual fund schemes, either from the same fund family or from other fund houses.
New Product categories
Capital Protection Oriented schemes
The term ‘capital protection oriented scheme’ means a mutual fund scheme which is designated as such and which endeavours to protect the capital invested therein through suitable orientation of its portfolio structure. The orientation towards protection of capital originates from the portfolio structure of the scheme and not from any bank guarantee, insurance cover etc. SEBI stipulations require these type of schemes to be close-ended in nature, listed on the stock exchange and the intended portfolio structure would have to be mandatory rated by a credit rating agency. A typical portfolio structure could be to set aside major portion of the assets for capital safety and could be invested in highly rated debt instruments. The remaining portion would be invested in equity or equity related instruments to provide capital appreciation. Capital Protection Oriented schemes are a recent entrant in the Indian capital markets and should not be confused with ‘capital guaranteed’ schemes.
Gold Funds
The objective of these funds is to track the performance of Gold. The units represent the value of gold or gold related instruments held in the scheme. Gold Funds which are generally in the form of an Exchange Traded Fund (ETF) are listed on the stock exchange and offers investors an opportunity to participate in the bullion market without having to take physical delivery of gold.
Quantitative Funds
A quantitative fund is an investment fund that selects securities based on quantitative analysis. The managers of such funds build computer based models to determine whether or not an investment is attractive. In a pure "quant shop" the final decision to buy or sell is made by the model. However, there is a middle ground where the fund manager will use human judgment in addition to a quantitative model. The first Quant based Mutual Fund Scheme in India, Lotus Agile Fund opened for subscription on October 25, 2007.
Funds Investing Abroad
With the opening up of the Indian economy, Mutual Funds have been permitted to invest in foreign securities/ American Depository Receipts (ADRs) / Global Depository Receipts (GDRs). Some of such schemes are dedicated funds for investment abroad while others invest partly in foreign securities and partly in domestic securities. While most such schemes invest in securities across the world there are also schemes which are country specific in their investment approach.
Real Estate Mutual Funds
Real Estate Mutual Funds or realty funds as they are popularly known are the latest addition to the mutual fund offerings in India. SEBI recently paved way for the launch of such products, by making amendments to its existing Regulations. However, real estate mutual funds are yet to be introduced in India by any asset management company. These schemes invest in real estate properties and earn income in the form of rentals, capital appreciation from developed properties. Also some part of the fund corpus is invested in equity shares or debentures of companies engaged in real estate assets or developing real estate development projects. REMFs are required to be close-ended in nature and listed on a stock exchange.
In addition to the above broad classification, mutual fund schemes can be further classified into sub-categories. Each of the sub-categories has a stated objective and caters to specific requirements of investors.
Investment options available to investors
Growth Option
Under growth option, dividends are not paid out to the unit holders. Income attributable to the Unit holders continues to remain invested in the Scheme and is reflected in the NAV of units under this option. Investors can realize capital appreciation by way of an increase in NAV of their units by redeeming them.
Dividend Payout Option
Dividends are paid out to the unit holders under this option. However, the NAV of the units falls to the extent of the dividend paid out and applicable statutory levies.
Dividend Re-investment Option
The dividend that accrues on units under option is re-invested back into the scheme at ex-dividend NAV. Hence investors receive additional units on their investments in lieu of dividends.
At the cornerstone of investing is the basic principal that the greater the risk you take, the greater the potential reward. Or stated in another way, you get what you pay for and you get paid a higher return only when you're willing to accept more volatility.
Risk then, refers to the volatility – the up and down activity in the markets and individual issues that occurs constantly over time. This volatility can be caused by a number of factors – interest rate changes, inflation or general economic conditions. It is this variability, uncertainty and potential for loss, that causes investors to worry. We all fear the possibility that a stock we invest in will fall substantially. But it is this very volatility that is the exact reason that you can expect to earn a higher long-termreturn fromthese investments than froma savings account.
Different types of mutual funds have different levels of volatility or potential price change, and those with the greater chance of losing value are also the funds that can produce the greater returns for you over time. So risk has two sides: it causes the value of your investments to fluctuate, but it is precisely the reason you can expect to earn higher returns.
You might find it helpful to remember that all financial investments will fluctuate. There are very few perfectly safe havens and those simply don't pay enough to beat inflation over the long run.
Types of Risks
All investments involve some form of risk. Consider these common types of risk and evaluate them against potential rewards when you select an investment.
Market Risk – At times the prices or yields of all the securities in a particular market rise or fall due to broad outside influences. When this happens, the stock prices of both an outstanding, highly profitable company and a fledgling corporation may be affected. This change in price is due to "market risk". It is also known as systematic risk.
Inflation Risk – It is sometimes referred to as "loss of purchasing power." Whenever inflation rises forward faster than the earnings on your investment, you run the risk that you'll actually be able to buy less, not more. Inflation risk also occurs when prices rise faster than your returns.
Credit Risk – In short, credit risk evaluates the following – how stable is the company or entity to which you lend your money when you invest? How certain are you that it will be able to pay the interest you are promised, or repay your principal when the investment matures.
Interest Rate Risk – Changing interest rates affect both equities and bonds in many ways. Investors are reminded that "predicting" which way rates will go is rarely successful. A diversified portfolio can help in offsetting these changes.
Exchange Risk – A number of companies generate revenues in foreign currencies and may have investments or expenses also denominated in foreign currencies. Changes in exchange rates may, therefore, have a positive or negative impact on companies which in turn would have an effect on the investment of the fund.
Investment Risks – The sectoral fund schemes, investments will be predominantly in equities of select companies in the particular sectors. Accordingly, the NAV of the schemes are linked to the equity performance of such companies and may be more volatile than a more diversified portfolio of equities.
Changes in the Government Policy Changes in Government policy especially in regard to the tax benefits may impact the business prospects of the companies leading to an impact on the investments made by the fund.
Effect of loss of key professionals and inability to adapt business to the rapid technological change – An industries' key asset is often the personnel who run the business i.e. intellectual properties of the key employees of the respective companies. Given the ever-changing complexion of few industries and the high obsolescence levels, availability of qualified, trained and motivated personnel is very critical for the success of industries in few sectors. It is, therefore, necessary to attract key personnel and also to retain them to meet the changing environment and challenges the sector offers. Failure or inability to attract/retain such qualified key personnel may impact the prospects of the companies in the particular sector in which the fund invests.