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Tuesday, October 2, 2012

Mutual Funds in a Nutshell

What is Mutual Fund?

Mutual Funds (MF) are the investment schemes managed by professionals who collect money from investors and invest the pool money into securities. Returns achieved on such investments are distributed among investors in proportion of their investment amount.
Simply put, mutual funds invest on investors behalf so that even an uninitiated person without any expertise can invest judiciously.

Advantages of MF

(1) Mutual funds are beneficial for people with no knowledge of capital markets but desirous of investing in it.

(2)Investors get the benefit of diversification even if they invest small amounts

(3)Transparency of the investing procedure

(4)Low cost (this cost is generally the expenses incurred in running the scheme)

(5) MFs are professionally managed.

(6)Tax benefits-some MF schemes (ELSS) give tax benefits under section 80 c. These benefits could be taken away with the implementation of DTC (Direct Tax Code).

What is the best time to invest in mutual Funds?

General rule of thumb is-

As far as equity MF's are concerned, the best time to buy is down market. During down market NAVs are low and more units can be bought for a specific amount.
When recovery comes, much appreciation is seen.

Best time for buying debt MF's is when interest rates are at its peak.
Generally higher interest rates are unfavourable for growing stock markets.

As it is very difficult to time the market correctly, best option is to invest through SIP (Systematic Investment Plan).

Why one should invest in equity?
Though debt instruments are more secure and offers sure returns in comparison to its equity counterpart but returns on debt is relatively less.

Also these returns are affected by Real Interest Rates in the hands of investors.

What is Real Interest Rate?

Real interest rate of an investment is the difference between nominal interest rate subtracted by the rate of inflation.

If an investment gives the interest return of 8 % per annum while inflation rate is 10% per annum, then resultant Real Interest Rate is -2%.

This is the persisting problem with majority of debt instruments, that’s why opportunities in equity instruments should be searched.

Types of Mutual Funds

By structure Mutual Funds are of two types-

(1)Open Ended MF Schemes: This type of MF schemes remain available for subscription and re-purchase on continuous basis. These funds don’t have fixed maturity period. There is no restriction on amount of units that fund house shall issue. Such funds also buy-back shares when investors wish to sell.
The majority of Mutual funds are open ended schemes.
The key feature of such schemes is liquidity.
New investor can directly invest in these schemes by directly approaching to MF companies (or third party distributors) to buy units at applicable NAV (Net Asset Value).
Simply put, investor can enter of exit in such MF schemes at any time even after the NFO (New Fund Offer) period.

(2) Close Ended MF Schemes: Fund house raises fixed amount of capital through NFO (New Fund Offer). Unlike open ended MF schemes raise prescribed amount of capital once through NFO.
Fund house repurchases units from investors through periodic repurchases.
The fund units are then listed on stock exchanges and traded like stocks.
After the expiry of NFO period, investors can by the fund units from secondary market. When units of a mutual fund scheme trade on stock exchanges fund is termed as an ETF (Exchange Traded Fund).

According to investment objective, Mutual Fund schemes could be mainly classified into following categories-

(1)Equity Oriented Schemes: The aim of such schemes is capital appreciation. Such schemes predominantly invest in equities. Due to this, such schemes bear greater risk.

Such MF schemes provide 3 different options-

(A) Capital Appreciation or pure Growth Plan: No dividend is paid to investors and therefore value of investment (NAV) increases.

(B)Dividend Payout Plan: As the name suggests, dividend is paid through dividend warrant (or ECS) to the investors.

(C) Dividend Re-investment Plan: In this plan dividend is used to issue new units of the scheme at prevailing NAV.

Note: NAVs of (B) and (C) options increase much slower than the option (A) and this is normal.
A few examples of equity funds are Diversified EquityFunds, Sector Funds, Thematic Funds and ELSS (EquityLinked Saving Schemes).

(2) Income or Debt Oriented Schemes: The aim of such MF schemes is to provide regular income to investors. Such scheme invests in debt instruments like bonds, debentures, government securities and money market instruments.
Such schemes carry much lower risk in comparison to equity schemes but chances of capital appreciation are also limited.
If interest rates rise, NAVs of such schemes decreases while when interest rates fall NAVs soar. Long term investor is not bothered much by such fluctuations.
Some example of debt funds are Gilt funds, Fixed maturity Plans (FMP), Floating Rate Funds and Liquid Schemes.

(3) Hybrid or Balanced Schemes: Such schemes are a judicious blend of both equity and debt schemes. These schemes are useful for investors seeking moderate growth.
Though such schemes are affected by share price fluctuations but are less volatile in comparison with equity schemes.

(4) Gold Funds: Gold Funds invest in Gold and gold related financial products.
Investment is this category can be done in two formats-
Gold ETF and Gold Sector Funds (Such funds invest in gold mining and processing companies ).


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