What is a Mutual Fund?

05 December, 2016

As a lay investor you are constantly exposed to mutual funds news and advertisements. The mutual fund market in India is still very nascent in term of how long it has been around and its spread. The first mutual fund in India was the Unit Trust of India, introduced in 1963 and it enjoyed a majority in India until 1987, after which a host of other government-controlled Indian financial companies established their own funds such as theState Bank of India, Canara Bank, and Punjab National Bank.

In 1993 private players were allowed to make their foray into the mutual fund market. This was a part of the liberalization, privatization and globalization scheme of the then Government. With the opening up of the market to private players, the first private sector fund to operate in India was Kothari Pioneer that later merged with Franklin Templeton. In 1996, SEBI, the regulator of mutual funds in India, formulated the Mutual Fund Regulations, which is a comprehensive regulatory framework that governs the working of Mutual Funds in India.

The Mutual Fund market in India is a highly regulated and is small as compared to other Mutual Fund markets in developed economies where they have been around for longer. Yet the value of the Mutual Fund market in India is close to 26 trillion INR which is a number that speaks of the strength and impact of the mutual fund market in India.

Indian Mutual Funds work like trusts and they are legally known as Asset Management Companies. Here is a list of Asset Management Companies in India with links to their websites.

The above list mentions 45 names in the Mutual Funds market. In spite of this records show that less than 10% of Indian households have invested in mutual funds.A recent report on Mutual Fund Investments in India shows that the reason why investors hold back from putting their money into mutual funds islack of information and a perceived sense of high risk attached to mutual fund investing in India.

The fact is that Mutual Funds are still a relatively newer form of investing and therefore a very small fraction of India’s population has the resources or wherewithal to explore the Mutual Funds market. Not surprisingly the chunk of Mutual Fund investing happens in the urban areas. So basically investors with a high savings rates almost 50 % of whom live in the Metros and Tier I cities considered such investments to be very risky, whereas 33% of those in Tier II cities said they did not know how or where to invest in such assets.

In this way lack of proper information can be a speed breaker in the way of healthy and safe investing. An informed investor is one who knows his options and understands the strengths and weaknesses of each one of them. It is only when one is aware of the market and all available options that one can make an informed and secure investment choice.

Keeping this in mind, let us now walk through everything that is important to know when making Mutual Fund investments.

What is a Mutual Fund?

In simple terms, Mutual Funds are investment vehicles where money of several investors are pooled together and invested in stocks, bonds, money market instruments and other types of securities. A particular fund’s objective is laid out in the fund's prospectus, which is the legal document that contains information about the fund, its history, its officers and its performance.

A mutual fund is a pool of money collected from numerous investors who wish to save and make money off their savings. Investing in a mutual fund is a lot easier than buying and selling individual stocks and bonds directly.

Salient features of Mutual Funds:

A Mutual Fund is managed by a team of highly qualified professionals and each fund's investments are chosen and monitored by qualified financial analysts who use this money to create a portfolio. A mutual fund can diversify its funds in a portfolio that could consist of stocks, bonds, money market instruments or a combination of all of them.

It is also important to know how the fund ownership in a Mutual Fund is distributed. The way it works is that as an investor in a Mutual Fund, you only own shares of the mutual fund not the individual securities. You yourself may be investing a relatively small sum of money in a mutual fund but as an investor through investing in a Mutual Fund you get to benefit from being involved in a large pool of cash invested by other investors like yourself. This means that all investors or shareholders own apart in the mutual fund' s gains and losses on an equal basis in the ratio of the sum they have individually invested.

Investors choose different Mutual Funds for different reasons, as every Mutual Fund is known for its individual investing system and reputation.

However, the general goal behind Mutual Funds can be broadly explained as follows. On the basis of their objective, Mutual Funds can be grouped together as follows:

a.Aggressive growth funds: These kinds of Mutual Funds invest your funds in stocks which have a chance for dramatic growth and high growth prospects. This type of investing carries a high element of risk because where there dramatic price appreciation there is also potential for dramatic reductions when there are downturns in the economy. It is a good idea to invest in Aggressive Growth Funds if you have a long term investing pattern to follow and you are open to a higher degree of risk.

b.Balanced funds: Balanced funds are those that have a mix of goals. They seek to provide investors with steady income while still offering the potential for growth. Some funds buy stocks and bonds so that the portfolio will generate income with the aim of keeping ahead of inflation. These balanced funds are able to achieve multiple objectives that may be exactly what you are looking for. These funds invest in equities that have the potential for growth and fixed income securities that provide stability. In this way, balanced or growth and income funds offer moderate stability along with a moderate potential for current income and growth.

c.Income funds. Income funds are funds that invest in a number of fixed-income securities. These funds provide for regular income and are best suited to retired investors or investors who do not have a high propensity for risk. Another advantage of these funds is the pay out of regular dividends. A fund manager in an income fund can choose to buy debentures, company fixed deposits etc. in order to provide its investors with steady income. Income Funds are known to be stable options but like in any invetment, there is some element of risk involved. As interest-rates go up or down, the prices of income fund shares, particularly bonds, will move in the opposite direction. This means that income dunds are interest rate sensitive and inflation can hit your profitability here.

d.Money Market mutual fund: This kind of fund is most suited to the careful investor who is aiming at capital preservation.

A detailed look at the structure of mutual funds in India.
The structure and form of a Mutual fund in India and the stipulations regulating the same is set out by the SEBI and the Association of Mutual Funds in India, which is a nodal body that is dedicated to developing the Mutual Fund industry in India maintaining a professional, healthy and ethical climate with a view to protecting and promoting the interests of mutual funds and their unit holders. AMFI is an association of SEBI set up to regulate all registered mutual funds in India and all the registered Asset Management Companies. The AMFI was incorporated on August 22, 1995, as a non-profit organisation. As of now, all the 44 Asset Management Companies that are registered with SEBI, are its members.

Now let us look at the structure of a Mutual Fund in India.

  • The Sponsor: At the top you have a sponsor, who is responsible for floating the Mutual Fund. The sponsor contributes 40% of the investment to start the Fund.
  • The Trustees: The Trustees are responsible for regulating the workings of the Mutual Fund to make sure it is running as per Mutual Fund guidelines.
  • The Custodian and the Asset Managemnt Company (AMC): the Custodian is the company that actually holds the shares in the Fund and the Asset Management Company actually manages the buying and selling transactions of the fund in different investment vehicles. The AMC appoints different Fund Managers to run the fund profitability.
  • The RTA: This is an adminstartive Agency appointed by a Fund to look after aministrative tasks of the fund.
  • What are the different types of mutual funds?
    Above, we have already briefly discussed the different kinds of Mutual Funds and their objectives. The chart below gives you a succinct overview of the different types of Mutual Funds at a glance.

    A reading of this chart tells us that Mutual Funds can broadly be classified into Open Ended and Close Ended types. Basically Open Ended Funds offer greater liquidity and profitability as opposed to Close Ended Funds where the investment is locked in for specific periods of time and the main aim with them is capital conservation as opposed to profitability or returns.

    Mutual Funds can also be sub-classified majorly on Debt and Equity based Funds depending on the investment pattern they follow. Debt Funds invest in the bonds market and Equity based funds invest in the stock market. Debt based funds are less risky than equity based funds where the rewards are higher.

    Why you should invest in mutual funds?
    Here are some of the advantages that come with investing in Mutual Funds:

  • Mutual Funds spread out investments by diversification and hence allows chances of higher returns.
  • Mutual Funds are known to be safe and transparent in their operations since they are professionally managed and accountable to their investors.
  • A bouquet of mutual fund investments can provide high returns as compared to other investmentavenues.
  • Open ended funds allow for high liquidity of funds.
  • The cost or fees associated with investing in Mutual Funds is reasonable as the costs are proportionally divided between various investors.
  • All AMCs and Mutual Funds have a team of well qualified managers and financial advisers who are equipeed to ably manage market changes, policy changes and inflation so as to maintain the safety of the funds invested.
  • Most Mutual Funds / AMCs allow for the reinvestment of dividend back into the fund.
  • Mutual Funds are highly regulated by the SEBI and the Mutual Fund market in India is one of the safest and best monitored in the world. This is commendable considering the crores of Rupees that are dealt with in the mutal Fund market every day.
  • Every coin has a flip side – these are the disadvantage of investing in mutual funds?

  • Since, Mutual Funds are so well managed, there are high costs involved in running them. There are hidden costs involved in running Mutual Funds that are mostly transferred to the investors.
  • Mutual Funds are not the best option if you are looking for tax efficiency as there are no tax rebates available on Mutual Fund earnings.
  • The Returns from Mutual Funds are fluctuating and there is no guaranteed fixed returns.
  • And lastly, as you would have heard, Mutual Fund invsments are subject to market risks. Rad the offer document carefully before investing.
  • Let us look at who all are eligible to invest in mutual funds? Here is a list of all the persons and entities who can legitimately invest in Mutual Funds in India.

  • Resident Indians
  • Non-resident Indians (NRI)
  • Persons of Indian Origin (POI)
  • Indian Public Sector Undertakings
  • Indian Private Sector Undertakings
  • Parents/Guardians on behalf of minors
  • Wakf Boards
  • Hindu Undivided Family
  • Sole Proprietorship Firms
  • Partnership Firms
  • Cooperative Societies
  • Charitable or Religious Trusts
  • Trustee, AMC or Sponsor of their associates
  • Endowment or Registered Societies
  • Army/Air Force/Navy/Para-Military funds and other eligible institutions
  • Scientific and/or industrial research organizations
  • And other associations, institutions, bodies, etc., authorized to invest in mutual funds
  • What is the procedure involved in investing in Mutual Funds? If you are looking at investing in Mutual Funds, these are the steps that you will have to follow:

  • First of all you will need certain mandatory documentary proof such as a valid document of identity proof, your address proof, your PAN Card, Bank details, Passport, PIO Card (if applicable) etc..
  • It is essential that you go through the offer document or prospectus of the fund you are looking at before investing. From this you will understand what type of fund it is, what is the net worth of the fund, what are the estimated rate of return you can expect from your investment.
  • Choose the right portfolio as per your personal requirements of liquidity and returns.
  • You can invest in Mutual Funds through:
    • Asset Management Companies
    • Brokers/Distributors
    • Financial Portals/Websites
  • This attributes to the ease of investing in Mutual Funds. Mutual Funds are known to be a transparent, convenient and advanced investment machinery that enjoys growing popularity in India. With the rapid urbanization and digitization of the financial markets in India the spread of Mutual Funds is slated to only grow in the coming decades. Since the Mutual Fund market is so well and highly regulated in India, it has been able to sail through worldwide market calamites such as the recession of 2008 and other socio-political upheaval with safe comfort. Mutual Fund investments in India are safe and convenient for every kind of investor.