What is a mutual fund


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What is a mutual fund

  1. 1. What is a Mutual FundMutual Fund is a investment company that pools money fromshareholders and invests in a variety of securities, such as stocks,bonds and money market instruments. Most open-end mutual fundsstand ready to buy back (redeem) its shares at their current net assetvalue, which depends on the total market value of the funds investmentportfolio at the time of redemption. Most open-end mutual fundscontinuously offer new shares to investors.Also known as an open-end investment company, to differentiate it froma closed-end investment company. Mutual funds invest pooled cash ofmany investors to meet the funds stated investment objective. Mutualfunds stand ready to sell and redeem their shares at any time at thefunds current net asset value: total fund assets divided by sharesoutstanding.In Simple Words, Mutual fund is a mechanism for pooling the resourcesby issuing units to the investors and investing funds in securities inaccordance with objectives as disclosed in offer document.Investments in securities are spread across a wide cross-section ofindustries and sectors and thus the risk is reduced. Diversificationreduces the risk because all stocks may not move in the same directionin the same proportion at the same time. Mutual fund issues units tothe investors in accordance with quantum of money invested by them.Investors of mutual funds are known as unitholders.The profits or losses are shared by the investors in proportion to theirinvestments. The mutual funds normally come out with a number ofschemes with different investment objectives which are launched fromtime to time. In India , A mutual fund is required to be registered withSecurities and Exchange Board of India (SEBI) which regulatessecurities markets before it can collect funds from the public.In Short, a mutual fund is a common pool of money in to whichinvestors with common investment objective place their contributionsthat are to be invested in accordance with the stated investmentobjective of the scheme. The investment manager would invest the
  2. 2. money collected from the investor in to assets that are defined/permitted by the stated objective of the scheme. For example, an equityfund would invest equity and equity related instruments and a debt fundwould invest in bonds, debentures, gilts etc . Mutual Fund is a suitableinvestment for the common man as it offers an opportunity to invest in adiversified, professionally managed basket of securities at a relativelylow cost. Types of Mutual FundsSchemes according to Maturity Period:A mutual fund scheme can be classified into open-ended scheme orclose-ended scheme depending on its maturity period.Open-ended FundAn open-ended Mutual fund is one that is available for subscription andrepurchase on a continuous basis. These Funds do not have a fixedmaturity period. Investors can conveniently buy and sell units at NetAsset Value (NAV) related prices which are declared on a daily basis.The key feature of open-end schemes is liquidity.Close-ended FundA close-ended Mutual fund has a stipulated maturity period e.g. 5-7years. The fund is open for subscription only during a specified period atthe time of launch of the scheme. Investors can invest in the scheme atthe time of the initial public issue and thereafter they can buy or sell theunits of the scheme on the stock exchanges where the units are listed.In order to provide an exit route to the investors, some close-endedfunds give an option of selling back the units to the mutual fund throughperiodic repurchase at NAV related prices. SEBI Regulations stipulatethat at least one of the two exit routes is provided to the investor i.e.either repurchase facility or through listing on stock exchanges. Thesemutual funds schemes disclose NAV generally on weekly basis.Fund according to Investment Objective:
  3. 3. A scheme can also be classified as growth fund, income fund, orbalanced fund considering its investment objective. Such schemes maybe open-ended or close-ended schemes as described earlier. Suchschemes may be classified mainly as follows:Growth / Equity Oriented SchemeThe aim of growth funds is to provide capital appreciation over themedium to long- term. Such schemes normally invest a major part oftheir corpus in equities. Such funds have comparatively high risks.These schemes provide different options to the investors like dividendoption, capital appreciation, etc. and the investors may choose an optiondepending on their preferences. The investors must indicate the optionin the application form. The mutual funds also allow the investors tochange the options at a later date. Growth schemes are good forinvestors having a long-term outlook seeking appreciation over a periodof time.Income / Debt Oriented SchemeThe aim of income funds is to provide regular and steady income toinvestors. Such schemes generally invest in fixed income securities suchas bonds, corporate debentures, Government securities and moneymarket instruments. Such funds are less risky compared to equityschemes. These funds are not affected because of fluctuations in equitymarkets. However, opportunities of capital appreciation are also limitedin such funds. The NAVs of such funds are affected because of changein interest rates in the country. If the interest rates fall, NAVs of suchfunds are likely to increase in the short run and vice versa. However,long term investors may not bother about these fluctuations.Balanced FundThe aim of balanced funds is to provide both growth and regular incomeas such schemes invest both in equities and fixed income securities inthe proportion indicated in their offer documents. These are appropriatefor investors looking for moderate growth. They generally invest 40-60%in equity and debt instruments. These funds are also affected becauseof fluctuations in share prices in the stock markets. However, NAVs ofsuch funds are likely to be less volatile compared to pure equity funds.Money Market or Liquid Fund
  4. 4. These funds are also income funds and their aim is to provide easyliquidity, preservation of capital and moderate income. These schemesinvest exclusively in safer short-term instruments such as treasury bills,certificates of deposit, commercial paper and inter-bank call money,government securities, etc. Returns on these schemes fluctuate muchless compared to other funds. These funds are appropriate for corporateand individual investors as a means to park their surplus funds for shortperiods.Gilt FundThese funds invest exclusively in government securities. Governmentsecurities have no default risk. NAVs of these schemes also fluctuatedue to change in interest rates and other economic factors as is the casewith income or debt oriented schemes.Index FundsIndex Funds replicate the portfolio of a particular index such as the BSESensitive index, S&P NSE 50 index (Nifty), etc These schemes invest inthe securities in the same weightage comprising of an index. NAVs ofsuch schemes would rise or fall in accordance with the rise or fall in theindex, though not exactly by the same percentage due to some factorsknown as "tracking error" in technical terms. Necessary disclosures inthis regard are made in the offer document of the mutual fund scheme.There are also exchange traded index funds launched by the mutualfunds which are traded on the stock exchanges. How To Invest in Mutual Funds ?Mutual funds normally come out with an advertisement in newspaperspublishing the date of launch of the new schemes. Investors can alsocontact the agents and distributors of mutual funds who are spreadall over the country for necessary information and application forms.Forms can be deposited with mutual funds through the agents anddistributors who provide such services. Now a days, the post offices andbanks also distribute the units of mutual funds. However, the investorsmay please note that the mutual funds schemes being marketed bybanks and post offices should not be taken as their own schemes and
  5. 5. no assurance of returns is given by them. The only role of banks andpost offices is to help in distribution of mutual funds schemes to theinvestors.Investors should not be carried away by commission/gifts given byagents/distributors for investing in a particular scheme. On the otherhand they must consider the track record of the mutual fund and shouldtake objective decisions.Non-Resident Indians (NRI) can also invest in mutual funds. Normally,necessary details in this respect are given in the offer documents of theschemes. HISTORY OF MUTUAL FUNDS IN INDIAMutual Fund History IndiaUnit Trust of India(UTI) was the first mutual fund set up in India in theyear 1963. In early 1990s, Government allowed public sector banks andinstitutions to set up mutual funds. UTI has an extensive marketingnetwork of over 40,000 agents all over the country.In the year 1992, Securities and exchange Board of India (SEBI) Actwas passed. The objectives of SEBI are – to protect the interest ofinvestors in securities and to promote the development of and toregulate the securities market.In 1995, the RBI permitted private sector institutions to set up MoneyMarket Mutual Funds (MMMFs). They can invest in treasury bills, calland notice money, commercial paper, commercial bills accepted/co-accepted by banks, certificates of deposit and dated governmentsecurities having unexpired maturity upto one year.As far as mutual funds are concerned, SEBI formulates policies andregulates the mutual funds to protect the interest of the investors. SEBInotified regulations for the mutual funds in 1993. Thereafter, mutualfunds sponsored by private sector entities were allowed to enter thecapital market. The regulations were fully revised in 1996 and have beenamended thereafter from time to time. SEBI has also issued guidelinesto the mutual funds from time to time to protect the interests of investors.
  6. 6. All mutual funds whether promoted by public sector or private sectorentities including those promoted by foreign entities are governed bythe same set of Regulations. There is no distinction in regulatoryrequirements for these mutual funds and all are subject to monitoringand inspections by SEBI. The risks associated with the schemeslaunched by the mutual funds sponsored by these entities are of similartype. Where do the Mutual Funds Invest ? How To Check itThe mutual funds are required to disclose full portfolios of all of theirschemes on half-yearly basis which are published in the newspapers.Some mutual funds send the portfolios to their unitholders.The scheme portfolio shows investment made in each security i.e.equity, debentures, money market instruments, government securities,etc. and their quantity, market value and % to NAV. These portfoliostatements also required to disclose illiquid securities in the portfolio,investment made in rated and unrated debt securities, non-performingassets ( NPAs), etc.Some of the mutual funds send newsletters to the unitholders onquarterly basis which also contain portfolios of the schemes.Where can an investor look out for information on mutual funds?Almost all the mutual funds have their own web sites. Investors can alsoaccess the NAVs, half-yearly results and portfolios of all mutual funds atthe web site of Association of mutual funds in India (AMFI)www.amfiindia.com. AMFI has also published useful literature for theinvestors.Investors can log on to the web site of SEBI www.sebi.gov.in and go to"Mutual Funds" section for information on SEBI regulations andguidelines, data on mutual funds, draft offer documents filed by mutualfunds, addresses of mutual funds, etc. Also, in the annual reports ofSEBI available on the web site, a lot of information on mutual funds isgiven.
  7. 7. There are a number of other web sites which give a lot of information ofvarious schemes of mutual funds including yields over a period of time.Many newspapers also publish useful information on mutual funds ondaily and weekly basis. Investors may approach their agents anddistributors to guide them in this regard.What is NET ASSET VALUE ?The Term Net Asset Value (NAV) is used by investment companies tomeasure net assets. It is calculated by subtracting liabilities from thevalue of a funds securities and other items of value and dividing this bythe number of outstanding shares. Net asset value is popularly used innewspaper mutual fund tables to designate the price per share for thefund.The value of a collective investment fund based on the market price ofsecurities held in its portfolio. Units in open ended funds are valuedusing this measure. Closed ended investment trusts have a net assetvalue but have a separate market value. NAV per share is calculated bydividing this figure by the number of ordinary shares. Investments trustscan trade at net asset value or their price can be at a premium ordiscount to NAV.Value or purchase price of a share of stock in a mutual fund. NAV iscalculated each day by taking the closing market value of all securitiesowned plus all other assets such as cash, subtracting all liabilities, thendividing the result (total net assets) by the total number of sharesoutstanding.Calculating NAVs - Calculating mutual fund net asset values is easy.Simply take the current market value of the funds net assets (securitiesheld by the fund minus any liabilities) and divide by the number ofshares outstanding. So if a fund had net assets of Rs.50 lakh and thereare one lakh shares of the fund, then the price per share (or NAV) isRs.50.00.What are Mutual funds?As implicit by name, mutual fund is a fund mutually held by the investorswho are the beneficiaries of the fund. It is a type of Investment Companywhich collects money from so many investors in common pool and then investsthis capital raised in variety of options like bonds, equity, gold, real estate etc.At the core of it are professionally qualified people called fund managersanalysing the markets conditions and making investment decisions with an
  8. 8. objective of maximization of profit. Substantially all the earnings of a MF arepassed on to the investors in proportion to their investments. In lieu of theservices offered, the mutual fund also charges some fees from the investors. Thediagram below clearly indicates that investors invest in mutual fund that furthermakes investment in various options.Mutual Funds BasicsHaving been through basics, one can infer that investing in mutual funds is aneasy way of playing safe in equity especially you being unaware of tactics ofstock markets because it provides professional expertise of fund managers whomake investment decisions based on constant study and market research.Besides this, it offers benefits like diversification of portfolio. Since mutualfund is a collective investment vehicle, they have an option to invest in differentsectors of market like retail, real estate in addition to options like debt andcommodities market. This reduces the risks to which an individual investorwould have been exposed if a particular sector is in period of downfall. Thesimplicity of investment and various benefits offered have made them sopopular that can be seen from their growth in past. They came into picture in1963 with 67bn assets under management (AUM) compared to current figuresof 4609.49bn with total of 35 mutual funds available at present and stillexpected to grow in years to come.Systematic Investment Plan is a feature specifically designed forthose who are interested in investing periodically rather than makinga lump sump investment. It is just like a recurring deposit with thepost office or bank where you put in a small amount every month.The difference here is that the amount is invested in a mutual fund.
  9. 9. SIP is provided by Mutual Funds to ensure that the investment goal is reached, and thus to compensate for apotential deficit if the systematic investment plan is interrupted due topremature death. It is a service option that allows investors to buymutual fund shares on a regular schedule, usually through bankaccount deductions. Th nomenclature of this mode of investment canbe different with some mutual fund houses; for example RelianceMutual Fund calls it Recurring Investment PlanPlease be clear that a systematic investment plan is not a tool thathelps improve your investment returns.The primary objective of a SIP is to enable investors to clearly definean investment goal, and then to help them reach it throughsystematic investment in select equity-oriented mutual fund schemesthat have a track record of consistent good performance.Most of themutual funds offer this facility. The real value lies in the portfolio ofthe fund. Almost all schemes have the facility of steady investmentplan.Systematic investment adds value through rupee cost averaging andthe power of compounding. The NAVs (net asset value) of thesefunds can vary widely, but, through rupee cost averaging, an SIP canmake this volatility work for you. Many investors tend to think thatmonthly income plan and systematic investment plan are one and thesame. The minimum monthly investment for a systematic investmentplan is Rs 1,000. If you are in the 30-40 year age group, you shouldprobably keep to an allocation of 30-40 per cent to equityinvestments. It is managed by a team of investment professionals andother service providers with advantages of professionals management,portfolio diversification, reducing risk, reduction of trading cost,convience and flexibility liquidity, access to information.In simple words Systematic investment plan, is a simple, time-honored strategy designed to help investors accumulate wealth ina systematic manner over the long-term. Systematic InvestmentPlan is the most effective way of investing in market especially in avolatile market. SIP is a way to invest in a regular and disciplined
  10. 10. manner while taking care of volatility. It is yet another investmenttechnique which helps in mitigation of risk in terms of the entrypoint in an equity fund.For individuals or families just getting started, based upon the abovementioned investment analysis, proper investment allocation isdetermined and asystematic investment plan is established throughone of the many mutual fund families offered by various MutualFunds in India - Principal Income Fund, Monthly Income Plan, ChildBenefit Fund , Balanced Fund, Index Fund, Growth Fund, EquityFund and Tax Savings Fund.The best way to enter a mutual fund is through a SystematicInvestment Plan. But to get the benefit of an SIP, think of minimumthree-year time frame when you wont touch your money. Small butregular investments go a long wayMutual FundsAn investment in knowledge always pays the best interest. —Benjamin FranklinA mutual fund company is an investment company that receivesmoney from investors for the sole purpose to invest in stocks, bonds,and other securities for the benefit of the investors. A mutual fund isthe portfolio of stocks, bonds, or other securities that generate profitsfor the investor, or shareholder of the mutual fund. A mutual fundallows an investor with less money to diversify his holdings forgreater safety and to benefit from the expertise of professional fundmanagers. Mutual funds are generally safer, but less profitable, thanstocks, and riskier, but more profitable than bonds or bank accounts,although its profit-risk profile can vary widely, depending on thefunds investment objective.
  11. 11. It is easier to pick an investment strategy, such as growth or income,with mutual funds than by buying the individual securities, sincemutual fund companies clearly specify the investment objectives ofeach fund that they manage. Other advantages to investing in mutualfunds is that the initial investment is generally low, it is easy toreinvest profits, and money can be invested continually, often inamounts less than the initial investment, such as every month. It caneven be done automatically.Mutual Fund CompaniesMutual fund companies are investment companies registered underthe Investment Company Act of 1940.Investment AdviserFunds are managed by an investment advisor or by professionalmoney managers under contract with the fund to invest to achievethe specific investment objectives of the fund, such as growth orincome. The investment advisor, who could be officers of the fund ora management company, makes the daily investment decisions forthe fund, and the funds success largely depends on their ability.The initial contract is for 2 years, and must be approved by the boardof directors and the shareholders. Afterwards, the contract must berenewed annually by the approval of the board of directors or theshareholders.The prospectus lists the name of the investment adviser, theirlocation, the term of their contract, and their principle duties andresponsibilities. Their typical management fee is 1/2% of the fundsassets.Board of DirectorsEvery investment company must have a board of directors, with nomore than 60% of the board consisting of insiders, and at least 40%consisting of individuals who have no affiliation with the company,
  12. 12. the funds investment adviser, its underwriter, or any organizationrelated to these entities.Although the outside representation may be in the minority, severalimportant decisions regarding the fund require the majority approvalof the outsider representation to prevent conflicts of interest.custodianA custodian, usually a bank, holds the money and securities in trust,and handles the relationships with the investors, such as sending themonthly financial statements and proxy forms for voting. It has nopart in the investment choices or decisions of the fund.Types of Investment CompaniesThe Investment Company Act of 1940 allowed the creation of 3different types of investment companies: 1. Face Amount Certificate Companies 2. Unit Investment Trusts 3. Management Companies o Open-end, which is the mutual fund. o Closed-endFace amount certificates are rare. The holder of the certificates paymoney periodically to issuer in exchange for the face value of thecertificate at maturity, or a surrender value if surrendered earlier.Unit investment trusts are investment companies with trustees, butwithout a board of directors, that issue securities representing anundivided interest in the principal and income of a fixed portfolio ofsecurities, usually consisting of bonds, but may also includemortgage-backed securities, or preferred or common stock. Unitinvestment trusts terminate either when the bonds mature or on aspecified date. These securities trade just like stock or closed-endmutual funds. Many exchange-traded funds are organized as unitinvestment trusts.
  13. 13. management CompaniesThe companies that operate mutual funds are called managementcompanies in the Investment Company Act, and are classified as: 1. open-end investment companies—commonly called mutual fund companies—which offers shares continuously and stands ready to redeem them, 2. and the closed-end investment company, which makes a 1-time offering of shares, which are securities that can be traded like stock, but the company does not redeem the securities.Open-End Mutual FundsMost mutual funds are open-end funds, which sells new sharescontinuously or buys them back from the shareholder (redeems them),dealing directly with the investor (no-load funds) or through broker-dealers, who receive the sales load of a buy or sell order. Thepurchase price is the net asset value at the end of the trading day,which is the total assets of the fund minus its liabilities divided by thenumber of shares outstanding for that day. The number of shares of anopen-end fund varies throughout its existence, depending on howmany shares are bought or redeemed by investors.A major disadvantage to open-end funds is that they need cash toredeem their shares for investors who want out, so they either have tohave a lot of cash on hand, which earns only the current prevailinginterest rate, or they have to sell securities to raise the cash, possiblygenerating capital gains taxes for the remaining investors of the fund.Closed-End Mutual FundsA closed-end mutual fund sells shares of the fund in an initialpublic offering (IPO). After the offering, no more shares are createdor redeemed. Therefore, less money is needed to manage the fund,since there is no need to deal directly with individual investors, suchas sending periodic statements, and it also eliminates the need toredeem shares to pay investors who want to cash out, such as occurs
  14. 14. in open-end mutual funds. Consequently, a closed-end fund can bemore fully invested, since it doesn’t need as much cash, and it is moretax efficient.The money from the IPO is used to buy a specific portfolio ofsecurities that satisfies the advertised investment objective of thefund. Thereafter, shares of the company are bought and sold over astock exchange or over-the-counter, just like any stock.Because fund shares cannot be exchanged for the underlyingsecurities that the shares represent an interest in, there is usually alarge difference between the share price of the fund, and the net assetvalue (NAV) of the fund, which is the actual value of the securitiesrepresented by each mutual fund share. This results because the actualshare price is determined by the supply and demand for the shares,which usually results in a market price that is different from the fundsNAV. When a fund is first sold, the share price is often at a premiumto the NAV, which is how the funds sponsors make money increating the fund, but eventually it drops to a discount, and remainsthere. If the funds share price is higher than its underlying NAV, thenthe shares are said to selling at a premium over their net assetvalue; if the price is lower, then the shares are selling at a discountfrom their net asset value.Note: Sometimes when an open-end fund receives too much moneyto invest profitably, the managers will close the fund to newinvestors. It is still an open-end fund, in that it continues to operateas an open-end fund, and existing shareholders can continue to buyor redeem shares from the fund or reinvest profits, but it is closed tonew investors.