Financial Services: Mutual Funds
Mutual funds are in the form of Trust (usually called Asset Management Company) that manages the pool of money collected from various investors for investment in various classes of assets to achieve certain financial goals. We can say that Mutual Fund is trusts which pool the savings of large number of investors and then reinvests those funds for earning profits and then distribute the dividend among the investors.
In return for such services, Asset Management Companies charge small fees. Each Mutual Fund Scheme is managed by a Fund Manager with the help of his team of professionals.
The Mutual Funds usually invest their funds in equities, bonds, debentures, call money etc., depending on the objectives and terms of scheme floated by MF. Now a days there are MF which even invest in gold or other asset classes.
Unit Trust of India was the first mutual fund set up in India in the year 1963. In early 1990s, Government allowed public sector banks and institutions to set up mutual funds.
A mutual fund is required to be registered with Securities and Exchange Board of India (SEBI) which regulates securities markets before it can collect funds from the public.
Advantages of Mutual Funds
- Professional expertise
- Low cost of asset management
- Ease of process
- Well regulated
- Convenient Administration
- Return Potential
- Choice of schemes
- Tax benefits
Disadvantages of Mutual Funds
- Costs: The investor pays fees as long as he remains with the fund.
- No tailor-made portfolios: High net-worth individuals may find this to be a constraint as they will not be able to build their own portfolio of shares.
- Managing a portfolio of funds: large number of funds can provide too much choice for the investor. He may need advice on how to select a fund.
- Delay in redemption: It takes 3-6 days for redemption of the units and the money to flow back into the investor’s account.
- Lower-than-market performance: Consistently beating the market is difficult. Many mutual funds just keep even with overall stock market index
Setting up a Mutual Fund
A mutual fund is set up in the form of a trust, which has sponsor, trustees, asset management company (AMC) and custodian. The trust is established by a sponsor or more than one sponsor who is like promoter of a company.
Asset Management Company (AMC) approved by SEBI manages the funds by making investments in various types of securities.
Custodian, who is registered with SEBI, holds the securities of various schemes of the fund in its custody.
The trustees are vested with the general power of superintendence and direction over AMC. They monitor the performance and compliance of SEBI Regulations by the mutual fund.
Regulation of mutual funds
Mutual funds are regulated primarily by Securities and Exchange Board of India (SEBI). In 1996, SEBI formulated the Mutual Fund Regulation. SEBI is also the apex regulator of capital markets and its intermediaries. Issuance and trading of capital market instruments also comes under the purview of SEBI.
Along with SEBI, mutual funds are regulated by RBI, Companies Act, Stock exchange, Indian Trust Act and Ministry of Finance.
RBI acts as a regulator of Sponsors of bank-sponsored mutual funds, especially in case of funds offering guaranteed returns. In order to provide a guaranteed returns scheme, mutual fund needs to take approval from RBI.
In addition, every mutual fund has a board of directors that represents the unit holders interests in the mutual fund.
Some SEBI regulations for mutual funds
Mutual funds must set up AMC with 50% independent directors, a separate board of trustee companies with minimum 50% of independent trustees and independent custodians to ensure an arm’s length relationship between trustees, fund managers, and custodians. As the funds are managed by AMCs and the custody of assets are with trustees, a counter balancing of risks exists as both can keep tabs on each other.
SEBI takes care of the track record of a Sponsor, integrity in business transactions and financial soundness while granting permission. The particulars of schemes are required to be vetted by SEBI. Mutual funds must adhere to a code of advertisement.
As per the current SEBI guidelines, mutual funds must have a minimum of Rs. 50 crore for an open-ended scheme, and Rs. 20 crore corpus for the closed-ended scheme. Within nine months, mutual funds must invest money raised from the saving schemes. This protects the mutual funds from the disadvantage of investing funds in the bullish market and suffering from poor NAV after that. Mutual funds can invest a maximum of 25% in money market instruments in the first six months after closing the funds and a maximum of 15% of the corpus after six months to meet short-term liquidity requirements.
SEBI inspects mutual funds every year to ensure compliance with the regulations.
Different types of mutual fund schemes
Schemes according to Maturity Period:
A mutual fund scheme can be classified into open-ended scheme or close-ended scheme depending on its maturity period.
Open-ended Fund/ Scheme
An open-ended fund or scheme is one that is available for subscription and repurchase on a continuous basis. These schemes do not have a fixed maturity period. Investors can conveniently buy and sell units at Net Asset Value (NAV) related prices which are declared on a daily basis. The key feature of open-end schemes is liquidity.
Close-ended Fund/ Scheme
A close-ended fund or scheme has a stipulated maturity period e.g. 5-7 years. The fund is open for subscription only during a specified period at the time of launch of the scheme. Investors can invest in the scheme at the time of the initial public issue and thereafter they can buy or sell the units of the scheme on the stock exchanges where the units are listed. In order to provide an exit route to the investors, some close-ended funds give an option of selling back the units to the mutual fund through periodic repurchase at NAV related prices. SEBI Regulations stipulate that at least one of the two exit routes is provided to the investor i.e. either repurchase facility or through listing on stock exchanges. These mutual funds schemes disclose NAV generally on weekly basis.
Schemes according to Investment Objective:
A scheme can also be classified as growth scheme, income scheme, or balanced scheme considering its investment objective. Such schemes may be open-ended or close-ended schemes as described earlier. Such schemes may be classified mainly as follows:
Growth / Equity Oriented Scheme
The aim of growth funds is to provide capital appreciation over the medium to long- term. Such schemes normally invest a major part of their corpus in equities. Such funds have comparatively high risks. These schemes provide different options to the investors like dividend option, capital appreciation, etc. and the investors may choose an option depending on their preferences. The investors must indicate the option in the application form. The mutual funds also allow the investors to change the options at a later date. Growth schemes are good for investors having a long-term outlook seeking appreciation over a period of time.
Income / Debt Oriented Scheme
The aim of income funds is to provide regular and steady income to investors. Such schemes generally invest in fixed income securities such as bonds, corporate debentures, Government securities and money market instruments. Such funds are less risky compared to equity schemes. These funds are not affected because of fluctuations in equity markets. However, opportunities of capital appreciation are also limited in such funds. The NAVs of such funds are affected because of change in interest rates in the country. If the interest rates fall, NAVs of such funds are likely to increase in the short run and vice versa. However, long term investors may not bother about these fluctuations.
The aim of balanced funds is to provide both growth and regular income as such schemes invest both in equities and fixed income securities in the proportion indicated in their offer documents. These are appropriate for investors looking for moderate growth. They generally invest 40-60% in equity and debt instruments. These funds are also affected because of fluctuations in share prices in the stock markets. However, NAVs of such funds are likely to be less volatile compared to pure equity funds.
Money Market or Liquid Fund
These funds are also income funds and their aim is to provide easy liquidity, preservation of capital and moderate income. These schemes invest 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 much less compared to other funds. These funds are appropriate for corporate and individual investors as a means to park their surplus funds for short periods.
These funds invest exclusively in bGovernment securities have no default risk. NAVs of these schemes also fluctuate due to change in interest rates and other economic factors as is the case with income or debt oriented schemes.
Index Funds replicate the portfolio of a particular index such as the BSE Sensitive index, S&P NSE 50 index (Nifty), etc These schemes invest in the securities in the same weightage comprising of an index. NAVs of such schemes would rise or fall in accordance with the rise or fall in the index, though not exactly by the same percentage due to some factors known as “tracking error” in technical terms. Necessary disclosures in this regard are made in the offer document of the mutual fund scheme.
There are also exchange traded index funds launched by the mutual funds which are traded on the stock exchanges.
Sector Specific funds/schemes
These are the funds/schemes which invest in the securities of only those sectors or industries as specified in the offer documents. e.g. Pharmaceuticals, Software, Fast Moving Consumer Goods (FMCG), Petroleum stocks, etc. The returns in these funds are dependent on the performance of the respective sectors/industries. While these funds may give higher returns, they are more risky compared to diversified funds. Investors need to keep a watch on the performance of those sectors/industries and must exit at an appropriate time. They may also seek advice of an expert.
Tax Saving Schemes
These schemes offer tax rebates to the investors under specific provisions of the Income Tax Act, 1961 as the Government offers tax incentives for investment in specified avenues. e.g. Equity Linked Savings Schemes (ELSS). Pension schemes launched by the mutual funds also offer tax benefits. These schemes are growth oriented and invest pre-dominantly in equities. Their growth opportunities and risks associated are like any equity-oriented scheme.
Fund of Funds (FoF) scheme
A scheme that invests primarily in other schemes of the same mutual fund or other mutual funds is known as a FoF scheme. An FoF scheme enables the investors to achieve greater diversification through one scheme. It spreads risks across a greater universe.
Load or no-load Fund
A Load Fund is one that charges a percentage of NAV for entry or exit. That is, each time one buys or sells units in the fund, a charge will be payable. This charge is used by the mutual fund for marketing and distribution expenses.
Suppose the NAV per unit is Rs.10. If the entry as well as exit load charged is 1%, then the investors who buy would be required to pay Rs.10.10 and those who offer their units for repurchase to the mutual fund will get only Rs.9.90 per unit.
The investors should take the loads into consideration while making investment as these affect their yields/returns. However, the investors should also consider the performance track record and service standards of the mutual fund which are more important. Efficient funds may give higher returns in spite of loads.
A no-load fund is one that does not charge for entry or exit. It means the investors can enter the fund/scheme at NAV and no additional charges are payable on purchase or sale of units.
Net Asset Value (NAV) of a scheme
The performance of a particular scheme of a mutual fund is denoted by Net Asset Value (NAV).
Mutual funds invest the money collected from the investors in securities markets. In simple words, Net Asset Value is the market value of the securities held by the scheme. Since market value of securities changes every day, NAV of a scheme also varies on day to day basis. The NAV per unit is the market value of securities of a scheme divided by the total number of units of the scheme on any particular date.
For example, if the market value of securities of a mutual fund scheme is Rs 200 lakhs and the mutual fund has issued 10 lakhs units of Rs. 10 each to the investors, then the NAV per unit of the fund is Rs.20.
NAV is required to be disclosed by the mutual funds on a regular basis – daily or weekly – depending on the type of scheme.
Mutual Funds vs. Hedge Funds
Hedge Funds are the investment portfolios which are aggressively managed and uses advanced investment strategies, such as leveraged, long, short and derivative positions in both domestic and international markets with a goal of generating high returns .
In case of Hedged Funds, the number of investors is usually small and minimum investment required is large.
Moreover, they are more risky and generally the investor is not allowed to withdraw funds before a fixed tenure.
Assets Under Management (AUM)
Assets under management (AUM) is a financial term denoting the market value of all the funds being managed by a financial institution (a mutual fund, hedge fund, private equity firm, venture capital firm, or brokerage house) on behalf of its clients, investors, partners, depositors, etc.