Investors Education Section

Investors Education

MUTUAL FUND

A mutual fund is an institution established with the intention of investing a pool of funds in various types of Securities for the benefit of investors. A small investor is unable to diversify his portfolio of funds simply because of high investment required for diversification, so a mutual fund provides a means of diversification of investment to small investors. Initially a mutual fund collects the funds from small investors, and when sufficient funds are gathered, then they are invested in the Securities of different types, thus diversifying the portfolio.

A mutual fund is managed by a management company. The management company is a bank of human resources, considered to be professionally qualified personnel. The portfolio of mutual fund is managed by a “Portfolio Manager”, whose responsibility is to be invested in, and satisfy the desire of the investors. While selecting the securities for investment, these managers analyze economic conditions, industry trends, government regulations and their impact on the stocks, and forecasts for the specific stocks to the project the future outcome generated by the companies. As we all know that the economic and business condition do not remain constant, so these managers also revise their portfolio with the passage of time, as the circumstances demand.

The Concept of Mutual Funds:

The concept is very simple, small investors invest their money into a common pool or fund and hand over the investment decision to fund manager/portfolio manager. This is expected to have several advantages for the small investors: no more searching for good buys or relying on the neighborhood sub-broker for advice or even anxiously waiting for the allotment. All this is taken care of by the cumulative bargaining power of the fund, which has trained professionals managing it.

Everyday, the fund manager/portfolio manager counts up the value of all fund’s holding, figures out how many shares have been purchased by shareholders, and then calculates the Net Asset Value (NAV) of the mutual fund, the price of a single share of the fund on that day. If you want to buy shares, you just send the manager your money, and they will issue new shares for you at the most recent price.
If the fund manager is doing a good job, the NAV of the fund will usually get bigger, and your shares will be worth more.

Types of Mutual Funds

There are two types of mutual funds, which are:

• Open-end mutual funds
• Closed-end mutual funds

Open-end Mutual Fund

Open-end mutual funds are those where subscription and redemption of shares are allopwed on a continuous basis. The price at which the shares of open-end funds offered for subscription and redemption is determined by the NAV after adjusting for any sales load or redemption fee..

Closed-end Mutual Fund

Closed-end mutual funds are those where the shares are initially offered to the public and are then traded in the secondary market. The trading usually occurs at a slight discount to the NAV. Over a period of time, the mutual fund managers have developed a variety of investment products to cater the requirement of investors, having different needs. These include:

• Growth
• Balanced
• Income(Money Market)
• Equity

Growth Funds

The “growth funds” offer potential for appreciation in share value, while the current income may be low. The fluctuation in share price may also be high. Such funds invest in stocks and have tendency to outperform other funds and other modes of savings over a period of time.

Balanced Funds

The “growth and income” funds or “balanced funds”, offer prospects of both moderate appreciation in share value as well as current income. The fluctuation in share price may be low. Such funds invest in stocks, corporate debts and Government paper.

Income Funds

The “bond fund” or “income funds” offer good current income but very little potential for growth. Such funds invest in government paper, bonds issued by municipal or local bodies, corporate debts and in stocks of utility companies, offering regular return.

Equity fund

The “Equity Fund” consists mainly of stock investments is the most common type of mutual fund. Often equity funds focus investments on particular strategies and certain types of issuers. The main objective for this fund is to participate fully in the growth of the economy.

Sources of Profit Generation

A mutual fund can generate profits from three different sources, which are:

• Dividend
• Capital Gains
• Appreciation of share price

Dividend:

Mutual funds generate income from dividends received from other joint stock companies whose shares the fund holds. A mutual fund uses this dividend income to distribute dividend to its stock holders.

Capital Gains:

As discussed earlier, the portfolio manager changes the portfolio of the fund with the passage of time and also with the changes in the economic and business conditions. So due to the sale and purchase of shares, the mutual fund generates capital from the sales/purchase of stocks. The capital gain generated by the mutual fund is also used to pay dividends to the investors of the fund.

Appreciation of Share Price:

Mutual funds also increases the wealth/investment of their shareholder through appreciation of share price of the mutual fund. For example, if the subscription price of a mutual fund is Rs.11.00, and after a period of seven months the price goes up to Rs. 18.00, thus the investor gets a profit of Rs. 7.00 if he sells the mutual fund shares in the market.

Advantages of Mutual Funds:

• Mutual Funds substantially lower the investment risk of small investors through diversification in which funds are spread out into various sectors, companies, securities as well as entirely different markets. It is always the objective of a fund manager to maximize a fund’s return for a given level of risk, however the dangers of “over-diversification” are always prevalent which would inevitably lead to reduced return on the portfolio.

• Mutual Funds mobilize the saving of small investors and channel them into lucrative investment opportunities. As a result, mutual funds add liquidity to the market. Moreover, given that the funds are long term investment vehicles, they reduce market volatility by offering support to scrip prices.

• Mutual Funds provide smaller investors access to the whole market which individually would be difficult to achieve.

• The investors save a great deal in transaction cost given that he has access to a large number of securities by purchasing a single share of the mutual fund.

• The investors can pick and choose a mutual fund to match his or her particular needs.

• Income is tax exempted.

Disadvantages of Mutual Funds:

As such as there is no major disadvantage attached to the mutual funds. However, the possible disadvantages could be:

• Economic and Business Conditions: As the business and economic conditions do not remain constant, the mutual fund may face some difficulties in the future. Especially if the manager does not shuffle the investment portfolio with the passage of time, or some other unforeseen disaster/event changes the investment scenario.

• Portfolio Managed by Managers: Portfolio of a mutual fund is managed by portfolio managers due to which the investor has no say in the affairs of a mutual fund.