Mutual Funds

What are Mutual Funds?

 A mutual fund is a financial product which pools in the money of several investors and has a professional fund manager who invests in equities (the stock market), bonds or even commodities. When an investor invests money in a mutual fund, the investor is allotted ‘units’ at the current NAV (Net Asset Value) of the fund. This is very similar to the process followed when somebody buys shares of a company. When you buy the shares of a company, you are allotted a certain number of shares (units in the case of a mutual fund) at the market price (NAV in the case of a mutual fund). After paying the operating costs, the gains made by the mutual fund is distributed to its investors either in the form of dividend (if you had selected a dividend fund) or more units of the fund (equivalent to the dividend) are allocated to you. As a fund makes more gains, its NAV could rise, hence raising the value of your invested capital.

Mutual funds might have an entry load (a charge when you buy the fund) and an exit load (a charge when you redeem your fund) in the range of 1-2%. Most mutual funds in the market now do not have an exit load but most would charge you an entry load if you buy it from a third party like your broker or a bank. You can avoid the entry load or just pay a negligible entry load if you buy the mutual fund directly from the fund’s website or from the mutual fund’s office in your city.  

So should I invest in a mutual fund?

Most people do not want to invest in a mutual fund because they are worried about what could happen to their investment if the stock market were to plunge taking their investment down with it. However, there are several mutual funds which do not invest in equities but in bonds and other ‘safer’ instruments (these are called debt funds) but over an extended period of time equity funds beat commodity and debt funds by a large margin. It has been proven again and again that over the long term, equity beats any investment product. Most mutual funds diversify their investments heeding the adage ‘Don’t put all your eggs in one basket’. To a certain extent this also hedges your risk. So it is prudent to invest in an equity mutual fund if you are investing for a long term goal like a house or the college education for your kids or simply building wealth for the long term.

Diversification is a method by which you can reduce risk on your investments but over-diversification could bring down your returns. Click here to view the article on diversification.   

When should I invest in a mutual fund?

The right time to invest in a mutual fund (equity mutual fund) is when the stock market is at a low and beaten down level. But it is virtually impossible to ‘time’ the market. You can try out an experiment for yourself – just tune into a business channel and watch various experts ‘forecast’ the direction of the markets! It is fun to see different ‘experts’ (each a ‘successful speculator’ in their own right) give their views on the market’s direction and most of the time their views are so divergent that I wonder as to why they keep coming on TV. If the TV channels actually kept a tab on their ‘predictions’, I doubt if they would call them again without serious reservations!

The fact of the matter being that it is not humanly possible to give exact predictions about the market. The world’s greatest investor, Warren Buffet once said “I have no idea on timing. It's far easier to tell what will happen than when it will happen”! Hence when is the right time to buy a mutual fund? The right time to buy is when the market has ‘bottomed out’. And when is that? I DO NOT KNOW. But what I know will happen is that an investment in a decently performing mutual fund in the long term will give you excellent returns.

The one technique to ensure that you are spared the headache of ‘timing the market’ is to invest in a mutual fund thorough SIPs (Systematic Investment Plan). When you invest through an SIP, you invest your amount periodically instead of at one go and since you buy over a period, you buy in the troughs and the peaks of the market, hence averaging out cost. In the absence of an accurate market forecasting mechanism, investing through SIPs is best way forward. This is also a disciplined approach to investing in volatile markets.

What are the different types of mutual funds available?

The most common types of mutual funds are listed below:

Equity Linked Savings Scheme (ELSS): Equity Linked Savings Schemes are funds designed to give investors tax savings under Section 80C as well as an opportunity to invest in the markets. ELSS funds have a lock-in period of at least 3 years.

Large Cap, Mid Cap and Small Cap funds: As their name suggests, these mutual funds invest in either Large Cap, Small Cap or Mid cap companies. Large Cap companies are those with a market capitalization of more than 5000 crores. Mid Cap companies are those with a market capitalization between 1000 and 4999 crores and Small Cap companies are those with a market capitalization of less than 1000 crores. Mid Cap and Small Cap funds give a high return in rising markets although they fall sharply in a falling market while Large Cap funds are safer since they are tend to be more stable.

Index funds:  The stocks in this fund mimic the stock in indexes like BSE or NSE. The ratios and number of companies exactly mimic the index it is following.
Sectoral Funds: Sectoral funds invest in the stocks of a particular sector like Telecom or Infrastructure or any other sector which the fund house believes is a high growth sector. These funds bet on a particular sector and invest on in stocks from that sector.

Exchange Traded Funds: ETFs are baskets of securities that track major indices around the world. They are not mutual funds per-se and trade the same way a stock would trade and are traded on a stock exchange. You need to have a demat account to buy and sell ETFs. However a new class of mutual funds have come up which invest in ETFs and hence an investor need not have a demat account to buy those mutual funds.

There are several classes of mutual funds and the different types of funds that come up are only limited by the imagination of the Fund House!

The top performing equity mutual fund in the past 12 months in India (as of October 25, 2011) is as below:

Click here to read the article on when to redeem your mutual fund