What are Mutual Funds?


Mutual Funds is a term that we all here almost everyday. But what exactly is a Mutual Fund? It is what its name suggests. Mutual Fund is like a company that brings together people from different strata and walks of life and helps them all to mutually invest their funds in stocks, bonds or other securities.

Types of Mutual Funds

Irrespective of who you are, what you do and what your income is, there is bound to be a Mutual Fund that would fit your necessities. According to the last count there are more than ten thousand kinds of Mutual Funds in North America, implying that there are more Mutual Funds than there are stocks!

Before we proceed on the various kinds of Mutual Funds, we would like to inform you that all Mutual Funds are subject to market risks though the amount of risk may vary between one Mutual Fund and another. Generally, higher the return potential, higher is the risk of loss. Please remember that it is impossible to diversify away all risks.

Coming to the kinds of Mutual Funds, there are largely three kinds of Mutual Funds with each fund having a predetermined investment objective tailoring the fund’s assets, regions of investment and investment strategies. These are:

  1. Equity Funds (stocks)
  2. Fixed-income funds (bonds)
  3. Money Market Funds

Of these, Money Market Funds are the least risky; hence we will start with that and then proceed towards the more risky kinds.

Money Market Funds
The safest area to invest in, you won’t get great returns but at the same time you don’t have to worry about losing your principal. Typically, you would get returns twice of what you would earn in a conventional savings account and a little less than a certificate of deposit. The Money Market consists of short-term debt instruments, mostly Treasury Bills.

Fixed-income Funds (Bonds)
The purpose of these funds is synonymous with its name. These funds provide you with a steady income. Best option available for conservative investors and retirees, while the fund holding may appreciate in value, the investors will be guaranteed of a constant cash flow. Please remember that while it’s true that bond funds give you higher returns, as stated earlier, they also have their share of risks. Bond funds vary noticeably depending on where the investment is. To give an example, a fund specialising in high-yield junk bonds is much more risky than a fund investing in government securities. In addition, all bonds are subject to interest rate risk meaning that if the rate goes up, the value of the fund goes down.

Balanced Fund
As the name goes, so does its objective. These funds provide you with a balanced mixture of safety, income and capital appreciation. The stratagem of this fund is to invest in a combination of fixed income and equities. A similar type of fund is asset allocation fund. While the objectives of both these funds are similar, the asset allocation fund doesn’t get restricted to a specified percentage of asset class unlike the balanced funds. It is because of this that the portfolio manager is given the freedom to switch the ratio of asset classes as the economy moves through the business cycle.

Equity Funds (Stocks)
Funds invested in stocks represent the largest category of mutual funds. Long-term capital growth with income – this is the aim of these funds. However, since there are many types of equities, there are also many types of equity funds. Equity funds are classified on the basis of the size of the company invested in and the investment style of the manager.

Global/International Funds
An International Fund is one that invests only outside your home country. Global fund, on the other hand, invest globally including your home country. We do not say that these funds are more/less riskier than those of your home country. Also its difficult to classify so as the world’s economies today are inter-related. But it is quite possible that some economy is doing better than your own home country’s economy, and hence investing there would perhaps yield greater returns.

Speciality Funds
All-encompassing funds, yet they do not belong to the categories mentioned above, hence are called speciality funds. This type of mutual fund forgoes broad diversification and concentrates on a certain segment of the economy. Extremely volatile, sector funds are targeted at specific economic sectors like finance, health, technology etc. There is a possibility of big gains but be prepared for losses as well. Regional funds make it easy to concentrate on a specific region in the world. With these funds you can focus on a particular region (Latin America) or a particular country (Brazil). Socially responsible funds or ethical funds invest in companies that meet certain guidelines or beliefs. Such funds do not invest in industries like tobacco, alcoholic beverages, nuclear arms etc.

Index Funds
This type of mutual fund replicates the performance of a brad market index such as S&P 500 and Dow Jones Industrial Average (DJIA). An index fund merely replicates the market returns and benefits the investors in the form of low fees.

Now that you know how Indian Mutual Funds are classified, let us tell you how non-residents can make money from the same. There are three ways:

  1. Mutual Fund income is earned from dividends on stocks and interest on bonds, held by the mutual fund.
  2. The Mutual Fund has a capital gain if the Indian Mutual Fund sells securities that have increased in price.
  3. If Mutual Fund holding increase in price but are not sold by the fund manager, the Mutual Fund’s shares increase in price. You can then sell your Indian Mutual Fund shares for a profit.

** Note: Mutual Funds will give you a choice to either receive a cheque or reinvest your gains by buying more shares.

Mutual Funds have a lot of advantages for all you non-residents:

  • Professional Management – Managing money and professionally managing your money are two different things, and Indian Mutual Fund is the most inexpensive way of letting a manager make and monitor all your investments.
  • Diversification – By owning shares of Mutual Funds as compared to individual stocks or bonds, non-residents’ reduce risk because large Indian Mutual Funds typically own different stocks in different industries in one mutual fund itself.
  • Economies of Scale – Transaction cost for non-residents is lower because a mutual fund buys and sells large amounts of securities at a time.
  • Liquidity – Indian Mutual Fund allows your shares to be converted into cash at any time.
  • Simplicity – Non-residents can trade (buy and sell) Indian Mutual Funds online.

Mutual Fund: The Costs

Costs are the biggest problem in Mutual Funds. They eat into your cost and is the reason why most Mutual Funds have sub-par performance. What is worse is the way the industry hides costs. Some companies opine that companies get away with fees they charge because many times the investor doesn’t know what he/she is paying for. It is because of this that we, at nriinvestindia.com, feel it is important that we guide you through this.

Fees can be broken down into:

  1. Ongoing yearly fees to keep you invested in the fund
  2. Transaction fees paid when you buy or sell shares in a fund (loads)

Expense Ratio
Expense ratio or Management Expense Ratio (MER) represents the ongoing expense of a Mutual Fund. The expense ratio is composed of the following:

  • Fund Managers’ Cost – Synonym for management fee, this cost is, on an average, between 0.5% and 1% of assets. It sounds small, but the managers actually earn quite a lot with this meagre fee in %. Obvious, if the manager charges you 1% of 250 million, they get 2.5 million!
  • Administrative Cost – These include necessities like postage, record keeping, customer service, and even cappuccino machines in some cases!
  • 12B-1 Fee (common to US market) – If you invest in a mutual fund having 12B-1 fees, it actually means that you are paying for the advertisements that the mutual fund runs!

On the whole, expense ratios range between 0.2% (index funds) to 2%. You would perhaps pay more for international and/or speciality funds, as that requires more expertise.

Loads
Loads on the other hand, will look like below:

  • Front-end Loads – Simplest kinds of loads, you pay the fee when you purchase the fund. For example: if you invest $1000 in a mutual fund with a 5% front-end load, $50 will be paid for the sales charge, and $950 will be invested.
  • Back-end Loads (Deferred Sales Charge) – In such a fund you pay the back-end load if you sell a fund within a certain time frame. For example, suppose the back end load is 5%, the load is 5% if you sell it within the first year, 4% in the second year and so on. If you do not sell the mutual fund by the sixth year, you do not have to pay the load at all.

A no-load fund sells its share minus sales charge or commission. Some in the industry will tell you that load is the fee you pay the agent for choosing the right mutual fund for you. Going by this pretext, your returns WILL be higher because of the professional advice. But there is hardly any evidence showing a correlation between load funds and superior performance.

How to pick a Mutual Fund

While it’s true that Mutual Funds are the best options to go in for and have the least risk involved, it’s also as important to pick the right mutual fund that would suit your investment style.

Net Asset Value (NAV): Value of your Fund

The NAV is the fund’s assets minus liabilities, and this is the value of your Mutual Fund. NAV per share is the value of one share in the mutual fund, and is the number quoted in the newspapers. In simple terms, NAV is the price of the Mutual Fund and fluctuates everyday with change in fund holding and outstanding shares. While buying shares, you pay the NAV plus the front-end load, if any. While selling, the fund will give you NAV minus any back-end load.

2 thoughts on “What are Mutual Funds?

  1. Hi ,
    Your post is really very informative and interesting keep goin 🙂
    I have invested my savings in “Mutual Fund”. The company gave me full safty and security , and im getting very good returns over my investment. They provided various funds like ” Select focus, select mid cap, balanced fund, growth fund,etc.. where i got full support and details from them to select my own fund.

    Regards,
    Aradhna

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