Understanding Mutual Funds

Introduction:

Mutual Fund which was once just another obscure financial instrument is now a part of our daily life with more than 80 million people investing in these instruments. A mutual fund is nothing but a collection of different financial instruments like stocks and bonds. Mutual fund companies gather money from different small investors and invest in bonds, stocks and other securities. A small investor cannot invest in multiple securities i.e., he cannot diversify his portfolio. With Mutual Funds one can diversify the portfolio.

Mutual Funds yields returns in three ways:

• Income earned from interest on bonds and dividends on stocks
• Whenever a fund sells its securities  that have increased in price, those capital gains will be transferred to  the investors
• Increase in Net Asset Value of fund holdings due to increase in share value.

Advantages of Mutual Funds:

Diversification: If one invests in individual stocks or bonds. The risk will be concentrated and it will be high. The idea of diversification is to spread and minimize the risk by investing in large number of assets such that loss in any particular asset class is minimized with gains in other asset class. Large Mutual Funds generally invest in hundreds of bonds and stocks in different industries. A small investor cannot build such a diversified portfolio with small investments.

Economies of Scale: As mutual funds transact large amounts of securities at a time, the transaction costs involved will be lower than what an individual would generally pay for transactions.

Liquidity: Mutual Funds are as liquid as individual stocks. Investors can buy or sell his mutual funds any time.

Professional Management: The major advantage of investing in mutual funds is that one will get a full-time manager to monitor the investments. The investments will be managed professionally.

Disadvantages of Mutual Funds:

Dilution: To achieve diversification of portfolio, Funds invests small amount in different industries and as a result if particular industry yields high returns that have a greater impact on overall portfolio.

Professional Management: There is always a debate among investors if the so-called professional managers are any better than a normal investor in picking stocks.

Costs: It is always expensive to create, distribute and run a mutual fund and also expenses like salaries of fund managers and other administrative expenses are involved. All these costs will be transferred to the investors.

Types of Mutual Funds:

There are about 4000 different mutual fund schemes in the market each with a different composition of stocks and bonds. At the fundamental level mutual funds can classified as:

1)      Equity Funds (Stocks)

2)      Debt Funds (Bonds)

3)      Money Market Funds

4)      Balanced Funds

Equity Funds: The funds which have majority of holdings in stocks are classified as equity funds. Generally majority of the funds fall in this category. The investment objective of equity funds is to achieve long term capital growth with some income. Equity funds are sub-classified depending on various parameters. Based on Market Capitalization of the stocks equity funds are classified as

• Large Cap Funds
• Mid Cap Funds
• Small Cap Funds

Debt Funds: The funds which invest primarily in government and corporate debt funds are classified as debt funds or income funds. The investment objective of these funds is to provide a steady cashflow to investors.  Debt funds yield more returns than certificate of deposit and money market funds but they aren’t without risk.

Money Market Funds: The funds which invest in short term debt instruments like treasury bills are classified as money market funds. These funds yield lower returns but are the safest returns without any risk of losing the principle.

Balanced Funds: The funds which invest in a combination of fixed income and equity securities are generally classified as balanced funds. A typical balanced fund might have equity and debt securities composition in the ratio of 60-40. The investment objective of the balance funds is to provide a mixture of safety, regular income and long term capital appreciation.

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