Mutual Funds

What is a mutual fund?
Simply put, a mutual fund is a basket of assets, typically stocks. An entity, usually a corporation, comes up with a plan to invest in certain assets, typically stocks and raises capital through the issue of shares to investors in a process called a New Fund Offer (NFO). This corporation is called the Mutual Fund. The fund is managed by an individual called the Fund Manager.

The fund then invests this capital in shares/bonds as per the objective of the fund as outlined in the prospectus issued to investors. The mutual fund investors therefore, indirectly own the assets that the mutual fund owns by owning pieces of the mutual fund.

Type of assets owned by the fund
Most mutual funds are equity funds, i.e. they invest in stocks. However, several mutual funds invest in corporate bonds, commodities or a combination of all of these. For example, the Fidelity Equity-Income fund aims to invest 80% of its portfolio in shares of large-cap American companies while the SBI Magnum Midcap fund aims to invest predominantly in a well diversified basket of shares of Midcap companies in India.

Investors will know beforehand, which asset classes the fund invests in as the target asset allocation and the type of investments considered will be outlined in the prospectus.

Open ended and Closed ended mutual funds
Open ended funds are mutual funds that do no limit the number of shares issued by them. In other words, shares of the open ended mutual funds can be issued and redeemed by the fund. The investors of open ended funds transact directly with the fund. New investors who would like to invest in the fund are issued new shares by the fund. Investors who want to disinvest from the fund receive cash from the fund after redemption of their shares.

Closed ended funds are mutual funds who limit the number of shares issued by them. After the NFO, investors who want to invest in closed ended funds have to buy shares of the fund from existing investors of the fund. The fund does not normally issue new shares after the NFO.

What is the risk-return profile of mutual funds?
The risk-return profile of a mutual fund depends heavily on the fund’s objective, the asset classes it invests and the type of securities it invests in. The bottom line is that a mutual fund has the same risk profile as the securities that it invests in. Equity mutual funds carry the risk profile of equity securities while bond funds carry the risks of bonds and so on. Midcap funds are generally more risky than large cap funds while money market funds are usually the safest. Since most mutual funds invest in a well diversified basket of securities, the risk carried by such funds is much lower than the risk from investing in a single security.

Types of mutual funds
Equity funds invest in equity securities i.e. shares. They may also invest in stock options, futures etc. Equity funds may focus on investment style such as Value, Growth funds, Index or on specific sectors such as Infrastructure, Automobiles, Telecom etc. Mid-cap funds invest in mid-market capitalization companies while small cap funds invest in companies with small market capitalization. Similarly, Emerging market funds invest in companies from emerging markets such as India, Russia, Brazil etc.

Bond funds invest in a basket of corporate bonds. Bond funds provide diversification benefits and reduce the total credit risk borne by the investor.

Balanced funds invest in a combination of equity and debt instruments i.e. shares and bonds.

Investing in mutual funds is a relatively cheap way of diversifying. Depending on the fund objective and structure, it could also provide economies of scale. For example, if person wanting to invest $100 in telecom companies in USA, it would be far easier and cheaper to buy 10 shares of XYZ Telecom mutual fund than buy 1 share of AT&T, 1 share of Verizon and so on. Mutual funds also, in a sense, force some amount of diversification and thus reduce the overall risk borne by the investor.

Disadvantages
Mutual funds often charge entry and exit loads i.e. one time fees to issuance and redeem of shares. This money goes to the fund and is often used for marketing and sales activities. These loads typically amount to about 1-3% of the investment. Thus, investors who invest $100 in mutual funds typically only end up getting shares worth $97. Funds also charge Management fees and/or Other fees which typically amounts to 1-1.5% p.a. This cost too is borne by the investor.

The emergence of No-Load mutual funds is a big step in towards eliminating such unnecessary expense for the investors. Several funds, especially Exchange Traded Funds (ETFs) now have low expense ratios, typically less than 1% p.a. Investors can consider investing in such funds.

Risks
The main risk that investors in mutual funds face is market risk, i.e. the risk that the prices of the assets that the mutual fund invests in, fall due to changes in market conditions thereby reducing the Net Asset Value of the fund. Note that unsystematic risk (The risk that fluctuations in the prices of individual stocks/bonds due to company specific reasons will effect the NAV), is virtually nil. This is due to diversification benefits.

Investors also bear the risk that the fund manager will deviate from the fund’s stated objective thereby distorting returns. This risk is called manager risk. Investors in funds that invest outside their home country also bear currency risk(The risk that changes in exchange rates distort returns).

How can one invest in mutual funds?

Investors can approach the fund directly or use the services of a broker(e.g. Charles Schwab or E-Trade) in order to buy shares of mutual funds. Most brokers charge a brokerage fee for enabling you to buy no load funds or exchange traded funds.

Next: Bonds and Debt securities