Mutual Funds
Concept of Mutual Fund:
Mutual fund is a vehicle to mobilize moneys from investors, to invest in different markets and securities, in line with the investment objectives agreed upon, between the mutual fund and the investors. In other words, through investment in a mutual fund, a small investor can avail of professional fund managem ent services offered by an asset management company.
Role of Mutual Fund:
Mutual funds perform different roles for different constituencies.
Their primary role is to assist investors in earning an income or building their wealth, by participating in the opportunities available in various securities and markets. It is possible for mutual funds to structure a scheme for any kind of investment objective. Thus, the mutual fund structure, through its various schemes, makes it possible to tap a large corpus of money from diverse investors.
Therefore, the mutual fund offers schemes. In the industry, the words ‘fund’ and ‘scheme’ are used inter-changeably. Various categories of schemes are called “funds”.
The money that is raised from investors, ultimately benefits governments, companies or other entities, directly or indirectly, to raise moneys to invest in various projects or pay for various expenses.
As a large investor, the mutual funds can keep a check on the operations of the investee company, and their corporate governance and ethical standards.
The projects that are facilitated through such financing, offer employment to people; the income they earn helps the employees buy goods and services offered by other companies, thus supporting projects of these goods and services companies. Thus, overall economic development is promoted.
The mutual fund industry itself, offers livelihood to a large number of employees of mutual funds, distributors, registrars and various other service providers.
Higher employment, income and output in the economy boost the revenue collection of the government through taxes and other means. When these are spent prudently, it promotes further economic development and nation building.
Mutual funds can also act as a market stabilizer, in countering large inflows or outflows from foreign investors. Mutual funds are therefore viewed as a key participant in the capital market of any economy.
Why Mutual Fund Schemes:
Mutual funds seek to mobilize money from all possible investors. Various investors have different investment preferences. In order to accommodate these preferences, mutual funds mobilize different pools of money. Each such pool of money is called a mutual fund scheme.
Every scheme has a pre-announced investment objective. When investors invest in a mutual fund scheme, they are effectively buying into its investment objective.
How do Mutual Fund Schemes operate:
Mutual fund schemes announce their investment objective and seek investments from the public. Depending on how the scheme is structured, it may be open to accept money from investors, either during a limited period only, or at any time.
The investment that an investor makes in a scheme is translated into a certain number of ‘Units’ in the scheme. Thus, an investor in a scheme is issued units of the scheme.
Under the law, every unit has a face value of Rs. 10. (However, older schemes in the market may have a different face value). The face value is relevant from an accounting perspective. The number of units multiplied by its face value (Rs. 10) is the capital of the scheme – its Unit Capital.
The scheme earns interest income or dividend income on the investments it holds. Further, when it purchases and sells investments, it earns capital gains or incurs capital losses. These are called realized capital gains or realized capital losses as the case may be.
Investments owned by the scheme may be quoted in the market at higher than the cost paid. Such gains in values on securities held are called valuation gains.
valuation losses when securities are quoted in the market at a price below the cost at which the scheme acquired them.
Running the scheme leads to its share of operating expenses .
Investments can be said to have been handled profitably, if the following profitability metric is positive:
(A) +Interest income
(B) + Dividend income
(C) + Realized capital gains
(D) + Valuation gains
(E) – Realized capital losses
(F) – Valuation losses
(G) – Scheme expenses
When the investment activity is profitable, the true worth of a unit goes up; when there are losses, the true worth of a unit goes down. The true worth of a unit of the scheme is otherwise called Net Asset Value (NAV) of the scheme.
When a scheme is first made available for investment, it is called a ‘New Fund Offer’ (NFO). During the NFO, investors may have the chance of buying the units at their face value. Post-NFO, when they buy into a scheme, they need to pay a price that is linked to its NAV.
The money mobilized from investors is invested by the scheme as per the investment objective committed. Profits or losses, as the case might be, belong to the investors. The investor does not however bear a loss higher than the amount invested by him.
Various investors subscribing to an investment objective might have different expectations on how the profits are to be handled. Some may like it to be paid off regularly as dividends. Others might like the money to grow in the scheme. Mutual funds address such differential expectations between investors within a scheme, by offering various options, such as dividend payout option, dividend re-investment option and growth option. An investor buying into a scheme gets to select the preferred option also.
The relative size of mutual fund companies is assessed by their assets under management (AUM). When a scheme is first launched, assets under management would be the amount mobilized from investors. Thereafter, if the scheme has a positive profitability metric, its AUM goes up; a negative profitability metric will pull it down.
Further, if the scheme is open to receiving money from investors even post-NFO, then such contributions from investors boost the AUM. Conversely, if the scheme pays any money to the investors, either as dividend or as consideration for buying back the units of investors, the AUM falls.
The AUM thus captures the impact of the profitability metric and the flow of unit-holder money to or from the scheme.
Advantage of Mutual Funds for Investors:
Professional Management
Mutual funds offer investors the opportunity to earn an income or build their wealth through professional management of their investible funds. There are several aspects to such professional management viz. investing in line with the investment objective, investing based on adequate research, and ensuring that prudent investment processes are followed.
Affordable Portfolio Diversification
Units of a scheme give investors exposure to a range of securities held in the investment portfolio of the scheme. Thus, even a small investment of Rs. 500 in a mutual fund scheme can give investors a diversified investment portfolio.
Consequently, the investor is less likely to lose money on all the investments at the same time. Thus, diversification helps reduce the risk in investment. In order to achieve the same diversification as a mutual fund scheme, investors will need to set apart several lakhs of rupees. Instead, they can achieve the diversification through an investment of less than thousand rupees in a mutual fund scheme.
Economies of Scale
The pooling of large sums of money from so many investors makes it possible for the mutual fund to engage professional managers to manage the investment. Individual investors with small amounts to invest cannot, by themselves, afford to engage such professional management.
Large investment corpus leads to various other economies of scale. For instance, costs related to investment research and office space get spread across investors. Further, the higher transaction volume makes it possible to negotiate better terms with brokers, bankers and other service providers.
Thus, investing through a mutual fund offers a distinct economic advantage to an investor as compared to direct investing in terms of cost saving.
At times, investors in financial markets are stuck with a security for which they can’t find a buyer – worse, at times they can’t find the company they invested in! Such investments, whose value the investor cannot easily realise in the market, are technically called illiquid investments and may result in losses for the investor.
Investors in a mutual fund scheme can recover the value of the moneys invested, from the mutual fund itself. Depending on the structure of the mutual fund scheme, this would be possible, either at any time, or during specific intervals, or only on closure of the scheme. Schemes, where the money can be recovered from the mutual fund only on closure of the scheme, are listed in a stock exchange. In such schemes, the investor can sell the units in the stock exchange to recover the prevailing value of the investment.
Tax benefits
Specific schemes of mutual funds (Equity Linked Savings Schemes) give investors the benefit of deduction of the amount subscribed (upto Rs. 150,000 in a financial year), from their income that is liable to tax. This reduces their taxable income, and therefore the tax liability.
The Rajiv Gandhi Equity Savings Scheme (RGESS) offers a rebate to first time retail investors (in equity or mutual funds) with annual income upto Rs. 12 lakhs. Mutual funds announce specific equity-oriented schemes that are eligible for the RGESS benefit.
The RGESS benefit is linked to amount invested (excluding brokerage, securities transaction tax, service tax, stamp duty and all taxes appearing in the contract note). Rebate of 50% of the amount invested upto Rs. 50,000, can be claimed as a deduction from taxable income. The investment limit of Rs. 50,000 is applicable for a block of three financial years, starting with the year of first investment.
Thus, if an investor invests Rs. 30,000 in RGESS schemes in a financial year, then he can reduce his taxable income for that previous year by 50% of Rs. 30,000 i.e. Rs. 15,000. In the following year, he still has an investment limit of Rs. 20,000 available. The maximum deduction that can be made from the taxable income over the period of three financial years is 50% of Rs. 50,000 i.e. Rs. 25,000
Dividends received from mutual fund schemes are tax-free in the hands of the investors.
Convenient Options
The options offered under a scheme allow investors to structure their investments in line with their liquidity preference and tax position.
There is also great transaction conveniences like the ability of withdraw only part of the money from the investment account, ability to invest additional amounts to the account, setting up systematic transactions, etc.
Investment Comfort
Once an investment is made with a mutual fund, they make it convenient for the investor to make further purchases with very little documentation. This simplifies subsequent investment activity.
Regulatory Comfort
The regulator, Securities & Exchange Board of India (SEBI), has mandated strict checks and balances in the structure of mutual funds and their activities. Mutual fund investors benefit from such protection.
Systematic Approach to Investments
Mutual funds also offer facilities that help investor invest amounts regularly through a Systematic Investment Plan (SIP); or withdraw amounts regularly through a Systematic Withdrawal Plan (SWP); or move moneys between different kinds of schemes through a Systematic Transfer Plan (STP). Such systematic approaches promote an investment discipline, which is useful in long-term wealth creation and protection. SWPs allow the investor to structure a regular cash flow from the investment account.