What are the prerequisite to invest in Mutual Funds? How does the Mutual Funds work?

Question

How does the investor get benifits in the mutual fund? What are best mutual funds to buy in the today's market? Any link for this information?

Answer 1

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Q. What is a mutual fund?
A mutual fund is a trust that invests money contributed by a number of people in securities such as stocks, bonds, money market instruments, or even in assets like real estate and gold. To do this the mutual fund launches schemes, with each scheme having a specific and defined investment goal.

An investor buys a share in the assets of a scheme in the form of units, which represent his interest in the scheme. In India a mutual fund is organised as a trust, and this trust in turn appoints an asset manager commonly called an Asset Management Company (AMC) -to carry out the investment activity on its behalf.

Q.What advantages do mutual funds offer?

* Professional Management - The money contributed by the investors is invested by professional fund managers in the relevant asset classes as per the investment objective. Professional fund management brings in greater skill and experience to investing.

* Lower Risk - Mutual Funds invest the money in a large number of securities, thereby spreading the funds invested over a large number of securities and at times even over different asset classes within the same scheme. Investment in a large number of securities, and different asset classes reduces the risk to which an ordinary person investing by himself might be exposed.

* Better portfolio for less money - Since the investor buys a share in the assets of the fund, he gets a proportionate right over a large number of securities, which he would be unable to possess if he were to invest himself. For instance Rs 5000 may not be enough to buy even one share of a top notch software company while the same Rs 5000 invested in an Information Technology Mutual Fund will get the investor a proportionate share in a large number of premium software scrips.

* Lower Transaction Cost - A mutual fund, by virtue of its status and the volume of the transactions it conducts is able to carry out buy and sell transactions more cost effectively.

Q.What is the disadvantage of a mutual fund?
An investor has little or no control over the investments made by his fund. Funds therefore, to quote a fund manager, cannot be managed by "popular democracy". While this lack of control may be viewed as a disadvantage by one investor, another may see it as an advantage.

Q.What are the various types of mutual fund schemes?
An umpteen number of criteria can be used to classify mutual funds into various categories. We have listed below the most common criteria used to classify funds :

* Primary Aim / Asset Class
It classifies funds according to the asset class they invest in.

* Secondary Aim / Investment Sector
It segregates funds on the basis of the sub sector or the special focus area on which the fund's investments are concentrated.

* Duration / Liquidity
This basis uses the maturity time i.e whether the funds have any specific maturity date or not as the determinant for classifying the funds.

* Trading Strategy
This classifies funds on the basis of frequency with which the portfolio is churned.

* Investment Strategy
It uses investment philosophy followed by the fund as the criterion for categorising the funds.

* Basis of Security Selection
It classifies funds according to the criteria used by the fund to select securities for its portfolio.

* Objective of Investment
Here the funds are classified on the basis of the investment objective where objective reflects the purpose for which the investor is investing his money.

* Costs/Loads charged
Here the funds are classified on the basis of whether or not there is any load attached on the purchase or sale of the units.

* Place of origin
Here the funds use the criterion of the place of incorporation of the fund as the determining criterion for categorisation.


Q. What are the factors that need to be considered while selecting a fund?

* Investment needs
It is necessary to decide the purpose for which the investment is being made. This is because the investment avenue can vary depending upon the needs of the potential investor. For instance if one is investing for some event like retirement or for marriage of children and there is plenty of time to go, then it is better to invest in equity-dominated funds. On the other hand if the idea is to invest the lump sum received on retirement for regular income then a fixed income dominated fund is suitable.

* Risk profile
It is essential to invest in accordance with one's risk bearing capability. Equity funds therefore are not suitable for those with little risk appetite as volatile equity markets can impact fund returns.

* Time frame of Investment
Generally, equity funds are considered to be performers over a relatively long period of time. In the short term they are prone to fluctuations of the market. So, at the time of the withdrawal of investment an equity fund may not have given any returns. In such a case an equity fund is not the solution. An income fund or a money market scheme is ideal in the situation.

* Consider liquidity
This is linked to the above point. If the time frame of investment is short then it is not really advisable to invest in close-ended schemes. Units of these schemes are generally listed on stock exchanges, and past experience has shown that they quote at a heavy discount to their value. On the other hand if one is willing to invest for a certain defined period a close-ended scheme may do the job. Further, liquidity of the scheme in terms of its ability to liquidate its portfolio should also be looked into.

* Service Levels / Expenses
With the top funds offering similar returns service level has become the differentiating factor. It is important to choose a fund that offers efficient service in terms of prompt delivery of account statement and quick redressal of the investor grievances. An investor also needs to consider the expense ratios of the funds he proposes to invest in.

* Transparency
It is another crucial factor. It is better to choose a fund that is open about its investments, its investment style, and in its communication with its investors.


Q. What is the cost associated with mutual fund investing?
In addition to loads a mutual fund also charges asset management fees, and certain other expenses. These charges imposed by mutual funds are meant to compensate the fund for the expenses it incurs in managing assets, processing transactions and paying brokerages. For instance every redemption request involves not only administrative processing costs but also other costs associated with raising money to pay off the outgoing investor.

Mutual Funds cannot, however, be arbitrary in the imposition of these charges. For instance, regulations stipulate that the difference between the repurchase and the resale price cannot exceed 7 per cent of sale price, and that recurring expenses cannot exceed 2.5 per cent of average weekly net assets.

Loads:

* Entry Load/Sale Load
It is the charge imposed on the investor at the time his entry into the fund. Thus, the investor has to pay for the value of the units plus an additional charge. This additional charge is called the entry/sale load.
* Exit Load/Repurchase Load
It is the charge imposed on the investor at the time of his exit from the scheme. Operationally, therefore, the mutual fund will pay back to the investor the value of the units reduced by the charge levied on exit.
* Contingent Deferred Sales Charge
A mutual fund may not want to charge an exit load in all the cases. In such a case the mutual fund may impose charges based on the time of withdrawal. Thus, a fund desirous of long-term investors may stipulate that the exit charge will keep reducing with duration of investment. Such a charge is called Contingent Deferred Sales Charge. The asset management company is entitled to levy a contingent deferred sales charge for redemption during the first four years after purchase, not exceeding 4% of the redemption proceeds in the first year, 3% in the second year, 2% in the third year and 1% in the fourth year. In order to charge a CDSC the scheme has to be a no load scheme as per the regulation laid down by SEBI. The idea behind charging CDSC is the recovery of expenses incurred on promotion or distribution of the scheme
* Switchover/Exchange Fee
It is the fees charged by a fund when the investor decides to switch his investment from one scheme of the fund to another scheme from the same fund family.

* Recurring Expenses:
Apart from loads, mutual funds also charge some other expenses. Even here regulations stipulate the ceiling on each head. Some of the fees charged by the fund are:
o Investment Management & Advisory Fees - As the name explains this is meant to remunerate the asset management company for managing the investor's money.
o Trustee Fees - is the fees payable to the trustees for managing the trust.
o Custodian Fees - is the fees paid by the fund to its custodians, the organisation which handles the possession of the securities invested in by the fund.
o Registrar and Transfer Agents Charges - is the fees payable to the registrar and the transfer agents for handling the formalities related to the transfer of units and other related operations.
o Broker/Dealer Remuneration, Audit Fees, Cost of Funds Transfer, Cost of providing a/c statements, Cost of Statutory Advertisements.

Q. How is the worth of an investment in a mutual fund measured? What is NAV?
The current value of your investment can be known from the Net Asset Value or the NAV. The NAV, in effect, measures the value of the net assets (gross assets less liabilities) per unit. Mathematically, the NAV is given by:

{(Market Value of the Scheme's Investments)+Other Assets (including accrued interest)+ Un amortised Issue Expenses (only in case of schemes launched on a load basis) - All Liabilities except unit capital and reserves)}Divided by the number of units outstanding at the end of the day.
All assets and liabilities are valued at the current prices.


Q. Do mutual funds guarantee safety of capital and returns?
No, mutual funds normally do not guarantee any returns. One thing that is important to remember is that neither the returns nor the capital are guaranteed in most mutual fund schemes. While full term assured schemes-both equity and debt-have been launched in the past, they are now being phased out with the maximum period of assurance having been limited to one year.

SEBI, the regulator, has now provided that no mutual fund scheme can assure a return beyond a period of one year. Therefore, unlike a fixed deposit in a bank very few mutual funds can give investors assured returns.

Though mutual funds may not offer assured returns it is also important to note that with the diversification of investments in a mutual fund, the risk of capital depreciation or erosion of capital is lower. This applies more so in the case of income funds. In equity funds there can be absolutely no assurance of returns considering the very volatile and unpredictable nature of the equity markets.


Q. What are the various ways in which fund performance can be measured?
There are various ways of measuring performance. The NAV serves as a basic material for evaluating the performance of a fund. Some of the methods that are used are:

* Relative to benchmark method
Under this method a comparison is made between the returns given by a market index, and the fund over a given period of time. If the returns generated by the fund as measured by changes in NAV over that given period of time are greater than those generated by the benchmark then the fund is deemed to have outperformed the market portfolio.

* Risk-Return Method
The Relative-to-Benchmark measure is very simplistic, as it does not incorporate any measure of risk in its calculation. An investor would naturally be interested in finding out the return generated for the risk undertaken, as, in a bid to generate super normal return, the fund may go overboard on the risk parameter. Therefore, risk adjusted measures of return are needed to measure the performance of funds. There are several such measures prominent among which are the Sharpe ratio, the Treynor ratio, and Alpha:
o Sharpe ratio
This measure uses standard deviation as a measure to evaluate a fund's risk-adjusted returns. The higher a fund's Sharpe ratio, the better it is i.e a fund's returns would be regarded good if the fund returns a high level of Sharpe ratio. Mathematically, it is arrived at by deducting the risk free returns from the returns generated by the fund and dividing the residual figure by the standard deviation of the fund's returns. One thing that has to be kept in mind while using this measure is that the ratio is not an absolute figure. Its real utility lies in inter scheme comparison.
o Treynor's ratio
The other measure Treynor's ratio also has the same attributes with the difference that the residual figure in this case is divided by beta rather than the standard deviation, thus reflecting only the systematic risk. Beta of the fund is a volatility measure that quantifies sensitivity of the fund's return to the benchmark index's returns i.e. given the movements of the benchmark how much the fund will move. It does not give representation to unsystematic risk under the assumption that the fund manager can easily wipe out the unsystematic risk by diversifying across a large number of stocks.
o Alpha
Basically, alpha is the difference between the return that would be warranted by its beta (expected return) and the return that is actually generated by the fund. If a fund returns more than what is anticipated by beta, it has a positive and favourable alpha, and if it returns less than the amount predicted by beta, the fund has a negative alpha. Mathematically, Alpha= fund return - [Risk free rate + Beta of fund (Benchmark return - Risk free return)]


Q. How relevant is past performance of a fund scheme?
There is no clear answer to this. Fund prospectuses will clearly tell you that "past performance is no indicator of the future", but, on the other hand many analysts will tell you that sustained performance over a reasonably long period of time is a good criteria.

There is truth in both. While past performance reflects the success of the fund manager, the broad investment strategy and related factors, it serves as no guarantee that the strategy will work in the future too. A change in the external environment could necessitate a change in investment strategy too. Again, past successes could imply that the probability of future successes is respectably high.


Q. Do fund managers commit to any particular investment philosophy and style?
Normally fund managers do define the approach they intend to adopt to realise the investment objective of the scheme. Fund offer documents and other communication often include a comment from the fund manager about the investment philosophy and the style that is proposed to be followed with regard to the scheme.


Q. What risks is one exposed to while investing in mutual funds?

* Market risk
If the overall stock or bond markets fall on account of macro economic factors, the value of stock or bond holdings in the fund's portfolio can drop thereby impacting the NAV.

* Non-market risk
Bad news about an individual company can pull down its stock price, which can affect, negatively, funds holding a large quantity of that stock. This risk can be reduced by having a diversified portfolio that consists of a wide variety of stocks drawn from different industries.

* Interest rate risk
Bond prices and interest rates move in opposite directions. When interest rates rise, bond prices fall and this decline in underlying securities affects the NAV negatively. The extent of the negative impact is dependant on factors such as maturity profile, liquidity etc.

* Credit risk
Bonds are debt obligations. So when the funds invest in corporate bonds, they run the risk of the corporates defaulting on their interest payment and the principal payment obligations and when that risk crystallises it leads to a fall in the value of the bond causing the NAV of the fund to take a beating.

* Inflation risk

Q.What is Rupee Cost averaging?
Rupee cost averaging is an investment strategy wherein equal amounts of money are invested in a scheme at regular intervals. This enables an investor to buy higher number of units when the NAV is high and less number of units when the NAV is ruling at a low figure.

It eliminates the need to keep a continuous track of the market. Regular investment over a period of time evens out the short term fluctuations associated with the market's volatility.

Q.What is an offer document?

* Offer document is a document meant for the purpose of disseminating extensive information about the scheme and the fund to prospective unit holders so that they are well apprised of the risk before they commit their funds. It has to be designed in accordance with the guidelines stipulated by SEBI.

* A prospectus must disclose certain types of information, including details about:
o investment objectives
o risk factors and special considerations
o summary of expenses
o constitution of the fund
o guidelines on how to invest
o organization and capital structure
o tax provisions related to transactions
o financial information

Q.How does one read the offer document?
While the offer document contains detailed information about the mutual fund as a whole and about the particular scheme, a reader is likely to be confused as the document uses a lot of legal language in explaining the various points it is supposed to address.

Further, not all sections require careful reading. But, some sections do require more than a cursory glance. Sections addressing issues like investment objectives, investment philosophy, expenses, fund management background, sale and repurchase procedures, etc need to be read carefully. Potential risks, financial highlights, and past record also need attention.


Q.What are the tax benefits one can avail of by investing in mutual funds?
The dividend distributed by mutual funds has been made tax exempt in the hands of investors from the financial year 1999 although some categories of funds now pay distribution tax at the rate of 10 per cent on the dividend distributed to the unitholders.

The investment in mutual funds designated as Equity Linked Saving Scheme(ELSS) qualifies for rebate under section 88. The maximum amount that can be invested in these schemes is Rs.10,000, therefore the maximum tax benefit available works out to Rs 2000. Apart from ELSS schemes, the benefit of Section 88 is also available in select schemes of some funds such as UTI ULIP, KP Pension Plan etc

Some schemes also offered the benefit of section 54EA and 54EB to the investors. This benefit now stands withdrawn and only those investors who have sold off their properties prior to 31st March, 2000 are eligible to take advantage of the provision..


Q. Aren't the recent tax provision of distribution tax biased against the small investors?
Yes, in a sense they are. This is because the small investor is no longer in a position to avail the benefit of section 80-L wherein a deduction could be claimed on dividends received from mutual funds. Now, while the dividend has been made tax free in the hands of the investors, it is the mutual funds -other than open ended equity funds- who now have to pay the distribution tax of 10 (plus surcharge) per cent.

Therefore, the small investors who were earlier in a position to exhaust the 80-L limit and thereby dilute the tax liability will now not be able to get the tax benefit. So now this investor gets dividends net of tax as compared to gross dividend which he used to get earlier, as the distribution tax would already have been paid by the mutual fund.

Q.Mutual fund advertisements make exaggerated claims. What points should one check to avoid being taken in by aggressive advertising and ever obliging salesmen?

* Most Mutual Funds do not carry any guarantee. Moreover, they are not insured by any bank or government agency. Even funds carrying a Bank's name do not offer guaranteed returns. Therefore, if an advertisement seems to promise attractive returns, it is wise to check out the basis on which such claims are being made.

* Mutual funds always carry one or the other investment risk depending on the asset allocation of the scheme. Some types carry more risk than others. While the offer document details the risk factors associated with the scheme, background research and inquisitive questioning is required to uncover all potential risks.

* Past performance is not a reliable indicator of future performance and there is no guarantee that the fund manager will be in a position to repeat the past performance on a consistent basis. It is necessary not to be overawed by the claims of spectacular past performance.

* All mutual funds carry costs and loads that go on to reduce effective returns. An investor needs to confirm all cost inputs before committing his money.

Q.Where can information about mutual funds be found?
There are various newspapers, magazines, journals and web sites that carry all relevant information on mutual funds. Sites such as this, and business newspapers such as The Economic Times carry details and provide extensive coverage of mutual funds. Mutual Funds and their agents are one of the most vital sources of detailed information.

Q.Is there any minimum investment amount being stipulated by the scheme?
Yes, there is a minimum initial and subsequent level of investment stipulated by each mutual fund scheme. These amounts vary from fund to fund.

Q.What is the 'switching facility' offered by various funds?
Many mutual funds offer the investors the benefit of mobility within the fund family i.e. unitholders can move over from one scheme to another with or without the payment of entry/exit charges. Such a facility enables investors to quickly move their investments as and when market conditions change.

Q.What needs to be done to buy units?
There are various modes available depending on the kind of scheme. Normally, the mutual fund industry falls back largely upon the agent network to attract investors. Apart from this many large mutual funds have their own offices in all major cities. Application forms can also be downloaded from the web sites of various funds. Also, in close-ended schemes units of an existing scheme are available through the stock exchange.

Q.How does the order get executed?
Most funds price their units on a prospective basis, i.e. an investor gets to buy units at a price to be determined in the future. For this purpose each fund fixes a cut off time. Applications for purchase or redemption submitted before the designated time are processed at a price linked to the NAV of that day-which is announced at the end of that day- while applications submitted after the cut of time are processed at a price linked to the NAV of the following day. This cut off time determined varies from fund.

The number of units to be allotted-in case of purchase requests- is determined by dividing the amount invested by the applicable NAV based sale price. Normally, within a week of the purchase transaction the investor is mailed an account statement confirming the NAV at which the investment has been made. Along with this, the statement contains full details of the investor's address, the broker's name, and other information furnished by the investor at the time of applying for the units.

Answer 2

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Investor gets benefits through mutual funds in the following ways;

1. If he is tax assesse there is an expection in tax to some extent as per the income tax law for some schemes like FTP (Fixed Term Plan)
2. It gives more returns when compared with bank deposites,fixed income schems ,Bonds etc.


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