Concepts of Mutual fund04/05/2020
Mutual funds are investment vehicles that pool money from many different investors to increase their buying power and diversify their holdings. This allows investors to add a substantial number of securities to their portfolio for a much lower price than purchasing each security individually.
Benefits of Mutual Funds
As mutual funds are managed professionally it reduces the risk factor. Also, they are invested in a huge number of companies. Thus, the risk factor is reduced more.
There are a large number of investors that has savings with them. Thus, these small savings are brought together and a mutual fund is created. So, this can be used to buy the share of many different companies. Also, because of this diversification, the investment ensures capital appreciation and regular return.
There are many schemes in a mutual fund that provide a tax advantage under the new income tax act. So, the liability of paying the tax of an investor is also reduced. This can be possible only when he/she invests in mutual funds.
Mutual funds are monitored and regulated by the SEBI. Thus, it provides better protection to its investors. Also, this makes sure that there is no legal obligation for the investors.
Disadvantages of Mutual Funds
Although mutual funds can be beneficial in many ways, they are not for everyone.
- No Control over Portfolio. If you invest in a fund, you give up all control of your portfolio to the mutual fund money managers who run it.
- Capital Gains. Anytime you sell stock, you’re taxed on your gains. However, in a mutual fund, you’re taxed when the fund distributes gains it made from selling individual holdings even if you haven’t sold your shares. If the fund has high turnover, or sells holdings often, capital gains distributions could be an annual event.
- Fees and Expenses. Some mutual funds may assess a sales charge on all purchases, also known as a “load” this is what it costs to get into the fund. Plus, all mutual funds charge annual expenses, which are conveniently expressed as an annual expense ratio this is basically the cost of doing business. The expense ratio is expressed as a percentage, and is what you pay annually as a portion of your account value. The average for managed funds is around 1.5%. Alternatively, index funds charge much lower expenses (0.25% on average) because they are not actively managed. Since the expense ratio will eat directly into gains on an annual basis, closely compare expense ratios for different funds you’re considering.
- Over-diversification. Although there are many benefits of diversification, there are pitfalls of being over-diversified. Think of it like a sliding scale: The more securities you hold, the less likely you are to feel their individual returns on your overall portfolio. What this means is that though risk will be reduced, so too will the potential for gains. This may be an understood trade-off with diversification, but too much diversification can negate the reason you want market exposure in the first place.
- Cash Drag. Mutual funds need to maintain assets in cash to satisfy investor redemptions and to maintain liquidity for purchases. However, investors still pay to have funds sitting in cash because annual expenses are assessed on all fund assets, regardless of whether they’re invested or not. According to a study by William O’Reilly, CFA and Michael Preisano, CFA, maintaining this liquidity costs investors 0.83% of their portfolio value on an annual basis.
Types of mutual funds in India Again, we are trying to make it as simple as possible in explaining to you the different types of mutual funds.
- Equity Funds: Equity funds invest most of the money that they gather from investors into equity shares. These are high risk schemes and investors can also make losses, since most of the money is parked into shares. These types of schemes are suitable for investors with an appetite for risk
- Debt Funds: Debt funds invest most of their money into debt schemes including corporate debt, debt issued by banks, gilts and government securities. These types of funds are suitable for investors who are not willing to take risks. Returns are almost assured in these types of schemes
- Balanced funds: Balanced funds invest their money in equity as well as debt. They generally tend to skew the money more into equity then debt. The objective in the end is again to earn superior returns. Of course, they might alter their investment pattern based on market conditions.
- Money Market Mutual Funds: Money market mutual funds are also called Liquid funds. They invest a bulk of their money in safer short-term instruments like Certificates of Deposit, Treasury and Commercial Paper. Most of the investment is for a smaller duration.
- Gilt Funds: Gilt Funds are perhaps the most secure instruments that are around. They invest bulk of their money in government securities. Since they have backing of the government they are considered the safest mutual fund units around.
Role in capital Market Development
Investing in mutual funds have become hugely popular since 2003. To add to it and bring awareness among investors and non-investors alike, AMFI (Association of Mutual Funds in India) has started ‘Mutual Funds Sahi Hai’ campaign. It is interesting to see that majority of the salaried population of India tends to invest in Mutual Funds. One of the major reason behind it is the diversification of the fund schemes that allows more investors to come in and invest. Also, investing Mutual funds provide tax exemption for the salaried class and thus, they opt towards investing in Mutual funds.