Ever since the widely popularised advertising campaign “Mutual Fund Sahi Hai,” all of us have at least heard the term Mutual Fund. However not many among us properly understand what a Mutual Fund is, what are its advantages and disadvantages as an investment option, how to select which Mutual Fund is right for us and what kind of risks a Mutual Fund investment carries. In this article, we help develop, from a layman’s perspective, a conceptually solid understanding of mutual funds as an investment option.
Understanding Mutual Funds
In simplest terms, a Mutual Fund is a portfolio of stocks, which is managed by investment professionals who have proper training in the field of finance and investment analysis. This gives Mutual Funds two core advantages: (1) the stocks selected in a Mutual Fund are selected after proper and thorough analysis by people who understand the art and science behind stock-picking and (2) it has multiple stocks so at any point of time the total risk an investor takes is spread out and not concentrated in one holding.
We should also understand why a product like a Mutual Fund is needed in the first place. The journey of an average investor begins with the most basic instrument: the savings bank account. An under informed but financially-conscious investor thereafter turns to investment options like the Employee Provident Fund, Fixed Deposits, Post Office Deposits and various other ‘fixed-return’ savings products. In these products, an investor gets a guaranteed rate of return but the rate of return is low. At the same time, the investor gets a high degree of security that his principal amount (the money he deposits) will be returned to him along with the promised interest (the rate of return). Essentially these are ‘low-risk’ but also ‘low-return’ products from where an investor begins their journey.
As the investor gains more knowledge, becomes more financially secure and accumulates more spare cash to invest, he/she begins to turn to stock markets for investment. At this stage, the investor only knows that the stock market is risky but can offer high returns
However, as the investor gains more knowledge, becomes more financially secure and accumulates more spare cash to invest, he/she begins to turn to stock markets for investment. At this stage, the investor only knows that the stock market is risky but can offer high returns. The choice therefore is either to invest directly in stocks or to buy mutual funds units.
Mutual Fund Vs Stocks
Stocks are shares in a company. Investing directly in one stock exposes the investor to all the risks of that company. If you buy shares of, say ABC Co., then your investment is exposed to business risks that ABC may not do as well as you expect in business. You are exposed to operational risks that some of the senior management of ABC are involved in unlawful activities having an impact on the reputation and brand value of ABC. You are exposed to regulatory risks wherein the Government may change regulations causing a deterioration of the business environment for ABC. There are many risks, which are concentrated in single stock.
Further, the biggest question is, even if those risks are not present, then how sound was your analysis when picking the stock for investment? Contrary to the belief of many untrained stock-market enthusiasts, there are ways to calculate the probable returns a stock might give and an untrained investor has little or no schooling in those methods. On the other hand, many trained professional investors specially look for opportunities to sell their stocks at high prices to, and buy them at cheap prices from, untrained investors. In short, untrained investors should generally avoid investing their hard-earned money directly in stocks.
Mutual Funds solve the above problems for the untrained investor. As we discussed above, Mutual Funds have two core advantages. Firstly, the stocks selected in a Mutual Fund are selected after proper and thorough analysis by people who understand the art and science behind stock-picking. Secondly, it has multiple stocks so at any point of time the total risk an investor takes is spread out and not concentrated in one holding. It is highly unlikely that all companies held by a Mutual Fund will suffer from business risk, or operational risk or regulatory risk at the same time. By spreading this risk between multiple stocks, Mutual Funds offer their investors market-linked returns at lower risk. This is their key advantage and also the reason why campaigns like “Mutual Fund sahi hai” have been run to encourage and educate investors about this investment option.
Selecting Mutual Funds
The market for Mutual Funds has grown and today there are so many of them that investors could get confused about how to select them. Investors who have very little proficiency on the subject should begin with three basic questions before selecting a Mutual Fund.
Questions that bother investors are who owns the Mutual Fund, what kind of stocks does the Mutual Fund invest in and how much does the Mutual Fund charge for its services
The answers to the above questions give us three important properties of the Mutual Fund: The Asset Management Company, Investment Strategy and Expense Ratio. Let us understand them one by one.
Answer to the first question tells us which Asset Management Company (AMC) has created the Mutual Fund. This is important to know because the management of the Mutual Fund will belong to that company and further the customer service, the complaints resolution process, the IT systems, the ethics and integrity of the Management all depend on the AMC. There have been cases in the past where Mutual Funds floated by less reputed AMCs have suffered from issues relating to unethical management behaviour or collapse of IT systems.
Answer to the second question tells us what is the investing strategy of the Mutual Fund. Labels such as ‘Blue-chip’ or ‘Bank and Financial Services’ or ‘Mid-Cap’ etc. tell us that the Mutual Fund has narrowed down the universe of investable stocks to a smaller number and now will be selecting stocks from that number alone. For example, while there are nearly 1,641 listed companies on NIFTY, a Mutual Fund describing itself as ‘Blue-Chip’ will invest in only the largest 100 companies of the NIFTY (large here refers to large by market capitalisation). A Mutual Fund saying it is a ‘Bank and Financial Services’ Mutual Fund will invest only in Banking and Financial Services stocks – it may invest in SBI or Paytm but will not invest in say Maruti Suzuki or Reliance. This declaration of investment strategy is regulated by the Government of India through the Securities and Exchange Board of India (SEBI), which is responsible for stock markets regulations.
Answer to the third question tells us what the Mutual Fund charges for its services: this is called the ‘Expense Ratio.’ Expense Ratio is deducted from the investors and should be seen as a kind of fees – clearly lower fees is better. Once again, owing to SEBI regulations, there are now upper limits on Mutual Funds fees so the cumulative difference from selecting a fund with lower fees tends to be small. However if you are confused between two funds that are equally good then you may choose the one with lower fees.
Investors also need to take a look into the following factors
- AUM Size: larger funds are more secure and robust and can handle market volatility better
- Continuity of Fund Manager: the same fund manager over a long period is usually seen as a positive for continuity of the investment strategy and also because the fund manager is likely to have significant incentives tied to fund performance
- Historical Performance: this point is deliberately kept for last as studies have shown that historical performance is not a good predictor of future performance; however investors may gain confidence in the fund management by seeing fund performance in specific periods of volatility
For an investor who is not financially perceptive or formally educated in the field of investment analysis, Mutual Funds are a good option to diversify their wealth away from fixed rate instruments and seek higher returns from the stock markets
Comprehending Index Funds
Index Funds are a special type of Mutual Fund. Index Funds do not carry out stock selection like Mutual Funds, rather an Index Fund simply picks up all the stocks in the Index, in the same proportion as the Index and aims to give the ‘same’ performance as the Index. Notice the word ‘same’ – while a Mutual Fund tries to ‘beat’ the market, an Index Fund tries to replicate the market.
This difference in investment approach results in Index Funds being passively managed with very small expense ratios since there is no need to employ a trained Fund Manager to copy the Index. Their low expense ratio and reduced operational risks (since there is little to no management) is the reason why many investors see Index Funds as a safer investment option compared to Mutual Funds.
For an investor who is not financially perceptive or formally educated in the field of investment analysis, Mutual Funds are a good option to diversify their wealth away from fixed rate instruments and seek higher returns from the stock markets. Investing in Mutual Funds also helps the investor take a share in the India growth story for which there is unequivocal optimism all over the world.