Investing in mutual funds can be a good option for small investors. It is an easiest way to invest in share and stock markets with less investment and enjoying benefits with a small improvement in share prices.
What are Mutual Funds? It is a professionally managed investment scheme run by asset management companies that pool money from investors and invest on their behalf in different securities such as stocks, bonds or a combination of both.
Depending on how the pooled money is being invested, there are different categories of mutual funds based on asset class, structure and investment objective. On the basis of asset class, mutual funds are of the following types:
- i) Equity Funds: Mutual funds where at least 70 per cent of the funds are invested in stocks or shares of firms listed on stock markets. Equity funds can be further classified based on sectors like infrastructure funds, IT funds; size of the firms like large cap, mid cap or small and medium enterprise (SME) funds; purpose like Equity Linked Savings Schemes (ELSS) that gives benefit of tax savings; tracking a particular index through index funds; or fund of funds which invests in other mutual funds.
- ii) Debt Funds: These are mutual funds where the majority of investments are in debt instruments like Government bonds, company debentures and other fixed income assets.
iii) Hybrid/Balanced Funds: Balanced funds invest in both the asset classes of equity and debt instruments with the proportion of equity and debt varying in different funds. A balanced fund could be 60 per cent invested in equities with remaining 40 per cent in debt or vice-versa.
- iv) Money Market Funds: Unlike equity, debt or balanced funds that invest in capital markets with longer maturities, money market funds invest in money markets that are short term in nature and are highly liquid and are mostly preferred by companies to park their idle cash and by large institutions and the Government to meet their short term fund requirements.
Mutual funds can also be categorised as open-ended or close-ended based on the structure. Just like an investor can buy or sell a share on the stock market any time, open-ended mutual funds can also be bought or sold any time after the New Fund Offer (NFO) directly from the fund instead of existing shareholders at the net asset value (NAV) declared by the fund which changes daily based on closing market prices of the underlying securities, whereas the number of units issued to the investors are fixed in close-ended mutual funds and are eligible for redemption only on a specific maturity date.
In addition, based on investment objectives, mutual funds can also be categorised as growth funds, income funds and liquid funds.
How is NAV calculated? The NAV of any open-ended mutual fund is calculated as NAV = (assets – liabilities) / number of outstanding shares, where assets include total closing market price of the assets of the fund investments on the day the NAV is calculated, cash and cash equivalents, any receivables and accrued income. Liabilities are the total short-term and long-term liabilities, plus all accrued expenses, such operating expenses, management expenses, distribution and marketing expenses, transfer agent fees, custodian and audit fees.
For example, if a mutual fund has Rs 10 crores of investments, based on the day’s closing prices for each individual asset and Rs 70 lakhs of cash and cash equivalents on hand, as well Rs 40 lakhs in total receivables. Accrued income for the day is one lakh rupee. The fund has Rs 1.3 crores in short-term liabilities and Rs 20 lakhs in long-term liabilities. Accrued expenses for the day are Rs 50,000. The fund has 50 lakh shares outstanding. The NAV is calculated as:
NAV = ((100,000,000 + 70,00,000 + 40,00,000 + 1,00,000) – (1,30,00,000 + 20,00,000 + 50,000)) / 50,00,000 = Rs 25.23
A word of caution: Small investors, who are trying to make most of their investments are plagued by questions: Are mutual fund investments safe? Are they safer than direct equity investments? What about the risk of mutual fund investing?
Invest according to Risk Appetite: The answer lies in the risk appetite of individual investors. Investments in stock markets either through buying of shares or through mutual funds, are subject to a risk-return trade off, which means the more risk an investor takes, the more the potential, (only potential and not certainty) for enhanced returns.
So, a young executive who has started earning recently should be more aggressive and invest in equity mutual funds which, although are riskier, but at the same time, have the potential to generate higher returns over long-term.
A middle-aged person, who wants to preserve capital but at the same time generate some returns, can invest in balanced funds which are less riskier than equity funds. A retired person, whose tolerance towards risk is very low should go for debt mutual funds or income funds.
Be aware of the Investment Objective of Mutual Funds: It is a well-known fact that fund managers are under pressure to post higher performance and beat their benchmarks. Therefore, sometimes, to generate above-average returns, fund managers, digress from their investment objectives, which means that if an investor with a low risk tolerance, intending to invest in a balanced fund may be unknowingly taking higher risk due to undue changes and inclusion of riskier securities in the portfolio by the fund manager to generate higher returns.
Investors should be highly aware and check the portfolio mix from time to time, to see whether the securities included and their proportion in the portfolio matches the investment objective of the mutual fund.
Hidden Expenses: As it is seen in the calculation of NAV, investors lose if the liabilities and expenses of the asset management company handling the mutual funds are high. Investors should be aware about any hidden charges, liabilities and higher asset management fee that an Asset management companies (AMC) could be levying without the knowledge of investors.
Mutual funds are an easier way for small investors to invest in the stock markets with low initial investment but at the same time get the benefit of any upswing in the prices of the shares because of professional expertise of fund managers.
However, small investors should be aware that since mutual funds in turn invest in shares, the returns are subject to the fluctuations of the stock market and are not fully insulated from it.
The extent of risk, and also the returns come down with the inclusion of debt securities in the portfolio of mutual funds and investors should understand their risk tolerance before investing. Mutual fund investing can be good alternative for small investors provided they tread with caution.
(The writer is Assistant Professor, Amity University)
Writer: Hima Bindu Kota