Mutual Funds Meaning, Features, Advantages, Disadvantages, Types will be discussed here.
There are various investments alternatives available for investors which are already discussed in my previous article. Out of these alternatives, mutual funds are now gaining popularity in our country. The main reason of this is that it offers many benefits to small and medium investors which are not available in other alternatives. Now take a look on complete concept of mutual fund.
Table of Contents
Mutual Funds Meaning
In general term, a mutual fund is an investment vehicle for medium and long term investors where they can pool their funds for investing in a diversified portfolio with a view to earn decent return and appreciation in their value. The fund so collected is management by the professional fund managers so investors need not worry too much about their investment. Mutual fund is the most suitable investment for the common man as it offers an opportunity to invest in a diversified, professionally managed basket of securities at a relatively low cost. Through investment in a mutual fund, an investor can get access to equities, bonds, money market instruments and/or other securities that may otherwise be unavailable to them and avail of the professional fund management services offered by an asset management company.
SEBI defines mutual funds as “A fund established in the form of a trust to raise monies through the sale of units to the public or a section of the public under one more schemes for investing in securities, including money market instruments.”
So, a mutual fund is a special institution, a trust or an investment company which acts as a pure intermediary who collects funds from investors and channelizes the savings in a diversified portfolio of securities is such a way that investors can get steady returns and capital appreciation at a low risk.
Mutual Funds History
Though the concept of mutual fund is a new concept in Indian securities market, but it is not new for international security market. Mutual funds first established in the Dutch Republic in the year 1772-73. Its main aim was to provide small investors an opportunity to diversify their investments. But mutual funds get popularity when they are introduced in United States in 1890s. That time mutual fund institutions deals only in closed ended funds. Since there is a lack of liquidity in closed ended fund, investors didn’t want to block their money in closed ended funds in the early phase. But with the introduction of open-ended funds on 21st Mar, 1924, investors started to invest more money in mutual funds.
The mutual fund industry in India started in 1963 with the formation of Unit Trust of India, at the initiative of the Government of India and Reserve Bank of India. The first mutual fund scheme was launched by UTI in 1964. Earlier private players are not allowed in mutual fund industry in India. But With the entry of private sector funds in 1993, a new era started in the Indian mutual fund industry, giving the Indian investors a wider choice of fund families.
Mutual Funds features
There are certain key features of mutual funds:
Some of the important features of mutual funds in points are listed below:
1. Mutual Fund Diversification: It is not possible for small investors to invest in variety of sectors. They mainly invest in few selected securities and rely on them for good return. An investor in a mutual fund gets the advantage of being invested in the entire fund’s portfolio which is invested in a diversified sector.
2. Mutual Fund Professional Management: The mutual fund institution employs professionals to manage the pool of funds collected from investors. Most small investors can’t possibly spend their days researching individual stocks or bonds and market trends. By owning a fund, the investors can take advantage of the abilities of the fund’s management team.
3. Small amount of investment: Investments in mutual funds can be started with small amount. Sometimes the initial investment may be as low as Rs.100, and subsequent investments into the fund may be made with similar small amounts.
4. Mutual Fund Liquidity: Mutual funds are highly liquid. They are sold at their net asset value which is computed on every business day after the close of the markets. The price you receive depends on the value of the securities in the fund.
5. Transparency: All the details relating to mutual funds investments are easily available online or one can get the complete details of his investment via mobile applications of their mutual fund institution.
6. Savings habit: It creates a habit of systematic and regular investment amongst the investors.
Mutual Funds Advantages
A mutual fund is a special type of institution which acts as an investment intermediary and channelizes the savings of large number of people towards the corporate securities in such a way that investors get steady returns and capital appreciation at low risk. Mutual funds are gaining popularity now days due to the following advantages:
1. Professional Management: A small investor cannot be an expert in portfolio management so there is a chance of loss for small investors. 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.
2. Diversification: It is not possible for small investors to invest in variety of sectors. They mainly invest in few selected securities and rely on them for good return. An investor in a mutual fund gets the advantage of being invested in the entire fund’s portfolio which is invested in a diversified sector. Thus, even a small investment of Rs 5,000 in a mutual fund scheme can give investors a diversified investment portfolio.
3. Economies of large Scale investment: 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.
4. Liquidity: The most peculiar advantage of a mutual fund is that investments made in its schemes can be converted into cash promptly with incurring any heavy expenditure. As per the regulations of SEBI, is becomes necessary for every mutual funds institutions is to ensure liquidity for its investors.
5. Tax Benefits: Mutual funds are not liable to pay tax on the income they earn. If the same income were to be earned by the investor directly, then tax may have to be paid in the same financial year. Specific schemes of mutual funds (Equity Linked Savings Schemes) give investors the benefit of deduction of the amount invested, from their income that is liable to tax. This reduces their taxable income, and therefore the tax liability.
6. Low risk: Mutual funds invest in a diversified sector and these funds are managed by highly qualified professionals. So, risk factor is reduced which is not possible in case of direct investment by an individual.
7. Higher return: Various reports now ensure that mutual funds are giving higher return with low risk as compared to other investment vehicles. But this is only possible when portfolio is well diversified and fund managers are efficient.
8. Convenient Options: The options offered under a scheme allow investors to structure their investments in line with their liquidity preference and tax position. Mutual funds also provide switch option form one scheme to another scheme.
9. 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.
10. 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. These are detailed in the subsequent units. Mutual fund investors benefit from such protection.
11. 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.
Mutual Funds Disadvantages
In spite of various advantages, mutual funds suffer from various disadvantages some of which are listed below:
1. Lack of portfolio customization: Mutual fund unit-holder is just one of several thousand investors in a scheme. Once a unit-holder has bought into the scheme, investment management is left to the fund manager. Thus, the unit-holder cannot influence what securities or investments the scheme would buy.
2. Liquidity crisis: Mutual funds in India face liquidity problems. Investors are not able to draw back from some of the schemes due to lack of no easy exit route. Recently, we saw that Franklin Templeton has defaulted in redemption of mutual funds during lock down period.
3. Choice overload: Over 1,200 mutual fund schemes offered by 38 mutual funds – and multiple options within those schemes – make it difficult for investors to choose between them.
4. No control over costs: All the investor’s moneys are pooled together in a scheme. Costs incurred for managing the scheme are shared by all the Unit holders in proportion to their holding of Units in the scheme. Therefore, an individual investor has no control over the costs in a scheme.
5. High Management Fee: The Management Fees charged by the fund reduces the return available to the investors.
6. Inadequate research: Most of the mutual funds in India suffer losses to lack of in-house research facilities. They mainly based their investment decision on external research which sometime causes loss.
7. Diversion of Funds: There may be unethical practices e.g. diversion of Mutual Fund amounts by Mutual Funds to their sister concerns for making gains for them.
8. Inadequate disclosures: There have not been timely and adequate disclosures of material information to the investors by the mutual funds in India.
9. Lock-In Period: Many MF schemes are subject to lock in period due to which it is not possible for investors to withdraw funds as and when they need.
10. Delay in grievance redressal: Due to large number of investors and few numbers of professionals in mutual funds, delay in redressal of investor’s grievances is quite obvious.
In spite of the above disadvantages of mutual funds, this alternative is considered to be best and most rewarding investment vehicle in present world.
Mutual funds Types
In order to suit the needs and preferences of investors, mutual funds institutions are now offering various types of mutual fund schemes. Mutual funds schemes as per the demand of the investors are classified into the following broad categories:
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1. According to ownership |
a) Public Sector Mutual Funds b) Private Sector Mutual Funds |
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2. According to the scheme of operation |
a) Open-ended Funds b) Closed-ended Funds c) Internal Funds |
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3. According to portfolio |
a) Income Funds b) Balanced Funds c) Growth Funds d) Stock/Equity Funds e) Debt Funds f) Hybrid Funds |
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4. According to location |
a) Domestic Funds b) Off-shore Funds |
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5. According to management |
a) Active Funds b) Passive Funds |
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6. Gold funds |
a) Gold Exchange Traded Funds b) Gold Sector Funds |
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7. others |
a) Real Estate Funds b) Exchange Traded Funds c) Commodity Funds d) Fund of Funds |
1. According to ownership
According to ownership, mutual funds in India may be classified as:
a) Public Sector Mutual Funds: Public sector mutual funds are those which are initiated by UTI and other public sector banks. For the first time, UTI started public sector mutual fund schemes in the year 1963-64. In the year 1987, second public sector mutual fund was established by SBI.
b) Private Sector Mutual Funds: Private sector mutual funds are those which are initiated by private sector corporate. In the year 1992, Government of India allowed the private sector corporate to start mutual fund schemes.
2. According to the scheme of operation
According to the scheme of operation, mutual funds in India are classified as:
a) Open-ended funds: Open-ended funds are open for investors to enter or exit at any time, even after the NFO. In such funds period of maturity is not specified. Investors can enter and exit at any time. The most important advantage of open-ended funds is that it offers liquidity to investors.
b) Close-ended funds: Close-ended funds are those which have a fixed maturity period. Investors can buy units of a close-ended scheme, from the fund, only during its NFO. After the close of NFO, investors can buy or sale units of close-ended fund only through stock exchange where these funds are listed.
c) Interval funds: Interval funds combine features of both open-ended and close ended schemes. They are largely close-ended, but become open ended at pre-specified intervals.
3. According to Portfolio
According to portfolio or objectives of investment, mutual funds are classified as:
a) Income Funds: These funds aim at providing maximum return to the investors. These funds mainly invest in low risk financial assets such as bonds, debentures, Commercial Papers (CPs) etc. These funds distribute the income earned by them periodically amongst the investors.
b) Balance funds: Balance funds are those which invest in both high risk financial asset such as equity for higher return and also in fixed interest/return bearing securities such as debentures, preference shares and bonds. Balance funds ensure both capital appreciation as well as regular return in the shape of interest and dividend.
c) Growth funds: Growth funds are those which invest mainly in those securities which have high potential of appreciation in the long term. These funds mainly concentrate on capital appreciation of the investors. Due to too much exposure in equity, these funds are more risky as compared to income and balance funds.
d) Equity funds: A scheme might have an investment objective to invest largely in equity shares and equity-related investments like convertible debentures. Such schemes are called equity schemes.
Types of Equity Funds
1. Diversified equity fund is a category of funds that invest in a diverse mix of securities that cut across sectors.
2. Sector funds however invest in only a specific sector. For example, a banking sector fund will invest in only shares of banking companies. Gold sector fund will invest in only shares of gold-related companies.
3. Thematic funds invest in line with an investment theme. For example, an infrastructure thematic fund might invest in shares of companies that are into infrastructure construction, infrastructure toll-collection, cement, steel, telecom, power etc.
4. Equity Linked Savings Schemes (ELSS), as seen earlier, offer tax benefits to investors. However, the investor is expected to retain the Units for at least 3 years.
5. Equity Income / Dividend Yield Schemes invest in securities whose shares fluctuate less, and therefore, dividend represents a larger proportion of the returns on those shares.
6. Arbitrage Funds take contrary positions in different markets / securities, such that the risk is neutralized, but a return is earned.
e) Debt funds: Schemes with an investment objective that limits them to investments in debt securities like Treasury Bills, Government Securities, Bonds and Debentures are called debt funds.
Types of Debt Funds
- Gilt funds invest in only treasury bills and government securities, which do not have a credit risk.
- Diversified debt funds on the other hand, invest in a mix of government and non-government debt securities.
- Junk bond schemes or high yield bond schemes invest in companies that are of poor credit quality.
- Fixed maturity plans are a kind of debt fund where the investment portfolio is closely aligned to the maturity of the scheme.
- Floating rate funds invest largely in floating rate debt securities i.e. debt securities where the interest rate payable by the issuer changes in line with the market.
- Liquid schemes or money market schemes are a variant of debt schemes that invest only in debt securities where the moneys will be repaid within 91-days.
f) Hybrid funds: Hybrid funds have an investment charter that provides for a reasonable level of investment in both debt and equity.
Types of Hybrid Funds
- Monthly Income Plan seeks to declare a dividend every month. It therefore invests largely in debt securities.
- Capital Protected Schemes are close-ended schemes, which are structured to ensure that investors get their principal back, irrespective of what happens to the market.
4. According to Location:
Mutual funds can also be classified on the basis of location from where they mobilise funds, as:
a) Domestic Funds: These are the funds which mobilise savings of people within the country where investments are made.
b) International Funds: These are funds that invest outside the country. For instance, a mutual fund may offer a scheme to investors in India, with an investment objective to invest abroad.
5. According to Management:
On the basis of management, Mutual funds are divided into two groups:
a)Actively Managed Funds: Actively managed funds are funds where the fund manager has the flexibility to choose the investment portfolio, within the broad parameters of the investment objective of the scheme. Since this increases the role of the fund manager, the expenses for running the fund turn out to be higher.
b)Passive Funds: Passive funds invest on the basis of a specified index, whose performance it seeks to track. Thus, a passive fund tracking the BSE Sensex would buy only the shares that are part of the composition of the BSE Sensex. Such schemes are also called index schemes. Since the portfolio is determined by the index itself, the fund manager has no role in deciding on investments. Therefore, these schemes have low running costs.
6. Gold Funds:
These funds invest in gold and gold-related securities. They can be structured in either of the following formats:
a)Gold Exchange Traded Fund, which is like an index fund that invests in gold. The structure of exchange traded funds is discussed later in this unit. The NAV of such funds moves in line with gold prices in the market.
b)Gold Sector Funds i.e. the fund will invest in shares of companies engaged in gold mining and processing. Though gold prices influence these shares, the prices of these shares are more closely linked to the profitability and gold reserves of the companies.
7. Other Types of Mutual Funds:
In addition to the above mentioned mutual funds, there are some other types of mutual funds:
a)Real Estate Funds: They take exposure to real estate. Such funds make it possible for small investors to take exposure to real estate as an asset class. Although permitted by law, real estate mutual funds are yet to hit the market in India.
b)Commodity Funds: The investment objective of commodity funds would specify which of these commodities it proposes to invest in.
c)Fund of Funds: Such fund invests in another fund. Similarly, funds can be structured to invest in various other funds, whether in India or abroad. Such funds are called fund of funds.
d)Exchange Traded Funds: Exchange Traded funds (ETF) are open-ended index funds that are traded in a stock exchange.
e)Others: Loan Funds, Non-loan Funds, Hub and Spoke Funds etc.