Mutual Funds and its advantages

Definition
A mutual fund is a trust that pools the money of several investors with common financial goals. The collected money is invested in various equity, debt or commodity markets, depending on the objective of the fund. The income generated from these instruments and the capital appreciation is shared by the investors in proportion to the number of units owned by them.

Working of mutual funds
A mutual fund is set up by a sponsor. However, the sponsor cannot run the fund directly. He has to set up two arms: a trust and Asset Management Company. The trust is expected to assure fair business practice, while the AMC manages the money.

The mutual fund collects money directly or through brokers from investors. The money is invested in various instruments depending on the objective of the scheme. The income generated by selling securities or capital appreciation of these securities is passed on to the investors in proportion to their investment in the scheme. The investments are divided into units and the value of the units will be reflected in Net Asset Value or NAV of the unit. NAV is Net Asset Value, as the name suggests it is arrived at after dividing the net assets of the mutual fund (current value of securities and cash and reduced by the liabilities, if any) by the number of units outstanding. Mutual fund companies provide daily net asset value of their schemes to their investors. NAV is important, as it will determine the price at which you buy or redeem the units of a scheme. Depending on the load structure of the scheme, you have to pay entry or exit load.

Entry load is the extra amount you pay when you invest in a scheme. It is also called front-end load or sales load.

Exit load is the amount collected when you are selling or redeeming units.
Types of Mutual Fund schemes

Mutual fund schemes are classified on the basis of its structure and investment objective.

By Structure
Open ended funds: Investors can buy and sell units of open-ended funds at NAV-related price every day. Open-end funds do not have a fixed maturity and it is available for subscription every day of the year. Open-end funds also offer liquidity to investments, as one can sell units whenever there is a need for money.

Close-ended funds: These funds have a stipulated maturity period. They are open for subscription only during a specified period. Investors have the option of investing in the scheme during initial public offer period or buy or sell units of the scheme on the stock exchanges. Some close-ended funds repurchase the units at NAV-related prices periodically to provide an exit route to the investors.

By Investment objective
Equity funds: They normally invest most of their corpus in equities, as their objective is to provide capital appreciation over the medium-to-long term. Equity schemes are ideal for investors with risk appetite.
Income funds: As the name suggests, the aim of these funds is to provide regular and steady income to investors. They generally invest their corpus in fixed income securities like bonds, corporate debentures, and government securities. Income funds are ideal for those looking for capital stability and regular income.
Balanced funds: The objective of balanced funds is to provide growth along with regular income. They invest their corpus in both equities and fixed income securities. Balanced funds are ideal for those looking for income and moderate growth.

Money market funds (MMF’s): These funds strive to provide easy liquidity, preservation of capital and modest income. MMFs generally invest the corpus in safer short-term instruments like treasury bills, certificates of deposit, commercial paper and inter-bank call money. Returns on these schemes hinges on the interest rates prevailing in the market. MMFs are ideal for corporate and individual investors looking to park funds for short periods.
Other schemes

These are more of a combination of Investment schemes.
Tax saving schemes: Tax saving schemes or equity-linked savings schemes offer tax rebates to investors under the Income Tax Act. They generally have a lock-in period of three years. They are ideal for investors looking to exploit tax rebates as well as growth in investments.

Special schemes: These schemes invest only in specified industries. These schemes are meant for aggressive and well-informed investors.

Index funds: Index Funds invest their corpus based on a specified Index. They try to mimic the composition of the index in their portfolio. Not only are the shares, even their weightage’s are replicated. Index funds are a passive investment strategy and the fund manager has a limited role to play here. The NAVs of these funds move along with the index they are trying to mimic.

Advantages of investing in Mutual Funds
The reason that mutual funds are so popular is that they offer the ability to easily invest in increasingly more complicated financial markets. Some of the advantages are listed below:

Flexibility: Mutual Fund investments offer you a lot of flexibility with features such as systematic investment plans, systematic withdrawal plans & dividend reinvestment.

Regulated for investor protection: The Mutual Funds sector is regulated to safeguard the investor's interests.

Affordability: Mutual funds are available in units so this allows you to start with small investments. If you want to buy a portfolio of blue chip scripts would need a large amount of money to invest in all of them, whereas if you invest in a mutual fund which invests in the blue chips, the amount of investment would be less. A mutual fund can do that because it collects money from many people and it has a large corpus. Because of the large corpus, even a small investor can benefit from its investment strategy.

Professional management: Expert Fund Managers of the Mutual Fund analyze all options based on experience & research. You can leave the investment decisions to them and only have to monitor the performance of the fund at regular intervals.

Potential of return: The fund managers who take care of your Mutual Fund have access to information and statistics from leading economists and analysts around the world. Because of this, they are in a better position than individual investors to identify opportunities for your investments to flourish.

Diversification: Risk is lowered as Mutual Funds invest across different industries & stocks. This is possible because of the large corpus. A small investor cannot have a well-diversified portfolio because it calls for large investment.

Convenience: Mutual funds offer tailor-made solutions like systematic investment plans and systematic withdrawal plans to investors, which is very convenient to investors. Investors also do not have to worry about the investment decisions or they do not have to deal with their brokerage or depository, etc. for buying or selling of securities. Mutual funds also offer specialized schemes like retirement plan, children’s plan, industry specific schemes, etc. to suit personal preference of investors. These schemes also help small investors with asset allocation of their corpus. It also saves a lot of paper work.

Low Costs: The benefits of scale in brokerage, custodial and other fees translate into lower costs for investors. As per SEBI the maximum fee an AMC can charge is 2.5%. Also, they get the service of a financial professional for a very small fee. If they were to seek a financial advisor's help directly, they may end up pay more. Also, the size of the corpus should be large to get the service of investment experts, who offer portfolio management.

Liquidity: You have the option of withdrawing or redeeming your money at any point of time at the current NAV. Most mutual funds dispatch checks for redemption proceeds within two or three working days. You also do not have to pay any penal interest in most cases. However, some schemes charge an exit load.

Tax breaks: You do not have to pay any taxes on dividends issued by mutual funds. Long Term capital gains are also tax free. Only short term capital gains are taxable. Tax-saving schemes and pension schemes give you the added advantage of tax rebates.

Transparency: Mutual funds offer daily NAVs of schemes, which help you to monitor your investments on a regular basis. They also send quarterly newsletters, which give details of the portfolio, performance of schemes against various benchmarks, etc. They are also well regulated and SEBI monitors their actions closely.