Mutual funds are touted to be the best tool for wealth creation over the long term.
Definition of Mutual Fund
A mutual fund is a fund that is created when a large number of investors put in their money, and is managed by professionally qualified persons with experience in investing in different asset classes-shares, bonds, money market instruments like call money, and other assets like gold and property.
The name of the mutual fund gives a good idea about what type of asset class a fund, also called a scheme, will invest in. For example, a diversified equity fund will invest in a large number of stocks, while a gilt fund will invest in government securities while a pharma fund will mainly invest in stocks of companies from the pharmaceutical and related industries.
Is SEBI approval necessary for Mutual Funds?
Yes. Mutual funds are compulsorily registered with the Securities and Exchange Board of India (Sebi), which also acts as the first wall of defence for all investors in these funds.
Who runs Mutual Fund?
A mutual fund is run by a group of qualified people who form a company, called an asset management company (AMC) and the operations of the AMC are under the guidance of another group of people, called trustees.
Both, the people in the AMC as well as the trustees, have a fiduciary responsibility because these are the people who are entrusted with the task of managing the hard-earned money of people who do not understand much about managing money.
How to Invest in Mutual Funds?
An investor willing to invest in a mutual fund can approach a fund house or a distributor working for the fund house (which could be an individual, a company or even a bank), and ask a person qualified to sell mutual funds to explain how to go about it.
After some regulatory requirement is fulfilled, the investor can fill up a form and write a cheque-the fund house or the distributor will take care of the process after that. Once the cheque is cleared by the investor’s bank, the fund house will allot what are called ‘units’ to the investor, at a price that is fixed through a process approved by Sebi.
This price is based on the net asset value (NAV), in simple terms which is the total value of investments in a scheme divided by the total number of units issued to investors in the same scheme.
In most mutual fund schemes, NAVs are computed and published on a daily basis. However, when a fund house is launching a scheme for the first time, the units are sold at Rs 10 each.
What are kinds of Mutual Funds?
There are three types of schemes in which an investor can invest in. These are open-ended schemes, closed-ended schemes, and exchange-traded funds (ETFs).
Open Ended Fund:
An open-ended fund is the one which is usually available from a mutual fund on an ongoing basis that is an investor can buy or sell as and when they intend to at a NAV-based price.
As investors buy and sell units of a particular open-ended scheme, the number of units issued also changes every day.
The value of the scheme’s portfolio also changes on a daily basis. So, the NAV also changes on a daily basis. In India, fund houses can sell any number of units of a particular scheme, but at times fund houses restrict selling additional units of a scheme for some time.
A close-ended fund usually issue units to investors only once, when they launch an offer, called new fund offer (NFO) in India.
Thereafter, these units are listed on the stock exchanges where they are traded on a daily basis. As these units are listed, any investor can buy and sell these units through the exchange.
As the name suggests, close-ended schemes are managed by fund houses for a limited number of years, and at the end of the term either money is returned to the investors or the scheme is made open-ended.
However, usually, units of close ended funds which are listed on the stock exchanges, trade at a high discount to their NAVs. But as the date for closure of the fund nears, the discount between the NAV and the trading price narrows, and vanishes on the day of closure of the scheme.
ETFs are a mix of open-ended and close-ended schemes.
ETFs, like close-ended schemes, are listed and traded on a stock exchange on a daily basis, but the price is usually very close to its NAV, or the underlying assets, like gold ETFs.
Advantages and Disadvantages of Mutual Funds
If one invests in a well-managed mutual fund scheme, the advantages outweigh disadvantages and in the long term, which is 10 years or more. There is a very high probability of investors making more money than by investing in other risk-free investments such as FDs, public provident fund, etc.
Advantages of investing in MFs include diversification, good investment management services, liquidity, strong government-backed regulatory help, professional service, and all these at a low cost. The disadvantages of mutual fund investing include lack of flexibility to sell or buy a stock or a portfolio of stocks of choice. The investor does not have any freedom relating to customize the fund’s portfolio. Another disadvantage is that although in the long term MFs give good returns, the returns are not as predictable as say in bank FDs and PPF.