What is a Mutual Fund?

A Mutual Fund is a trust that pools the savings of a number of investors who share a common financial goal. The money thus collected is invested by the fund manager in different types of securities depending upon the objective of the scheme. These could range from shares to debentures to money market instruments.

The income earned through these investments and the capital appreciation realized by the scheme is shared by its unit holders in proportion to the number of units owned by them. Thus a Mutual Fund is the most suitable investment for the common man as it offers an opportunity to invest in a diversified, professionally managed portfolio at a relatively low cost. The small savings of all the investors are put together to increase the buying power and hire a professional manager to invest and monitor the money.

Anybody with an investible surplus of as little as a few thousand rupees can invest in Mutual Funds. Each Mutual Fund scheme has a defined investment objective and strategy.

The flow chart below describes broadly the working of a mutual fund:

• Organization of a Mutual Fund
• Types of Mutual Fund Schemes
• Benefits of Investing in Mutual Funds
• How to invest in Mutual Fund?
• Which fund does one choose?

Organisation of a Mutual Fund

There are many entities involved and the diagram below illustrates the organisational set up of a mutual fund:

Types of Mutual Fund Schemes

Wide variety of Mutual Fund Schemes exist to cater to the needs such as financial position, risk tolerance and return expectations etc. The table below gives an overview into the existing types of schemes in the Industry.

1. By Structure
• Open - Ended Schemes
• Close - Ended Schemes
2. By Investment Objective
• Growth Schemes
• Income Schemes
• Balanced Schemes
• Money Market Schemes
3. Other Schemes
   • Tax Saving Schemes
   • Special Schemes
     • Index Schemes
     • Sector Specific Scheme

Benefits of Investing in Mutual Funds

The benefits of investing in a Mutual Fund are:

• Professional Management
• Diversification
• Convenient Administration
• Return Potential
• Low Costs
• Liquidity
• Transparency
• Flexibility
• Choice of schemes
• Tax benefits
• Well regulated

As an investor, you would like to get maximum returns on your investments, but you may not have the time to continuously study the stock market to keep track of them. You need a lot of time and knowledge to decide what to buy or when to sell. A lot of people take a chance and speculate, some get lucky, most don t. This is where mutual funds come in. Mutual funds offer you the following advantages:

Professional management: Qualified professionals manage your money, but they are not alone. They have a research team that continuously analyses the performance and prospects of companies. They also select suitable investments to achieve the objectives of the scheme. It is a continuous process that takes time and expertise that will add value to your investment. Fund managers are in a better position to manage your investments and get higher returns.

Diversification: As the saying goes "don't put all your eggs in one basket" really applies to the concept of intelligent investing. Diversification lowers your risk of loss by spreading your money across various industries and geographic regions. It is a rare occasion when all stocks decline at the same time and in the same proportion. Sector funds spread your investment across only one industry so they are less diversified and therefore generally more volatile.

More choice: Mutual funds offer a variety of schemes that will suit your needs over a lifetime. When you enter a new stage in your life, all you need to do is sit down with your financial advisor who will help you to rearrange your portfolio to suit your altered lifestyle.

Affordability: As a small investor, you may find that it is not possible to buy shares of larger corporations. Mutual funds generally buy and sell securities in large volumes, which allow investors to benefit from lower trading costs. The smallest investor can get started on mutual funds because of the minimal investment requirements. You can invest with a minimum of Rs.500 in a Systematic Investment Plan on a regular basis.

Tax benefits: Investments held by investors for a period of 12 months or more qualify for capital gains and will be taxed accordingly (10% of the amount by which the investment appreciated, or 20% after factoring in the benefit of cost indexation, whichever is lower). These investments also get the benefit of indexation.

Liquidity: With open-end funds, you can redeem all or part of your investment any time you wish and receive the current value of the shares. Funds are more liquid than most investments in shares, deposits and bonds. Moreover, the process is standardized, making it quick and efficient so that you can get your cash in hand as soon as possible.

Rupee-cost averaging: With rupee-cost averaging, you invest a specific rupee amount at regular intervals regardless of the investment's unit price. As a result, your money buys more units when the price is low and fewer units when the price is high, which can mean a lower average cost per unit over time. Rupee-cost averaging allows you to discipline yourself by investing every month or quarter rather than making sporadic investments.

Transparency: The performance of a mutual fund is reviewed by various publications and rating agencies, making it easy for investors to compare fund to another. As a unit holder, you are provided with regular updates, for example daily NAVs, as well as information on the fund's holdings and the fund manager's strategy.

Regulations: All mutual funds are required to register with SEBI (Securities Exchange Board of India). They are obliged to follow strict regulations designed to protect investors. All operations are also regularly monitored by the SEBI.

How to invest in Mutual Fund?

Researching Mutual Funds: When you're looking to invest in a mutual fund, dig deeper than past performance. Mutual fund advertisements tell you, usually in the finest of print "Past performance is no guarantee of future results." While that statement has always been true, now's a particularly good time to take heed.

Which is not to say you should ignore a fund's recent performance if you want to add it to your portfolio. Just take it with a big ol' grain of sodium chloride.

Once you have a particular fund in mind, check with a fund-rating agency to see how the fund compared with its peers over one, three, five and 10-year periods. If its annual returns are not in the top half of all funds in its category over most, if not all, of those time periods, this investment is a nonstarter. Walk away. If it is in the top 50 percent -- over all or most periods, look into it a little further.

Also check to see how a fund stacks up in terms of volatility. Some funds skyrocket during one quarter, only to plummet during another; while others are steady-as-she-goes. While volatility isn't always a terrible thing -- some of that volatility is upward -- the best-performing funds over time tend to be those that post consistently solid returns relative to their volatility rank.

Also see how long the fund manager has been on the job. After all, a 10-year track record isn't worth much if the manager has been making the investment decisions for only three of those years. The stock picker doesn't matter if you opt for an index fund, of course; and it matters less at big, process-oriented companies. But a manager's tenure and performance is generally your best window into how a fund will behave in the future.

Finally, don't overpay. Why pick a high-expense fund if there's a low-expense alternative that's just as good? And don't pay a sales charge, or load, to a broker if you've done the investment homework yourself.

There are plenty of low-cost, no-load funds out there with above-average returns and managers with long-term track records. You just have to look closely enough to find them.

Which fund does one choose?

India today has over 36 fund houses that offer over 340 different schemes and the number is growing at the rate of 10% per annum. Types of schemes range from those investing in equity (diversified, sector specific, index specific), debt (gilt, income, liquid, money market) and balanced funds. As can be seen this motley collection of funds is sure to confuse even the most savvy of investor. Complexity and confusion call for an explicit investment design.