Demystifying Mutual Funds – Part 1

Author
Anmol Gupta

Congratulations on acknowledging that you need to understand mutual funds, and finally landing here :) In this first part, we explain what Mutual Funds exactly are, and what are their pros and cons.

Why is there a need of Mutual Funds, and hence, what are they?

So, assume you have made a sound financial plan, considering all your goals and also your financial condition. Please don’t ask us what are financial goals! Financial goals are something which we have been focusing on since our inception. We hope that you have been a good learner and understand the importance of defining the financial goals by now! :)

After defining the financial goals, you must have concluded that you need to invest in different kinds of investment schemes for different goals. Even if you have not finalized the specific investment schemes, you can surely realize that you need to invest some portion in debt instruments, usually for short term goals, and some portion in equity instruments for long term goals. Now, when it comes to equity, the number of options which you have got is overwhelming! There are thousands of companies whose shares are available in stock markets. Which one should you buy? Which one you shouldn’t? Similarly, the number of options for debt instruments is no less. You have different kinds of bank deposits, government schemes, provident funds and what not! And then, you also have got options to invest in commodities like gold or in assets like real estate. While you define your financial goal, you only conclude how much money do you need and when. You do not conclude any particular financial instrument while defining a financial goal. Hence, to fulfil your financial objective, you need to match your requirements with the outcomes of some financial instrument. And this process of matching your requirements with possible outcomes of different financial instruments is a very important and tiring process in making your financial plan. That’s because there are literally 1000’s of investment options available in the market.

Suppose after applying all your energy, you come out with 10 different investment options which will constitute your investment portfolio in order to achieve your financial goals. Now, you will go to the market and purchase all those 10 different schemes and complete the formalities for each of them. You will also need to bear costs like brokerage, management charges etc. related to each of them. Then you will need to monitor performance of each of them over time to see if they would be able to meet your goals. Doesn’t it sound too much? What if someone existed who could take care of all these hassles on your behalf? What if you could just tell your requirements and let someone else take care of choosing all the different financial instruments? What if you could just manage relationship with a single agency rather than dealing with different agents? What if you could investment in things which you could not have invested at individual level? Well, as the posts is about praising Mutual Funds, you must have guessed that answer to all the above questions is Mutual Funds!

First of all, you need to understand that Mutual Funds are not something alien. Mutual Funds take money from many small investors and invest that money in different financial instruments on behalf of those investors. Those investors are mainly common people like us. It’s simply like, you and 2 of your friends decide to invest together by pooling in Rs. 100,000 each. Whatever your investment earns, you all get 33% of that. Just that in case of mutual funds, there will be 1000’s of such people, each having some share in the fund. And when there are so many investors, to take the investment decision, people hire some experts to take care of the fund and pay them their fees.

Advantages of Mutual Funds

a) Mutual Funds gives you the option to invest in variety of instruments (Diversification). Suppose you want to purchase a set of stocks for your long term goals. A set of stock because you must have heard that “Don’t put all your eggs in one basket”. It often gets difficult for a common man to purchase those number of stocks and make a “Diversified Portfolio”. That’s because some stocks might be costlier, you may not be able to purchase them in proportion you want to, or you might not have budget to purchase those many stocks. But in a mutual fund, the amount of money invested is immense and of course much greater than any one’s individual capacity (of course if you are not already a billionaire). Mutual Funds can form a diversified portfolio quite easily. So, you can take the advantage of diversification through investing in Mutual Funds.

b) Investment decisions are taken by experts! You can sleep peacefully! Mutual Fund hire experts in the field of financial markets who take care of parking your money as per the goals of the fund. Yes, Mutual Funds are also based on Goals or Investment Objectives. We will be dealing with them in coming articles. So, this point needs no explanation. You can deduce that an expert who gets paid for managing your money, and who is also well educated about dynamics of financial markets will take a better decision than you! They follow the markets day and night. You can’t dedicate that much of time with your day job.

c) You can easily invest or take your investment back from the Mutual Funds. In general, mutual funds gives you the option to invest in it at any time you like and pull out your money when you need or when your requirements have been fulfilled. However, some funds may have costs associated with withdrawing money within a certain period of investment. We’ll deal with costs of entering and exiting from mutual funds in subsequent posts. The point to be taken from here is that it’s easy to enter and exit a mutual fund investment than it is to enter and exit money invested in individual schemes. For example, if you have invested in a fixed deposit, you cannot simply withdraw that before maturity without bearing costs. How exactly you can exit, that depends on whether the scheme is closed ended, open ended or interval (We will deal with those in subsequent posts :))

d) You can invest in wide range of investment options through Mutual Funds. Being an individual, you might not be able to invest in things like foreign funds or some government bonds which require a large ticket size. You can get access to all kinds of investment options through mutual funds.

e) Mutual Funds are regulated by authorities, they cannot play fraud game. Mutual funds are required to disclose a number of things from time to time to keep the investors well informed about their money. Hence, you can always assess the performance of various mutual funds, compare them and take a well informed decision.

Disadvantages of Mutual Funds

While the above points lay the foundation for existence of mutual funds, there are also some disadvantages or costs associated with mutual fund which should always be considered. As they say, ‘There is no free lunch’ or everything comes at a cost. There is no charity going on here :)

a) Fees of professional fund manager is often a significant amount. Well, when you hire some experts to manage your money, and when they are putting their day and night to make your money grow (we trust that they do! ), you have to pay them for their services. It’s their job after all, just like you are writing some code in some corner. And the interesting part is, you have to pay them even if your fund does not perform well. So, when your mutual fund makes some profit, you effectively get a lower amount as some amount is paid to the management team. And when your fund makes a loss, you lose even more money than that as you still have to pay the management fees. So, you might be thinking that mutual funds can also make losses? How come it can make loss when it is being managed by experts? Read the next point.

b) “Mutual funds are subject to market risks”, as they have always been saying :D You must have read about equities in our earlier posts. If not, then please go through them! Well, mutual funds are not some black magic box. It’s just an investment on your behalf by professionals. So you can expect them to take better decision than you, you can expect them to manage funds in a better way than you, but, in the end, your money goes into various kinds of investment options. It might be debt or equity and all have got their own kinds of risk associated with them. Mutual funds are not exempted from that risk, obviously. So that’s why they always say that it is subject to market risks and ‘urge’ you to read the offer document carefully before investing. We deal with exact kinds of risk associated with different types of mutual funds in subsequent posts.

c) You do not get to take any investment decisions. Well, this is an advantage for those who are not well aware of financial markets. Some geniuses might feel that they can perform better than the experts. For them, it’s a disadvantage as you don’t have any say in decisions of making investments. You appoint professional fund managers and they take all the decisions. You can only review the performance of those managers and collectively take the decisions to hire or fire them, but can’t directly take the decision of day to day investments.

Phewww!! End of this post :) But it’s just the start for understanding mutual funds completely. Follow this series to understand whatever you want to understand about mutual funds. As you see, there are 1000’s of mutual fund schemes existing in the market and you ought to know the basics of mutual fund before investing in those. You need not follow the series in any particular order, you may just pick any specific post as some of you might have a fair understanding of a few things. So, pick what you don’t know and share it with your loved ones :)

About the Author
Anmol Gupta
Anmol is CEO at 7Prosper. He is SEBI Registered Investment Adviser, with expertise in Finance and Technology domains. Anmol is committed to help people achieve their financial freedom.

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