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June 8, 2000
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Sameer Doctor flags off a series on mutual funds. In the first of the series, he explains the basics of a mutual fund in an FAQ format.
What is a mutual fund?
If one were to give a text book definition, this is how it would read:
"A mutual fund is a collective investment vehicle formed with the specific objective of raising money from a large number of individuals and investing it according to a pre-specified objective, with the benefits accrued to be shared among the investors on a pro-rata basis in proportion to their investment."
Simply put, a mutual fund pools together money from a number of investors, uses professionals to manage and invest it with the aim of achieving a return.
How is it formed?
The mutual fund itself is a trust registered under the Indian Trust Act, and is initiated by a sponsor. The sponsor then appoints an asset management company (AMC) to manage the investment, marketing, accounting and other functions pertaining to the fund. It also appoints another entity to be the custodian to the assets of the fund, and often a registrar to handle the registry work. Various schemes or individual funds with different objectives can be floated under the umbrella of one parent. For example, Alliance95 and Alliance Equity are both independent schemes of Alliance Capital Mutual Fund, and are managed by Alliance Capital Asset Management, the AMC to all the Alliance funds.
Who regulates it?
The mutual funds industry is regulated by the Securities and Exchange Board of India (SEBI), ensuring that the investors' interests are taken care of, and all norms are followed by the AMC.
How are the investments selected?
A team of professionals within the AMC will be appointed with the task of studying and analysing all investments within an asset class. This investment analysts' team obtains reports from external researchers, meets the top management and employees, vendors, customers and competitors of each company in order to understand the business, and also takes the industry / sector and the overall economy into account before recommending an investment in that company.
The fund or portfolio manager, who heads the investment activity of a particular scheme, will then decide whether to actually invest, and how much to invest. The dealer will then execute the transaction. This whole team continues to monitor the investment to see if it is time to sell, if the company is no longer capable of achieving expected results, or if better opportunities for investment exist.
Equity fund
An equity mutual fund would try to achieve a higher long-term appreciation or growth of your capital. But then you had better be prepared for a certain amount of volatility (fluctuation in value of investment).
An equity mutual fund identifies and invests in shares of high quality companies whose businesses are sound and have good, steady growth. The share price of such companies should show an increase over a period of time, although it can fluctuate substantially in the short term. Thus, one can achieve higher growth if one were to invest for a long term (usually 2-3 years at least). In the short term, the prices may come down, causing a temporary reduction in value of the investment.
Debt fund
This one would aim to achieve steady income at low risk to the invested principal. To achieve this the mutual fund would invest in what are called fixed-income instruments.
These are similar to the fixed deposits of banks, but are usually issued by private and public sector companies as well as by the Indian government as a means to borrow money.
Some of the money with the fund may be lent to various banks and other institutions for a very short term (call money and money market instruments). The value of these securities increases steadily as the interest associated with them accrues to the fund. Further fluctuations may also come about due to a change in the government or RBI interest rates, which may affect the value of your investments, or if one of the debtors is faced with an inability to return the money borrowed.
Therefore, although the actual returns cannot be guaranteed due to such fluctuations, debt funds usually are a very safe way to invest money and achieve superior returns to conventional bank deposits.
Balanced fund
A balanced fund seeks a mix of the two classes, debt and equity, to achieve a higher return than debt without forsaking completely its safety and stability. The offer document of the fund would specify the percentage range that would be allocated to equity and to debt. Usually, the range is between 50 per cent and 75 per cent in equity, and the rest in debt.
Close-ended fund
A close-ended fund's units can be bought from the fund house only during the initial offer period (IPO), and sold back to the fund at NAV related price upon maturity. During the life of the fund, the units can be bought or sold on the stock market, and the price would be based on market sentiment rather than on the actual NAV.
Open-ended fund
An open-ended fund's units can be bought from or sold back to the fund house at any point of time. The NAV is declared daily, and the buying (subscription) and selling (redemption) price follows a known formula to the NAV.
Interval fund
An interval fund is like a close-ended fund, but it reopens for subscription / redemption at various intervals of time. Today, the trend is more towards open-ended funds.
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