Mutual fund companies [also known as Asset Management Companies (AMCs)] collect funds from public (mainly from small investors) and invest such funds in market and distribute returns/surpluses in the form of dividends. Surpluses can also be reflected in higher Net Asset Value (NAV) of the scheme. In simple words, a mutual fund company collects savings of small investors (pool their money); the fund managers of the concern invest such pool of funds to market (securities); when returns are generated from such investment, passed back to the investors.
This is how a mutual fund works. First an offer document (containing details of the scheme, its investment horizon and class(es) of securities it intends to invest etc.) is issued to the public. Then the collected money is pooled together to constitute a fund. This fund is managed by fund managers of AMC who take major investment decisions. A trust takes care that the mutual fund investments are in accordance with the scheme of the fund and is being managed in the interest of the investors. The returns from such investment activities are distributed in accordance with the scheme of the fund. NAV of a mutual fund (or in other words NAV per unit) refers to the total asset managed by the fund at its market value divided by the number of outstanding (issued and sold) units of the fund. For instance, a fund having net asset worth of Rs.100 crores and Rs.10 crore units are outstanding then the NAV per unit of the fund would be Rs.10. The NAV of a scheme depends on the market value of its investments and hence it fluctuates with the fluctuating share prices of its investment. An increase in NAV means capital appreciation for investors.
Since mutual funds are managed by professionals who have requisite experiences and qualifications in the areas of stock market, as far as a new entrant in the stock markets are concerned, these funds act as a safe vehicle for investment. Moreover, as mutual funds invest in a number of scrips, the impact of risks associated with individual securities is minimized. To put in financial language, the aim is to diversify the unsystematic risk in the portfolio. Also, since the pooled funds are invested in different sectors and stocks, there is a diversification effect reducing overall risk of the portfolio.
Since mutual funds generally trade in large number of securities at the same time, there is advantage of economies of scale. In other words, there is savings in transaction costs.
According to the investment objective, mutual funds can be classified as: (a) growth funds, (b) income funds and (c) balanced funds. Growth funds invest majority of their pooled amount with the objective of achieving long term capital appreciation. Income funds provide periodic returns to investors in the form of dividends. Balanced funds are a midway between growth funds and income funds. They balance their investment in such a way that investors not only get periodical return, but their capital also tends to appreciate which is reflected in higher NAV.
If you are an investor who seek for a suitable fund, then it depends on your risk bearing capacity (your risk profile). If you are a highly risk averse investor who requires periodic return, then you should always prefer investment in income funds. If you have a high risk taking capability and you have surplus funds to invest, then go for growth funds. If you want a small periodic return along with capital appreciation, then go for balanced funds.
Investment in mutual funds should never be looked upon from the point of view of return. It is the risk return paradigm which can help us to optimize our return over a period of time. Another point you should remember is that, you should never attempt to compare two schemes of mutual fund with different investment objectives on the basis of the returns provided by them, if you do so, it would be like comparing apples with mangoes.
Sharpe ratio and Treynor Ratio are the tools to measure the performance of mutual funds over a period of time. Sharpe Ratio is obtained by dividing the difference between return of the portfolio and risk free rate of interest to the standard deviation of the portfolio return. This ratio takes into account surplus return earned by the fund over risk free rate of interest and then divides it by standard deviation of the portfolio return (which is basically a representative of risk which measures deviation of actual return of the portfolio with respect to mean return). Higher the return better is the fund. Treynor Ratio also takes into account surplus return earned over risk free return but the measure of risk here is beta (a measure of systematic risk) rather than standard deviation. Thus, Treynor ratio is obtained by dividing the difference between return of the portfolio and risk free rate of interest to the beta (market risk/systematic risk) of the portfolio.
There are some absolute performance measures such as Jenson’s Alpha, Fama’s Measure and Expense Ratio which provide an indication about the performance of a mutual fund as a whole. Jenson’s Alpha Measure helps us in identifying whether the fund has been able to outsmart its expected return.
The expected return of a security is equal to:
Re = Rf + Î²(Rm — Rf)
Where, Rf is the risk free return, Î² is the systematic risk and Rm is the return on market index (return earned by the fund).
Fama’s measure is obtained by the following formula:
Fama’s Measure = Rp — [Rf + (Ïƒp/Ïƒm)(Rm — Rf)]
Where, Rp = actual return of portfolio; Rf = risk free return, Rm = return on market index, Ïƒp = standard deviation of portfolio return, Ïƒm = standard deviation of market index return.
Thus, instead of Î², which takes into account only systematic risk, this measure takes into account standard deviation of stock return as well as standard deviation of market returns.
Expense ratio refers to the total amount of expenses of the fund as a percentage of total assets of the fund. The expenses include all the charges in the form of administrative overheads, salary of staff etc. However, expenses do not include brokerage.
The return on mutual funds is never equal to the return on securities which the investor can earn if he invests directly in those securities since there are front end load, back end load and annual expenses which will be deducted from the fund. Front end fee is charged by the AMC at the time of initial investment in the fund. Exit load is the amount of fees charged at the time of redemption (surrender) of unit. Generally, funds which charge front end fees do not charge back end fees/exit load. Moreover, there are expenses which are deducted annually for meeting administrative and other expenses of the fund.
Mutual fund schemes can be in the form of open ended schemes or closed ended schemes. In closed ended schemes, a fixed number of units are issued by the fund and thereafter this number remains constant till the maturity of the scheme. The option available to the investors in this case is that they can buy and sell the units in secondary market. The open ended schemes are without any fixed number of outstanding units. Any investor can invest money in accordance with the NAV of the scheme any time. Similarly investors get an opportunity to redeem their units any time. The logic here is that since there are no fixed total number of units, mutual fund not only accepts money for investment purpose later on after the scheme is launched but also redeems units of holders as and when required by them.
Finally, there are index funds, ETFs and Fund of Funds, which should also be analyzed. Index funds are those funds which create a portfolio which replicate the composition of a particular index. For instance, an index fund on NIFTY will invest in all those securities which are a part of that index and the proportion is also similar to the weights which the individual securities have in that index. Thus these funds tend to replicate the performance of that index. If we put it in financial language, these funds create a portfolio with a Î² of 1 which exactly matches the performance of the market.
For example, when the market i.e. SENSEX moves up by 15% over a time period, the portfolio value also rises by 15% (or rather is expected to rise). This is because the securities which have been purchased by this fund are a part of that index and have been purchased in the same proportion as is the weightage of those securities in the index. If an investor intends to have a complete elimination of unsystematic risk, i.e. he wants to earn a return which the the index earns irrespective of performance of individual stocks in the market he should invest in such funds.
Exchange traded funds or popularly known as ETFs are mutual funds whose units are traded in stock exchanges. Unlike the traditional funds in which units are directly redeemed by the mutual fund itself, the units of these funds are bought and sold in the market just like shares. These funds may be open ended or closed ended. The investors of ETFs do need to have a demat account.
There are ETFs which are traded on stock exchanges with underlying asset as gold, known as ‘Gold Exchanged traded Fund’. They provide a convenient and easy vehicle for retail investors to participate in gold bullion market. Thus the fund issues a certificate for specified amount of gold to its unit holders. The scheme is listed on a stock exchange and hence investors can buy and sell the units on stock exchange. The advantage here is that there is no risk of holding physical gold stock and investor can still have a notional claim over units of gold.
There are also mutual funds which invest in other mutual funds and these mutual funds are known as fund of funds. Thus, instead of directly investing in securities of corporates or bonds, these mutual funds invest I other mutual funds in order to get maximum diversification.