Mutual Funds: Meaning, Characteristics, Advantages and Limitations, Types and Significance [Indian Financial System Notes BCOM NEP Syllabus]

byKumar Nirmal Prasad -

Mutual Funds: Meaning, Characteristics, Advantages and Limitations
Types of Mutual Funds and Significance of Mutual Funds Institutions
[Indian Financial System Notes BCOM NEP Syllabus]

Introduction & Meaning of Mutual Funds

‘A mutual fund means pooling the investments of a number of investors by way of investment in units of equal size’. They are financial intermediaries which collect funds from the public and invest them in a diversified portfolio of securities, including equity, bonds debenture and other instruments issued by business or government undertakings. The purpose of mutual fund is to help small investors participate in the securities market indirectly with reduced risk for small investors by diversifying the investment into various types of securities of different corporations and industry.

According to Association of Mutual Funds in India (AMFI), “A Mutual fund is a trust that pools number of savings investors, who shares common financial goal’. 

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Key Characteristics of Mutual Funds

There are certain key characteristics of mutual funds:
a. Mutual Fund Diversification: Most individual investors are unable to purchase 50 or 60 different issues of stocks. They typically have to rely on a few selections and hope for the best. An investor in a mutual fund gets the advantage of being invested in the entire fund’s portfolio. This helps lower the exposure to problems with any individual issue.
b. Mutual Fund Professional Management: The fund employs professionals to manage the fund's investments. Most small investors can’t possibly spend their days researching individual stocks or bonds and market trends. By owning a fund, the investors can take advantage of the abilities of the fund’s management team. The fund charges a management fee to cover the cost of management.
c. Mutual Fund Affordability: Investments in mutual funds can often be opened with small investments. Sometimes the initial investment may be as low as Rs.100, and subsequent investments into the fund may be made with similar small amounts.
d. Mutual Fund Liquidity - Mutual funds are liquid on every business day. They are sold at their net asset value which is computed on every business day after the close of the markets. The price you receive depends on the value of the securities in the fund

Advantages of Mutual Funds for Investors

1. Professional Management: Mutual funds offer investors the opportunity to earn an income or build their wealth through professional management of their investible funds. There are several aspects to such professional management viz. investing in line with the investment objective, investing based on adequate research, and ensuring that prudent investment processes are followed.
2. Affordable Portfolio Diversification: Units of a scheme give investors exposure to a range of securities held in the investment portfolio of the scheme. Thus, even a small investment of Rs 5,000 in a mutual fund scheme can give investors a diversified investment portfolio.
3. Economies of Scale: The pooling of large sums of money from so many investors makes it possible for the mutual fund to engage professional managers to manage the investment. Individual investors with small amounts to invest cannot, by themselves, afford to engage such professional management.
4. Liquidity: Investors in a mutual fund scheme can recover the value of the moneys invested, from the mutual fund itself. Depending on the structure of the mutual fund scheme, this would be possible, either at any time, or during specific intervals, or only on closure of the scheme.
5. Tax Deferral: Mutual funds are not liable to pay tax on the income they earn. If the same income were to be earned by the investor directly, then tax may have to be paid in the same financial year.
6. Tax benefits: Specific schemes of mutual funds (Equity Linked Savings Schemes) give investors the benefit of deduction of the amount invested, from their income that is liable to tax. This reduces their taxable income, and therefore the tax liability.
7. Convenient Options: The options offered under a scheme allow investors to structure their investments in line with their liquidity preference and tax position.
8. Investment Comfort: Once an investment is made with a mutual fund, they make it convenient for the investor to make further purchases with very little documentation. This simplifies subsequent investment activity.
9. Regulatory Comfort: The regulator, Securities & Exchange Board of India (SEBI) has mandated strict checks and balances in the structure of mutual funds and their activities. These are detailed in the subsequent units. Mutual fund investors benefit from such protection.
10. Systematic approach to investments: Mutual funds also offer facilities that help investor invest amounts regularly through a Systematic Investment Plan (SIP); or withdraw amounts regularly through a Systematic Withdrawal Plan (SWP); or move moneys between different kinds of schemes through a Systematic Transfer Plan (STP). Such systematic approaches promote an investment discipline, which is useful in long term wealth creation and protection.

Limitations of a Mutual Fund

1. Lack of portfolio customization: Mutual fund unit-holder is just one of several thousand investors in a scheme. Once a unit-holder has bought into the scheme, investment management is left to the fund manager. Thus, the unit-holder cannot influence what securities or investments the scheme would buy.

2. Choice overload: Over 800 mutual fund schemes offered by 38 mutual funds – and multiple options within those schemes – make it difficult for investors to choose between them.

3. No control over costs: All the investor's moneys are pooled together in a scheme. Costs incurred for managing the scheme are shared by all the Unit holders in proportion to their holding of Units in the scheme. Therefore, an individual investor has no control over the costs in a scheme.

4. High Management Fee: All the investor's moneys are pooled together in a scheme. Costs incurred for managing the scheme are shared by all the Unitholders in proportion to their holding of Units in the scheme. Therefore, an individual investor has no control over the costs in a scheme.

5. Diversification: Diversification minimizes risk but does not guarantee higher return.

6. Diversion of Funds: There may be unethical practices e.g. diversion of Mutual Fund amounts by Mutual Fund/s to their sister concerns for making gains for them.

7. Lock-In Period: Many MF schemes are subject to lock in period and therefore, deny the investors market drawn benefits.

Types of Mutual Funds

In order to suit the needs and preferences of investors, mutual funds institutions are now offering various types of mutual fund schemes. Mutual funds schemes as per the demand of the investors are classified into the following broad categories:

1. According to ownership

a) Public Sector Mutual Funds

b) Private Sector Mutual Funds

2. According to the scheme of operation

a) Open-ended Funds

b) Closed-ended Funds

c) Internal Funds

3. According to portfolio

a) Income Funds

b) Balanced Funds

c) Growth Funds

d) Stock/Equity Funds

e) Debt Funds

f) Hybrid Funds

4. According to location

a) Domestic Funds

b) Off-shore Funds

5. According to management

a) Active Funds

b) Passive Funds

6. Gold funds

a) Gold Exchange Traded Funds

b) Gold Sector Funds

7. others

a) Real Estate Funds

b) Exchange Traded Funds

c) Commodity Funds

d) Fund of Funds

 1. According to ownership

According to ownership, mutual funds in India may be classified as:

a) Public Sector Mutual Funds: Public sector mutual funds are those which are initiated by UTI and other public sector banks. For the first time, UTI started public sector mutual fund schemes in the year 1963-64. In the year 1987, second public sector mutual fund was established by SBI.

b) Private Sector Mutual Funds: Private sector mutual funds are those which are initiated by private sector corporate. In the year 1992, Government of India allowed the private sector corporate to start mutual fund schemes.

2. According to the scheme of operation

According to the scheme of operation, mutual funds in India are classified as:

a) Open-ended funds: Open-ended funds are open for investors to enter or exit at any time, even after the NFO. In such funds period of maturity is not specified. Investors can enter and exit at any time. The most important advantage of open-ended funds is that it offers liquidity to investors.

b) Close-ended funds: Close-ended funds are those which have a fixed maturity period. Investors can buy units of a close-ended scheme, from the fund, only during its NFO. After the close of NFO, investors can buy or sale units of close-ended fund only through stock exchange where these funds are listed.

c) Interval funds: Interval funds combine features of both open-ended and close ended schemes. They are largely close-ended, but become open ended at pre-specified intervals.

3. According to Portfolio

According to portfolio or objectives of investment, mutual funds are classified as:

a) Income Funds: These funds aim at providing maximum return to the investors. These funds mainly invest in low risk financial assets such as bonds, debentures, Commercial Papers (CPs) etc. These funds distribute the income earned by them periodically amongst the investors.

b) Balance funds: Balance funds are those which invest in both high risk financial asset such as equity for higher return and also in fixed interest/return bearing securities such as debentures, preference shares and bonds. Balance funds ensure both capital appreciation as well as regular return in the shape of interest and dividend.

c) Growth funds: Growth funds are those which invest mainly in those securities which have high potential of appreciation in the long term. These funds mainly concentrate on capital appreciation of the investors. Due to too much exposure in equity, these funds are riskier as compared to income and balance funds.

d) Equity funds: A scheme might have an investment objective to invest largely in equity shares and equity-related investments like convertible debentures. Such schemes are called equity schemes.

Types of Equity Funds

1. Diversified equity fund is a category of funds that invest in a diverse mix of securities that cut across sectors.

2. Sector funds however invest in only a specific sector. For example, a banking sector fund will invest in only shares of banking companies. Gold sector fund will invest in only shares of gold-related companies.

3. Thematic funds invest in line with an investment theme. For example, an infrastructure thematic fund might invest in shares of companies that are into infrastructure construction, infrastructure toll-collection, cement, steel, telecom, power etc.

4. Equity Linked Savings Schemes (ELSS), as seen earlier, offer tax benefits to investors. However, the investor is expected to retain the Units for at least 3 years.

5. Equity Income / Dividend Yield Schemes invest in securities whose shares fluctuate less, and therefore, dividend represents a larger proportion of the returns on those shares.

6. Arbitrage Funds take contrary positions in different markets / securities, such that the risk is neutralized, but a return is earned.

e) Debt funds: Schemes with an investment objective that limits them to investments in debt securities like Treasury Bills, Government Securities, Bonds and Debentures are called debt funds.

Types of Debt Funds

Gilt funds invest in only treasury bills and government securities, which do not have a credit risk.

Diversified debt funds on the other hand, invest in a mix of government and non-government debt securities.

Junk bond schemes or high yield bond schemes invest in companies that are of poor credit quality.

Fixed maturity plans are a kind of debt fund where the investment portfolio is closely aligned to the maturity of the scheme.

Floating rate funds invest largely in floating rate debt securities i.e. debt securities where the interest rate payable by the issuer changes in line with the market.

Liquid schemes or money market schemes are a variant of debt schemes that invest only in debt securities where the moneys will be repaid within 91-days.

f) Hybrid funds: Hybrid funds have an investment charter that provides for a reasonable level of investment in both debt and equity.

Types of Hybrid Funds

Monthly Income Plan seeks to declare a dividend every month. It therefore invests largely in debt securities.

Capital Protected Schemes are close-ended schemes, which are structured to ensure that investors get their principal back, irrespective of what happens to the market.

4. According to Location:

Mutual funds can also be classified on the basis of location from where they mobilise funds, as:

a) Domestic Funds: These are the funds which mobilise savings of people within the country where investments are made.

b) International Funds: These are funds that invest outside the country. For instance, a mutual fund may offer a scheme to investors in India, with an investment objective to invest abroad.

5. According to Management:

On the basis of management, Mutual funds are divided into two groups:

a) Actively Managed Funds: Actively managed funds are funds where the fund manager has the flexibility to choose the investment portfolio, within the broad parameters of the investment objective of the scheme. Since this increases the role of the fund manager, the expenses for running the fund turn out to be higher.

b) Passive Funds: Passive funds invest on the basis of a specified index, whose performance it seeks to track. Thus, a passive fund tracking the BSE Sensex would buy only the shares that are part of the composition of the BSE Sensex. Such schemes are also called index schemes. Since the portfolio is determined by the index itself, the fund manager has no role in deciding on investments. Therefore, these schemes have low running costs.

6. Gold Funds:

These funds invest in gold and gold-related securities. They can be structured in either of the following formats:

a)Gold Exchange Traded Fund, which is like an index fund that invests in gold. The structure of exchange traded funds is discussed later in this unit. The NAV of such funds moves in line with gold prices in the market.

b)Gold Sector Funds i.e. the fund will invest in shares of companies engaged in gold mining and processing. Though gold prices influence these shares, the prices of these shares are more closely linked to the profitability and gold reserves of the companies.

7. Other Types of Mutual Funds:

In addition to the above mentioned mutual funds, there are some other types of mutual funds:

a) Real Estate Funds: They take exposure to real estate. Such funds make it possible for small investors to take exposure to real estate as an asset class. Although permitted by law, real estate mutual funds are yet to hit the market in India.

b) Commodity Funds: The investment objective of commodity funds would specify which of these commodities it proposes to invest in.

c) Fund of Funds: Such fund invests in another fund. Similarly, funds can be structured to invest in various other funds, whether in India or abroad. Such funds are called fund of funds.

d) Exchange Traded Funds: Exchange Traded funds (ETF) are open-ended index funds that are traded in a stock exchange.

e) Others: Loan Funds, Non-loan Funds, Hub and Spoke Funds etc.

Role of Mutual Funds Institutions

Mutual funds Institutions perform different roles for different constituencies:
1. Wealth Building: Their primary role is to assist investors in earning an income or building their wealth, by participating in the opportunities available in various securities and markets. It is possible for mutual funds to structure a scheme for any kind of investment objective. Thus, the mutual fund structure, through its various schemes, makes it possible to tap a large corpus of money from diverse investors.
2. Source of Finance for government and companies: The money that is raised from investors, ultimately benefits governments, companies or other entities, directly or indirectly, to raise moneys to invest in various projects or pay for various expenses.
3. Corporate Governance and ethical standards: As a large investor, the mutual funds can keep a check on the operations of the investee company, and their corporate governance and ethical standards.
4. Project Financing: The projects that are facilitated through such financing, offer employment to people; the income they earn helps the employees buy goods and services offered by other companies, thus supporting projects of these goods and services companies. Thus, overall economic development is promoted.
5. Employment creation: The mutual fund industry itself, offers livelihood to a large number of employees of mutual funds, distributors, registrars and various other service providers. Higher employment, income and output in the economy boost the revenue collection of the government through taxes and other means. When these are spent prudently, it promotes further economic development and nation building.
6. Growth of capital market: Mutual funds can also act as a market stabilizer, in countering large inflows or outflows from foreign investors. Mutual funds are therefore viewed as a key participant in the capital market of any economy.
7. Protection to Small Investors: A small investor is not safe in share market. In mutual industry there is no such risk. Mutual funds help to reduce the risk of investing in stocks by spreading or diversifying investments. Small investors enjoy the benefit of diversification.
8. Tax Benefit: Investors in mutual funds enjoy tax benefits. Dividend received byinvestors is tax free. Tax exemption is allowed on income received on units of mutual funds and UTI.
9. Diversification: Investment in mutual funds enable investors to spread out and minimise the risks upto certain extent. Mutual fund invests in a diversified portfolio of securities. This diversification helps to reduce risk since all the stocks do not fall at same time. Thus investors are assured of average income which is not possible in other sources.
10. Arrival of Foreign Capital: Mutual funds attract foreign capital. Indian Mutual Fund Industries open offshore funds in various foreign countries and secure safe investment avenues abroad to domestic savings. These funds enable NRI’s and foreign investors to participate in Indian Capital Market.
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Posted by Kumar Nirmal Prasad