Wednesday, May 9, 2007

Investing in Mutual Funds!

Investing in Mutual Funds!
What are Mutual Funds?
Mutual funds are one of the most convenient way to invest! Mutual funds allow you to invest your money like an expert without being an expert!

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 are shared by its unit holders in proportion to the number of units owned by them (pro rata). 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. 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
A mutual fund is the ideal investment vehicle for today’s complex and modern financial scenario. Markets for equity shares, bonds and other fixed income instruments, real estate, derivatives and other assets have become mature and information driven. Price changes in these assets are driven by global events occurring in faraway places. A typical individual is unlikely to have the knowledge, skills, inclination and time to keep track of events, understand their implications and act speedily. An individual also finds it difficult to keep track of ownership of his assets, investments, brokerage dues and bank transactions etc.

Basically, mutual funds are a way for you to outsource the whole “investing” headache to people who are experts at investing. Simply put, you give the money you want to invest to people who are experts at investing. They will invest your money and make it grow & for this service they charge you a small fee!

Why invest in mutual funds?
Good investing generally requires a good knowledge about the market, economics, world politics and a lot of experience etc. Most people who want to invest their money, do not have the time to follow and learn all these things. For them “Mutual Funds” are the best option. You do not have to worry about anything when investing in Mutual Funds. You just have take out the money for investing. The Mutual Fund managers are people who will do all the work for you and make your money grow!

The actual process of investing in mutual funds is also quite easy. You do not have to do anything except for write a cheque and give it to the mutual fund company. You do not have the hassles of using a “broker” or a “demat” account or anything.

Besides this, there are certain mutual funds that will “really” help you in your financial planning. There are certain mutual funds that are designed to help you invest and accumulate money for your “big buys”! All in all, we highly recommend that you use mutual funds for investing, as you are probably a new investor.
Mutual funds have some risk associated with them. But the risk is not very high. It is generally considered to be a moderately safe investment. However, mutual funds can produce pretty good returns!

One of the best things about mutual funds is that they are “liquid”! What is liquid? To understand what “liquid” means, let us try to understand what non-liquid investments are.

There are some investments that take some time period to “mature”. This means that once you invest the money in the investment, you cannot withdraw it until the time period is up. Once the time period is up, then only will you be able to withdraw the money you invested and the returns produced. These investments are non-liquid. If on the other hand, you can withdraw the money invested and the returns at any point of time, then the investment is considered to be a liquid investment.
Generally, it is good to try and put your money in liquid investments. This is because in case there is a sudden need for money like an operation, an accident etc. you should not have to borrow money. You should have the money available.
Mutual funds are very liquid investments. The process of re-claiming your money in most mutual funds will take a maximum time of 2-3 days.

How to invest in mutual funds?
There are many different kinds of mutual funds. Instead of trying to figure out what is good for you what is bad for you etc, you should get yourself a good mutual fund agent! You just call one of these agents up and tell them you invest in mutual funds. They will help you out with everything that you need to know. You just have to tell them what kind of “financial aims” you have and they will come up with a whole plan for you to reach your “financial aims”!


Issuing a Mutual Fund Offer!
A draft offer document is to be prepared at the time of launching the fund. Typically, it pre specifies the investment objectives of the fund, the risk associated, the costs involved in the process and the broad rules for entry into and exit from the fund and other areas of operation. In India, as in most countries, these sponsors need approval from a regulator, SEBI (Securities exchange Board of India) in our case. SEBI looks at track records of the sponsor and its financial strength in granting approval to the fund for commencing operations.

A sponsor then hires an asset management company to invest the funds according to the investment objective. It also hires another entity to be the custodian of the assets of the fund and perhaps a third one to handle registry work for the unit holders (subscribers) of the fund.
In the Indian context, the sponsors promote the Asset Management Company also, in which it holds a majority stake. In many cases a sponsor can hold a 100% stake in the Asset Management Company (AMC). E.g. Birla Global Finance is the sponsor of the Birla Sun Life Asset Management Company Ltd., which has floated different mutual funds schemes and also acts as an asset manager for the funds collected under the schemes.

Classification of Mutual Fund!
Mutual fund schemes may be classified on the basis of its structure and its investment objective:
By Structure:

Open-ended Funds
An open-end fund is one that is available for subscription all through the year. These do not have a fixed maturity. Investors can conveniently buy and sell units at Net Asset Value ("NAV") related prices. The key feature of open-end schemes is liquidity.

Closed-ended Funds
A closed-end fund has a stipulated maturity period which generally ranging from 3 to 15 years. The fund is open for subscription only during a specified period. Investors can invest in the scheme at the time of the initial public issue and thereafter they can buy or sell the units of the scheme on the stock exchanges where they are listed. In order to provide an exit route to the investors, some close-ended funds give an option of selling back the units to the Mutual Fund through periodic repurchase at NAV related prices. SEBI Regulations stipulate that at least one of the two exit routes is provided to the investor.

Interval Funds
Interval funds combine the features of open-ended and close-ended schemes. They are open for sale or redemption during pre-determined intervals at NAV related prices.

By Investment Objective:

Growth Funds
The aim of growth funds is to provide capital appreciation over the medium to long- term. Such schemes normally invest a majority of their corpus in equities. It has been proven that returns from stocks, have outperformed most other kind of investments held over the long term. Growth schemes are ideal for investors having a long-term outlook seeking growth over a period of time.

Income Funds
The aim of income funds is to provide regular and steady income to investors. Such schemes generally invest in fixed income securities such as bonds, corporate debentures and Government securities. Income Funds are ideal for capital stability and regular income.


Balanced Funds
The aim of balanced funds is to provide both growth and regular income. Such schemes periodically distribute a part of their earning and invest both in equities and fixed income securities in the proportion indicated in their offer documents. In a rising stock market, the NAV of these schemes may not normally keep pace, or fall equally when the market falls. These are ideal for investors looking for a combination of income and moderate growth.

Money Market Funds
The aim of money market funds is to provide easy liquidity, preservation of capital and moderate income. These schemes generally invest in safer short-term instruments such as treasury bills, certificates of deposit, commercial paper and inter-bank call money. Returns on these schemes may fluctuate depending upon the interest rates prevailing in the market. These are ideal for Corporate and individual investors as a means to park their surplus funds for short periods.

Load Funds
A Load Fund is one that charges a commission for entry or exit. That is, each time you buy or sell units in the fund, a commission will be payable. Typically entry and exit loads range from 1% to 2%. It could be worth paying the load, if the fund has a good performance history.

No-Load Funds
A No-Load Fund is one that does not charge a commission for entry or exit. That is, no commission is payable on purchase or sale of units in the fund. The advantage of a no load fund is that the entire corpus is put to work.

Other Schemes:
Tax Saving Schemes
These schemes offer tax rebates to the investors under specific provisions of the Indian Income Tax laws as the Government offers tax incentives for investment in specified avenues. Investments made in Equity Linked Savings Schemes (ELSS) and Pension Schemes are allowed as deduction u/s 80 of the Income Tax Act, 1961.

Special Schemes
Industry Specific Schemes
Industry Specific Schemes invest only in the industries specified in the offer document. The investment of these funds is limited to specific industries like InfoTech, FMCG, Pharmaceuticals etc.


Index Schemes
Index Funds attempt to replicate the performance of a particular index such as the BSE Sensex or the NSE 50.

Sectoral Schemes
Sectoral Funds are those, which invest exclusively in a specified industry or a group of industries or various segments such as 'A' Group shares or initial public offerings

Benefits of Mutual Fund investment
Professional Management
Mutual Funds provide the services of experienced and skilled professionals, backed by a dedicated investment research team that analyses the performance and prospects of companies and selects suitable investments to achieve the objectives of the scheme.

Diversification
Mutual Funds invest in a number of companies across a broad cross-section of industries and sectors. This diversification reduces the risk because seldom do all stocks decline at the same time and in the same proportion. You achieve this diversification through a Mutual Fund with far less money than you can do on your own.

Convenient Administration
Investing in a Mutual Fund reduces paperwork and helps you avoid many problems such as bad deliveries, delayed payments and follow up with brokers and companies. Mutual Funds save your time and make investing easy and convenient.

Return Potential
Over a medium to long-term, Mutual Funds have the potential to provide a higher return as they invest in a diversified basket of selected securities.

Low Costs Mutual Funds are a relatively less expensive way to invest compared to directly investing in the capital markets because the benefits of scale in brokerage, custodial and other fees translate into lower costs for investors.

Liquidity
In open-end schemes, the investor gets the money back promptly at net asset value related prices from the Mutual Fund. In closed-end schemes, the units can be sold on a stock exchange at the prevailing market price or the investor can avail of the facility of direct repurchase at NAV related prices by the Mutual Fund.

Transparency
You get regular information on the value of your investment in addition to disclosure on the specific investments made by your scheme, the proportion invested in each class of assets and the fund manager's investment strategy and outlook.

Flexibility
Through features such as regular investment plans, regular withdrawal plans and dividend reinvestment plans, you can systematically invest or withdraw funds according to your needs and convenience.

Affordability
Investors individually may lack sufficient funds to invest in high-grade stocks. A mutual fund because of its large corpus allows even a small investor to take the benefit of its investment strategy.

Choice of Schemes
Mutual Funds offer a family of schemes to suit your varying needs over a lifetime.

Well Regulated
All Mutual Funds are registered with SEBI and they function within the provisions of strict regulations designed to protect the interests of investors. The operations of Mutual Funds are regularly monitored by SEBI.


Who are the issuer of Mutual Funds in India!

Unit Trust of India was the first mutual fund which began operations in 1964. Other issuers of Mutual funds are Public sector banks like SBI, Canara Bank, Bank of India, Institutions like IDBI, ICICI, GIC, LIC, Foreign Institutions like Alliance, Morgan Stanley, Templeton and Private financial companies like Kothari Pioneer, DSP Merrill Lynch, Sundaram, Kotak Mahindra, Cholamandalam etc.

Are there any risks involved in investing in Mutual Funds?
Mutual Funds do not provide assured returns. Their returns are linked to their performance. They invest in shares, debentures and deposits. All these investments involve an element of risk. The unit value may vary depending upon the performance of the company and companies may default in payment of interest/principal on their debentures/ bonds/ deposits. Besides this, the government may come up with new regulation, which may affect a particular industry or class of industries. All these factors influence the performance of Mutual Funds.

How is the worth of an investment in a mutual fund measured? What is NAV?
The current value of your investment can be known from the Net Asset Value or the NAV. The NAV, in effect, measures the value of the net assets (gross assets less liabilities) per unit.
Mathematically, the NAV is given by:
{(Market Value of the Scheme's Investments) + Other Assets (including accrued interest) + Unamortised Issue Expenses (only in case of schemes launched on a load basis) - All Liabilities except unit capital and reserves)} Divided by the number of units outstanding at the end of the day.

How often is the NAV declared?
The NAV of a scheme has to be declared at least once a week. However many Mutual Fund declare NAV for their schemes on a daily basis. As per SEBI Regulations, the NAV of a scheme shall be calculated and published at least in two daily newspapers at intervals not exceeding one week. However, NAV of a close-ended scheme targeted to a specific segment or any monthly income scheme (which are not mandatory required to be listed on a stock exchange) may be published at monthly or quarterly intervals.

What is Entry/Exit Load?
A Load is a charge, which the AMC may collect on entry and/or exit from a fund. A load is levied to cover the up-front cost incurred by the AMC for selling the fund. It also covers one time processing costs. Some funds do not charge any entry or exit load. These funds are referred to as 'No Load Fund'. Funds usually charge an entry load ranging between 1.00% and 2.00%. Exit loads vary between 0.25% and 2.00%

What is Sale/Purchase Price?
Sales/Purchase price is the price paid to purchase a unit of the fund. If the fund has no entry load, then the sales price is the same as the NAV. If the fund levies an entry load, then the sales price would be higher than the NAV to the extent of the entry load levied.

What is Redemption Price?
Redemption price is the price received on selling units of open-ended scheme. If the fund does not levy an exit load, the redemption price will be same as the NAV. The redemption price will be lower than the NAV in case the fund levies an exit load.

What are the other costs involved in Mutual Fund Investing?
In addition to entry and exit charges, a mutual fund also charges asset management fees and certain other expenses. These charges compensate the fund for the expenses it incurs in managing assets, processing transactions and paying brokerages. For instance, every redemption request involves not only administrative processing costs but also other costs associated with raising money to pay off the outgoing investor. Regulations stipulate that the difference between the repurchase and the resale price cannot exceed 7 % of sale price, and that recurring expenses cannot exceed 2.5 % of average weekly net assets. The recurring expenses limit is even lower for schemes with a size exceeding Rs. 100 crores in net assets.
Is there any minimum lock-in-period for units?
There is no lock-in period in the case of open-ended funds. However in the case of tax saving funds a minimum lock-in period is applicable. The lock-in period for different tax saving schemes is 3 yrs

What are the factors that influence the performance of Mutual Funds?
The performances of Mutual funds are influenced by the performance of the stock market as well as the economy as a whole. Equity Funds are influenced to a large extent by the stock market. The stock market in turn is influenced by the performance of the companies as well as the economy as a whole. The performance of the sector funds depends to a large extent on the companies within that sector. Bond-funds are influenced by interest rates and credit quality. As interest rates rise, bond prices fall, and vice versa. Similarly, bond funds with higher credit ratings are less influenced by changes in the economy.

As a new investor how do I Select a Particular Scheme?
Choice of any scheme would depend to a large extent on the investor preferences. For an investor willing to undertake risks, equity funds would be the most suitable as they offer the maximum returns. Debt funds are suited for those investors who prefer regular income and safety. Gilt funds are best suited for the medium to long-term investors who are averse to risk. Balanced funds are ideal for medium- to long-term investors willing to take moderate risks. Liquid funds are ideal for Corporates, institutional investors and business houses who invest their funds for very short periods.
An important aspect while selecting a particular scheme is the duration of the investment. Depending on your time horizon you can select a particular scheme. Besides all this, factors like objective of the fund and returns given by the funds on different schemes should also be taken into account while selecting a particular scheme.

What are the various ways in which fund performance can be measured?
NAV serves as the basic material for evaluating the performance of a fund. Some of the methods used are explained below:

Relative-To-Benchmark method :
Under this method, a comparison is made between the returns given by a market index and the fund over a given period of time. If the returns generated by the fund (as measured by changes in NAV over that given period of time) are greater than those generated by the benchmark, then the fund is said to have outperformed the market portfolio.

Risk-Return method:
The Relative-to-Benchmark measure is very simplistic, as it does not incorporate any measure of risk in its calculation. An investor would naturally be interested in finding out the return generated for the risk undertaken, as, in a bid to generate super-normal returns, the fund may go overboard on the risk parameter. Therefore, risk-adjusted measures of return are needed to evaluate the performance of funds. There are several such measures prominent among which are the Sharpe ratio, the Treynor ratio, and Alpha:

Sharpe ratio:
This measure uses standard deviation as a measure to evaluate a fund's risk-adjusted returns. The higher a fund's Sharpe ratio, the better it is. Thus, a fund's returns would be regarded good if the fund returns a high level of Sharpe ratio. Mathematically, it is arrived at by deducting the risk-free returns from the returns generated by the fund and dividing the residual figure by the standard deviation of the fund's returns. One thing that has to be kept in mind while using this measure is that the ratio is not an absolute figure. Its real utility lies in inter-scheme comparison.

Treynor's ratio:
Treynor's ratio also has the same attributes as Sharpe's with the difference that the residual figure in this case is divided by beta rather than the standard deviation, thus reflecting only the systematic risk. Beta of the fund is a volatility measure that quantifies the sensitivity of the fund's return to the benchmark index's returns, i.e., given the movements of the benchmark how much the fund will move. It does not represent unsystematic risk under the assumption that the fund manager can easily wipe out the unsystematic risk by diversifying across a large number of stocks.

Alpha:
Basically, alpha is the difference between the return that would be warranted by its beta (expected return) and the return that is actually generated by the fund. If a fund returns more than what is anticipated by beta, it has a positive and favourable alpha, and if it returns less than the amount predicted by beta, the fund has a negative alpha. Mathematically, Alpha = fund return - [Risk free rate + Beta of fund (Benchmark return - Risk free return)]

How relevant is the Past Performance of a Fund Scheme?
Fund prospectuses will clearly tell you that "past performance is no indicator of the future", but, on the other hand, many analysts will tell you that sustained performance over a reasonably long period of time is a good criteria. There is truth in both points of view. While past performance reflects the success of the fund manager, the broad investment strategy and related factors, it serves as no guarantee that the strategy will work equally well in the future. A change in the external environment could necessitate a change in investment strategy too. Again, past successes could imply that the probability of future successes is respectably high. So it's one of those issues where you'll have to rely partly on information and partly on intuition. Do fund managers commit themselves to any particular investment philosophy and style? Normally fund managers do define the approach they intend to adopt to realise the investment objective of the scheme. In fact, if you want to know what your fund manager's philosophy is, go through the fund offer documents and other communication - that should give you a clear idea of what the fund manager proposes to do with your money.

What is Cost Averaging?
Cost averaging is an investment strategy in which equal amounts of money are invested in a scheme at regular intervals. So, you can buy a lower number of units when the NAV is high and a higher number of units when the NAV is low. What it does, in effect, is eliminate the need to keep a continuous track of the market. Regular investment over a period of time evens out the short term fluctuations associated with the market's volatility, so you don't suffer.

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