In the previous article, we saw why investing directly in stocks to get rich may not be everybody’s cup of tea. To do it, you need knowledge about finance and you need to put in a lot of time and effort into tracking companies and markets. Tough if you have a full-time job!
So how would you like it, if a professional investor with decades of experience offered to take your money and invest it in a portfolio of good stocks for a yearly fee of 1.5 per cent or 2 per cent? All gains (or losses) will be passed on to you. That’s what a mutual fund does.
In fact, mutual funds are not a vehicle for stocks alone. They collect and pool money from thousands of investors, to invest in stocks, bonds, government bonds, gold, overseas stocks and other assets too.
But aren’t mutual funds supposed to be risky vehicles? They are subject to ‘market risks’. That’s quite correct. The returns you can earn from mutual funds are not predictable and you can make losses, because the returns they deliver to you depend entirely on how markets fare. But there are some unique advantages to mutual funds too.
When you invest money in a bank FD, you vaguely know that it is supposed to be safe. But do you know what the bank is actually doing with your money? You don’t.
Well, in mutual funds you know exactly the stocks, bonds or securities the fund manager is parking your money in. MFs are supposed to disclose their entire portfolio to the public at the end of every month. Even better, they are required to calculate the value of their portfolio called the Net Asset Value or NAV, every day and disclose it to the public. This leads to two benefits. You know exactly where your money is going and if things are going wrong, you get to know about it within a day.
There are many types of mutual funds. But a majority of mutual funds in India are open-ended ones. This means that on any working day of the week, you can sell all or part of your holdings in the fund at that days’ NAV. So if you see your fund’s NAV losing a lot of value, you can not only find out why it happened by looking at its portfolio. You can also sell your holdings immediately for a transparent price.
Most other investments don’t allow you to do this. If you’ve ever tried to sell a flat, a plot of land or a piece of jewellery you know that you can never predict the price you’ll get. If a NBFC or bank runs into trouble, you will not know exactly how much money you will get back from its bonds or FD.
Many financial products in India are not well-regulated. So you have fraud operators who are unregistered and make away with your money. Or you are charged a usurious fee or cost that takes a big bite out of your return. Or your money gets siphoned off into the promoter’s pocket. Sometimes, the product is mis-labelled to make a risky investment seem like a guaranteed one.
The Securities Exchange Board of India (SEBI) strictly regulates mutual funds to make sure that none of these things can easily happen with this vehicle.
The total costs that mutual funds can charge you are capped by SEBI at 1 per cent to 2.25 per cent annually of the NAV. The types of funds that can be sold are decided by fixed categorization rules. Where MFs invest and how they label their schemes, is again decided by SEBI. So, if a fund calls itself a mid-cap fund, it needs to invest 65 per cent of its portfolio in the 150 mid-cap stocks designated by SEBI.
Therefore, though mutual funds do carry market risks, they don’t carry the other types of risks – on fraudulent promoters, illiquidity, mis-labelling, usurious charges etc that other vehicles may be subject to.
Mutual funds invest your money in instruments whose market value swings every day. This is what they mean by warning you that mutual funds are subject to market risks. When you are a direct investor and are buying stocks that you think will give you big returns, you don’t give much thought to how you can reduce the swings in your portfolio returns.
But mutual fund managers do. They are required to spread their holdings over multiple stocks or bonds to own a diversified portfolio at all times. By law, they cannot invest more than 10 per cent of their portfolio value in a single stock and more than 25 per cent in a single sector. When a stock or sector becomes too large a component of the portfolio, they sell and lock into profits on it and find replacements. They may also follow other risk control techniques, like holding more cash or moving into safer investments (like bluechip stocks) when they believe markets are ripe for a fall.
As an individual investor, it is quite difficult to do all of this at a portfolio level. But the really cool thing is that mutual funds are not required to pay any tax every time they sell any of their holdings, as they are treated as pass-through entities for tax purposes. Whereas you as an individual investor will certainly have to pay tax if you churn your portfolio.
Variety of assets
Most people think of mutual funds as being synonymous with stock markets. But SEBI allows Indian fund houses to offer 36 types of schemes investing in different kinds of assets. So you have mutual funds investing in stocks and within that, large-cap, mid-cap and small-cap stocks. You have funds investing in high-quality corporate bonds (corporate bond funds) and those investing in lower-rated ones (credit risk funds).
You have funds investing in absolutely safe investments like government bonds (gilt funds) and treasury bills (money market funds). You have funds to invest in specific themes in the stock market (like IT, consumption, PSUs etc) and also funds that buy bonds of differing duration ranging from 90 days to over 10 years.
Then you have funds that invest in gold (gold ETFs) and foreign stocks (Nasdaq and country equity funds).
This varied menu allows you to mix and match mutual funds to meet any need, not matter what your investing horizon or risk profile.