Mutual Funds in India: An Overview

  • Kanan Arora
  • May 19, 2021
  • Financial Analytics
Mutual Funds in India: An Overview title banner

Introduction

 

Finance seems fascinating to many people, especially those working in an unrelated profession. The simple idea that a person can make their money work for themselves amazes people. Listening to stories of successful investors and traders entices them to enter the markets some way or the other.

 

However, investing in largest stock markets and other capital markets is not as easy a task as it may seem listening to success stories. First of all, it requires a sufficient amount of capital and other resources to enter the markets. Then, it takes a significant amount of research and analysis to search for particular investment opportunities and paramount discipline to profit from the opportunities identified.

 

Many people might now have the capital, time, energy, and other required resources required to partake in such ventures independently. Pooled investment vehicles help these people enter the markets and participate in the markets by providing them with the necessary aid.

 

A collective investment vehicle or a CIV is any entity that allows investors to pool their money and invest the pooled funds rather than buying securities individually. The most popular investment vehicle is mutual funds. We’ll try to understand them in this blog.


 

What is a Mutual Fund?

 

A mutual fund is a financial intermediary that allows investors to pool their money to attain an investment objective. Mutual funds usually invest money in stocks, bonds, short-term money market instruments, and other such securities. They typically do not trade very high-risk asset classes like derivatives. 

 

Different mutual funds comprise various types of securities depending on the nature of the mutual fund and the investment objective.

 

Terms associated with Mutual Funds:

 

  1. Net Asset Value: 

 

The market value of a fund per unit is represented by its net asset value (NAV). This is the amount at which customers purchase or sell fund units from a fund company. It is obtained by subtracting the total value of all assets in a portfolio by the full value of all liabilities in the portfolio. After considering the closing trading prices of the shares, NAV is determined at the end of each business day. 

 

  1. Entry Load: 

 

Entry load refers to the charges a mutual fund charges to meet the selling and distribution expenses of the mutual fund. It presented the investors with a high additional cost but has been banned since 2009.

 

  1. Exit Load: 

 

Exit load refers to the charges levied to the investors while selling the mutual fund units.

 

  1. Expense ratio: 

 

The expense ratio refers to the amount charged by the mutual fund to manage the funds. It considers all the charges and is a critical metric to understand the real returns of the mutual fund.

 

  1. Portfolio Turnover ratio: 

 

The portfolio turnover ratio is the ratio that helps an investor understand the frequency with which the fund's holdings have changed over the past year. It helps understand the passiveness/ activeness of the portfolio.

 

  1. Systematic Investment Plan (SIP): 

 

A systematic investment plan refers to the process of investing a certain amount at specified time intervals. The concept of SIPs is based on the long-term upward trend of the markets. It tries to go with the market rather than time it and is perfect for passive investors. SIPs are widely used by retail investors all over the world.

 

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Structure of Mutual Funds in India: 

 

The Securities and Exchange Board of India (SEBI) Mutual Fund Regulations, 1996 gave birth to the Mutual Fund system. As per SEBI’s regulations, mutual funds are supposed to follow a three-tier procedure in India:

 

  1. Fund’s Sponsor: 

 

Fund’s sponsor forms the first tier of the mutual fund system. The mutual fund’s sponsor is the entity that sets up the mutual funds. It capitalizes on setting up the mutual fund. The SEBI specified eligibility criteria specifies the eligibility criteria that need to be met for an entity to become a fund’s sponsor. These regulations are imposed to avoid scams.

 

  1. Trust and Trustees: 

 

Trust and trustees form the second tier of the mutual fund system. Fund’s sponsors create the trust of the fund. The trustees are in charge of the trust and are accountable to the investors.

 

They are the principal stewards of the mutual fund. Their job is to supervise the asset management companies forming the third layer and report to SEBI every six months.

 

  1. Asset Management Companies: 

 

Asset management companies (AMCs) form the third and final tier of the mutual fund. They act as the fund’s managers or investment managers for the trust and receive a nominal fee for their services. The AMC manages all fund-related operations. 

 

The AMC has a legal obligation to handle the capital deployed and offer services to investors. It partners with other components such as brokers, auditors, bankers, registrars, and lawyers to obtain these services.

 

 

Advantages of Investing in Mutual Funds:

 

  1. Professional management: 

 

The mutual funds are managed by experienced portfolio managers who have industry experience of several years and have highly trained analysts working with them.

 

  1. Diversification: 

 

Since mutual funds essentially consist of vast amounts of pooled money, more diversification is possible than individual portfolios. Diversification spreads the risk across different assets and reduces the component of idiosyncratic risk or the risk individual to a particular investment. The systematic risk or the risk faced by the whole market is still quite active even with diversification.

 

  1. Access to asset classes: 

 

Individual investors usually do not have access to all asset classes, including the different types of bonds. Mutual funds bridge this gap between retail and institutional traders.

 

  1. Scale economies: 

 

Since mutual funds are involved in bulk activities, there are economies of scale at play. Just like a wholesale vendor purchasing from a wholesale market is provided with discounts, mutual funds save on many expenses while working in large orders. 

 

  1. Liquidity: 

 

Mutual funds are just as liquid as stocks. All mutual fund orders are executed at the fund's net asset value (NAV). High liquidity in mutual funds indicates the high amount of consumer confidence in such investment alternatives. 

 

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Disadvantages of Investing in Mutual Funds:

 

  1. Underperformance relative to indices funds: 

 

A lot of the time, mutual funds are seen underperforming to funds that simply mimic the whole market’s movement and are passive. Such funds are called index funds. In India, index funds mimic indices- Nifty and Sensex and provide exposure to the whole market. The outperformance of market-following indices makes an investor question the active management of the mutual funds.

 

  1. Scale diseconomies: 

 

Since mutual funds transact huge quantities, they face a lot of price pressure at times. Also, since mutual funds invest in various securities, they may face a lack of sufficient liquidity to trade profitably in the illiquid holdings. 

 

  1. Costs: 

 

Additional costs are incurred to the investors who invest in mutual funds to finance the expenses of the mutual fund’s managers. Such charges are not incurred when investing in various asset classes, including equity on one’s own.

 

Data including the mutual fund investment data and free investment tips and analysis are available on the internet, which can outperform mutual funds in theory and avoid additional fees.

 

  1. Tax inefficiency: 

 

The gains from mutual funds are subject to both short-term and long-term capital gain taxes.          

 

  1. Possibility of unhealthy competition: 

 

Actively managed mutual funds might have fund managers who may resort to risky practices to increase the gains on the mutual funds, putting the funds at more risk according to their discretion. To avoid such situations, an investor should study mutual funds in detail and invest only in the one he/she fully understands and trusts.

 

 

Conclusion

 

With an exponential increase in the penetration of the general public in the stock markets in the recent past, collective investment vehicles, especially mutual funds, have gained a lot of interest. Many new mutual funds have been created in the recent past, and they provide profitable alternatives for all types of traders.

 

There are a wide variety of mutual funds available in the markets today, and an investor, after sufficient research, can systematically buy such funds and enjoy long-term gains. However, it is essential to acknowledge the disclaimer telling us that mutual funds are subject to market risks.

 

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It is vital to understand the market risks involved in mutual funds and not get caught in the herd mentality. Specific periods of financial disasters, including the most recent Covid crash, have left investors in turmoil. In such situations, only the ones with efficient risk management practices in place survive.

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