It is advisable that beginners start their investment journey with mutual funds. In last decade, liking of people for mutual funds has increased several folds. Beginners in particular like mutual funds more than any other investment vehicle.
As no expertise is needed to practice mutual funds investment, makes it so likable. This is one investment vehicle where returns are not compromised even if the persons know-how about investment is only basic.
Only if one has invested in a right mutual fund, return of a pro and a beginner will be the same. And selection of right mutual funds is not a rocket science.
This is what we are going to discuss in this tutorial about mutual funds. Basic know-how required to select a right mutual fund will be explained. This tutorial will be a chain of 5 posts. Reading through all posts will give in-depth understanding about mutual funds.
In last few years, mutual funds in India has grown to become more than 8,000 Billion INR industry (Average Asset Under Management).
Gradual growth of this industry proves that mutual fund has won peoples trust.
Mutual funds are life-line for beginners. Beginners are not so knowledgeable about investment. This is where mutual funds proves its utility the most.
Lack of investment knowledge in beginners induces the ‘risk of loss’ whenever they invest money.
The very concept of mutual fund business is tailor made to reduce investment risk.
‘Investment diversification’ and ‘expert services’ are the two biggest benefits of mutual funds.
Fund managers who manage investment of funds are experts of investments. Fund managers are the most highly paid employees in the banking business.
Just to give you an idea of how much money these fund managers make, lets take an example.
HDFC Mutual Fund is the biggest fund house of India. Some of their Top fund ranked in order of their Asset Under Management (AUM-Rs Crore) are listed here.
HDFC Equity Fund has AUM of Rs 14,513 Crores. Fund Manager of this fund is Prashant Jain.
Generally, fund managers are paid in tune of 0.5% to 1% of AUM as compensation. So you can calculate, how must Prashant Jain is making per annum. 0.5% of 14,513 Crore is Rs 72.5 Crore per annum.
Wow is the first word that comes to mind…isn’t it?
Why fund managers are paid so much?
This is because they know their job. They know how to make money for us. Isn’t this a sufficient qualification to earn that FAT paycheck? Of course it is…
On our behalf they buy stocks and other securities. As they are experts, they take wiser investment decision than us.
This expert service does not come free. Fees are charged by mutual fund for the expert services they provide.
If we were Warren Buffett, we would have not used mutual funds for investing. Why should I pay fees for something that I know very well?
But the fact is, many of us do not know how to invest. And this is what makes investing risky when done on our own.
The risk of investing becomes more magnified in equity linked investments.
What are Mutual Funds?
Mutual funds are like investment bank.
They collect money from different people, and pool it in one place.
The collected money is then used to buy different assets.
Depending on the funds objective, they buy shares, bonds, deposits, precious metals, real estate, keep cash etc.
Generally, mutual fund portfolio is a combination of several asset classes. This is what makes mutual fund so well diversified.
When we buy mutual funds we actually buy its ‘units’. Total asset value of mutual fund is subdivided into small units.
Suppose a mutual fund has asset size $100 million. If the fund has 100 million units, means each unit will be of worth $1. This is called as funds NAV (Net Asset Value).
As the value of assets (shares, real estate, bonds etc) increase the market price of each unit also increases.
Suppose I bought mutual fund units at $1. After five years the market price per unit becomes $2.5. It means my annualized return is 20%.
In order to book profits, I can sell my mutual fund units back to the Mutual Fund house at $2.5 price.
The ease, with which the units are bought and sold, makes mutual funds such an ideal investment for all.
Advantages of Mutual Funds
Expert Handle our money:
Mutual funds are managed by experts. This is one big advantage of mutual funds.
The way experts research and includes assets in portfolio is job of a master.
As mutual fund invests in variety of assets it provides excellent diversification as well. Due to diversified portfolio, risk of investing reduces to great extent.
Assets of different sectors are held in portfolio. Due to this bad performance of one sector is balanced by good performance of other sector.
Like stocks; mutual funds are also available in smaller units. This makes mutual fund very affordable.
At times mutual fund NAV can be as low as $1/unit. No matter if one would like to make one time purchase or systematic monthly purchases (SIP), mutual funds are affordable.
To create a diversified portfolio, one must include several asset class in ones portfolio. But to do this one must shelve huge amount of funds. Hence for small investors it is impossible to afford a well diversified portfolio on their own.
But a person can buy only one unit of a mutual fund and get a perfect investment diversification.
Just one unit of mutual fund will provide the same diversification as 100,000 units.
Mutual funds have been specifically designed to accommodate small investors.
Small investors do not like funds locked helplessly for too long. Liquidity of mutual funds makes it ideal for beginners.
Any time one can sell mutual fund units. Mutual fund redemption forms are available online. One shall just download the form, fill few details, and units can be redeemed.
From the date of filling the form, mutual funds can be redeemed in matter of 3/4 days.
These days, online service provides like FundsIndia.com has made online trading of mutual funds units even easier.
Mutual Funds has some disadvantages….???
Well…nothing is born in this world with perfection. Even lord Rama and Krishna had weaknesses.
…and so does our nearly perfect mutual funds as well.
Risk of Loss:
Mutual funds are moody and unpredictable like stocks. One cannot be sure if the returns will be positive or negative.
It will not be wrong to say that mutual funds are as risky as stocks. This is one reason why one can make losses in short term in mutual fund investing.
Regardless of whether the fund is giving positive or negative returns, fees will be charged. Mutual funds never guarantee returns but they will charge fees for sure.
No Control on Portfolio:
If you are like me, you would like to know how mutual fund portfolio is managed.
What shares are bought?
When and why they are sold?
Why some shares are not being purchased?
These are some intriguing questions that come to mind. But believe me, we can do nothing.
We cannot even question mutual fund manager on his work. Basically we have no control on how fund is managed.
Not only this, even mutual fund NAV’s are like a puzzle. A common man can never know how accurately the NAV is calculated.
If you are paying $1/unit for a mutual fund, one cannot do its price valuation.
Are Mutual Funds of Only One Type?
No, mutual funds has many types. Generally people buy mutual funds of open ended type.
Open ended funds has four sub-types. These are the most traded funds in the open market.
Depending on the type of goal, one can select a suitable fund.
The variety that is offered by open ended funds covers all needs.
How to Buy Mutual Fund
The easiest way to buy mutual funds is using online trading platforms.
This facility is not provided default in trading platforms. So one must contact the broker by email or on toll free number.
Tell them that you would like to trade mutual fund using trading platform. They will include mutual fund buying-selling facility with some extra fees.
One can also buy mutual fund units directly from fund house website. Mutual fund can be bought form websites by making payments using online banking.
These days, web portals like FundsIndia.com has revolutionize the way mutual funds are bought and sold. I will recommend FundsIndia for all beginners.
How Mutual Fund Make Money for us?
When I first bought a mutual fund I was not sure how will I make profit.
The only way I knew was to hold it for long term and then sell.This strategy works fantastically even today.
But there are also other ways to make money from mutual funds.
Basically one makes money in two ways from mutual fund investment.
– Mutual funds distribute dividends.
– Mutual funds works to provide capital gain.
Expense Ratio of Mutual Funds
There are several expenses that need to be managed to operate a mutual fund. But who pays for this expense?
We investors have to bear this cost.
In mutual fund brochures all expense are categorized. One type of funds expense is called management expense. The fees paid to people like fund manager are categorized as management expense.
Mutual fund companies also market their products. The expense of marketing and selling are funded from their asset. This also includes printing leaflets and brochures. This expense is called as distribution expense.
Fund houses use brokers who sell units directly to investors. The compensation paid to brokers are charged to investors as entry and exit loads.
All other expense which cannot be categorized as management and distribution expense are called other expense.
Expense ratio will be total of all expense divided by fund’s net asset value. Suppose a mutual fund has expense ratio of 1.5%.
It means for $1000 asset, $15 is used to manage funds expenses.
Generally, bigger will be the fund lower will be the expense ratio.
Ideally a mutual fund shall delivery best results with minimum expense.
Example of a mutual fund with its expense ratio highlighted below: