Having grasped the basic of mutual funds, let us try to understand why you as an investor would want to invest in them.
Professional expertise: Investing requires skill. It requires a constant study of the dynamics of the markets and of the various industries and companies within it. Anybody who has surplus capital to be parked as investments is an investor, but to be a successful investor, you need to have someone managing your money professionally.
Just as people who have money but not have the requisite skills to run a company (and hence must be content as shareholders) hand over the running of the operations to a qualified CEO, similarly, investors who lack investing skills need to find a qualified fund manager.
Mutual funds help investors by providing them with a qualified fund manager. Increasingly, in India, fund managers are acquiring global certifications like CFA and MBA which help them be at the cutting edge of the knowledge in the investing world.
Diversification: There is an old saying: Don’t put all your eggs in one basket. There is a mathematical and financial basis to this. If you invest most of your savings in a single security (typically happens if you have ESOPs (employees stock options) from your company, or one investment becomes very large in your portfolio due to tremendous gains) or a single type of security (like real estate or equity become disproportionately large due to large gains in the same), you are exposed to any risk that attaches to those investments.
In order to reduce this risk, you need to invest in different types of securities such that they do not move in a similar fashion. Typically, when equity markets perform, debt markets do not yield good returns. Note the scenario of low yields on debt securities over the last three years while equities yielded handsome returns. Similarly, you need to invest in real estate, or gold, or international securities for you to provide the best diversification.
If you want to do this on your own, it will take you immense amounts of money and research to do this. However, if you buy mutual funds — and you can buy mutual funds of amounts as low as Rs 500 a month! — you can diversify across asset classes at very low cost. Within the various asset classes also, mutual funds hold hundreds of different securities (a diversified equity mutual fund, for example, would typically have around hundred different shares).
Low cost of asset management: Since mutual funds collect money from millions of investors, they achieve economies of scale. The cost of running a mutual fund is divided between a larger pool of money and hence mutual funds are able to offer you a lower cost alternative of managing your funds.
Equity funds in India typically charge you around 2.25% of your initial money and around 1.5% to 2% of your money invested every year as charges. Investing in debt funds costs even less. If you had to invest smaller sums of money on your own, you would have to invest significantly more for the professional benefits and diversification.
Liquidity: Mutual funds are typically very liquid investments. Unless they have a pre-specified lock-in, your money will be available to you anytime you want. Typically funds take a couple of days for returning your money to you. Since they are very well integrated with the banking system, most funds can send money directly to your banking account.
Ease of process: If you have a bank account and a PAN card, you are ready to invest in a mutual fund: it is as simple as that! You need to fill in the application form, attach your PAN (typically for transactions of greater than Rs 50,000) and sign your cheque and you investment in a fund is made.
In the top 8-10 cities, mutual funds have many distributors and collection points, which make it easy for them to collect and you to send your application to.
Well regulated: India mutual funds are regulated by the Securities and Exchange Board of India, which helps provide comfort to the investors. Sebi forces transparency on the mutual funds, which helps the investor make an informed choice. Sebi requires the mutual funds to disclose their portfolios at least six monthly, which helps you keep track whether the fund is investing in line with its objectives or not.
However, most mutual funds voluntarily declare their portfolio once every month.
We will look at some of the risks of investing in a mutual fund and the costs of the same in the next article.
The author is Director, PARK Financial Advisors Pvt. Ltd., Mumbai. He is an IIM-Ahmedabad almunus.