A mutual fund (MF) is a vehicle to pool money from investors, with a promise that the money would be invested in a particular manner, by professional managers who are expected to honour the promise. In India mutual funds are governed by the regulations of Securities and Exchange Board of India (SEBI).
The idea behind a mutual fund is that individual investors generally lack the time, the inclination or the skills to manage their own investments. Thus, mutual funds appoint an Asset Management Company (AMC) that hires professional fund managers to manage the investments for the benefit of their investors. In return, the AMC earns a management fee from the investors. This is payable irrespective of whether or not the investor earns a return.
You might wonder — why does the investor go to an AMC that in turn will appoint a professional fund manager?
Why does the investor not approach a professional fund manager directly?
Indeed, an individual investor could choose to hire a professional fund manager to manage her money as per her investment and risk preferences. Such personal treatment, often referred to as Portfolio Management Scheme (PMS) in India, entails significant demands on the time of the managers; this increases the costs for the investor. Further, PMS can be offered only to clients having investment portfolio above 25 lakh. Many PMS providers operate with a higher minimum investment requirement.
It is possible to balance the time and cost required to manage investments by grouping investors together based on their preferences. In this manner, the focus of the investment activity can be shifted from a single investor (as in the case of PMS) to a group of investors having similar expectations (as in the case of a mutual fund).
For ease of management and reporting, such a group of investors is identified with a “mutual fund scheme”. In commercial terminology, the investors invest in a scheme — and the professional managers manage the scheme. A mutual fund can, and typically does, have several schemes to cater to different investor preferences.
The AMC manages investments of the scheme for the benefit of its investors. Every scheme has an:
>> Investment portfolio (Portfolio Statement);
>> Account of income and expenditure (Revenue Account); and
>> Account of assets and liabilities (Balance Sheet).
In order to ensure fairness to investors, SEBI regulates the expenditure that can be charged to a scheme (borne by investors in that scheme), whether as management fees or as other expenses.
The gains of any scheme (after accounting for income, permitted expenses, profits and losses from the investment activity) belong to its investors. Similarly losses, if any, would need to be borne by its investors, up to the amount invested. Thus, the mutual fund manages the scheme’s money in trust for the benefit of its investors.
Across the world, the mutual fund sector is viewed as a critical mechanism to channel investor funds into the capital market. Since these investors are often not so well qualified to invest, the mutual fund business is highly regulated. Regulations vary from country to country. But, broadly, they provide for:
- Checks and balances in the legal structure;
- Pre-qualifications to start a mutual fund;
- Permissible schemes and investments;
- Control over marketing process;
- Level of operational flexibility to the professional investors; and
- Valuation of securities, etc.
Association of Mutual Funds in India (AMFI) is a body that represents the interests of the industry. All mutual funds in India are members of AMFI.
Every investor, given her financial position and personal disposition, has a certain inclination to take risk (risk appetite). The hypothesis is that by taking an incremental risk (of losing capital, wholly or partly), it would be possible for the investor to earn an incremental return.
But assuming risk without regularly monitoring it is foolhardy. Therefore, it would be prudent for investors who take a risk to be able to manage this risk.
A mutual fund is the solution for investors who lack the time, the inclination or the skills to actively manage their investment risk in individual securities. They can delegate this role to the mutual fund, while retaining the right and the obligation to monitor their investments in the scheme (which, in turn, invests in individual securities).
In the absence of a mutual fund option, the moneys of such “passive” investors would lie either in bank deposits or other “safe” investment options, thus depriving them of the possibility of earning a better return.
Investing through a mutual fund would make economic sense for an investor if her investment, over the medium to long term, fetches a return (net of all costs, expenses and taxes) that is higher than what she would otherwise have earned by investing directly, or parking the funds in the bank.
As Bogle succinctly puts it, “Because the goal of investing is to accumulate real wealth — an enhanced ability to pay for goods and services — the ultimate focus of the long-term investor must be on real, not nominal, returns.” 1(Nominal Returns minus Inflation = Real Returns).
Trustees are the people within a mutual fund organization who are responsible for ensuring that investors’ interests in a scheme are properly taken care of.
In return for their services, they are paid trustee fees, which are normally charged to the scheme.
Their roles and responsibilities are discussed in detail as follows:
(i) The Trustee shall enter into an investment management agreement with the AMC
(ii) They shall be accountable for, and be custodian of , the funds and property of the respective schemes and shall hold the same in trust for the benefit of the unit holders.
(iii) Every half-yearly, the trustee shall furnish to SEBI a Report on the activities of the Mutual Fund.
(iv) Trustees shall ensure that all activities of the AMC are in accordance with the provisions of the SEBI regulations.
(v) If they have reason to believe that the conduct of business of the mutual fund is not in accordance with the regulations or the offer document of the scheme, they shall take appropriate remedial steps and inform SEBI immediately.
(vi) Each trustee shall file the details of her transactions in securities with the mutual fund on a quarterly basis.
(vii) They shall meet at least once every two calendar months, and at least six such meetings shall be held every year.
(viii) They shall call for details of transactions in securities by the key personnel of the AMC.
(ix) They shall review quarterly, all transactions between the mutual fund, AMC and its associates.
(x) They shall review quarterly, the net worth of the AMC and ensure that any shortfall is made up.
(xi) They shall periodically review the investor complaints received and their redressal by the AMC.
(xii) They shall abide by the prescribed code of conduct.
AMCs manage the investment portfolios of schemes and handle various other routine activities incidental to the mutual fund business. An AMC’s income comes from the management fees it charges the schemes it manages. The management fee is calculated as a percentage of net assets managed. Some countries provide for performance based management fees as well.
In order to earn the management fee, an AMC has naturally to employ people and bear all the establishment costs that are related to its activity, such as for premises, furniture, computers and other assets, software development, communication costs, etc. These are to be met out of the management fee earned.
Expenses such as on distributor commission, marketing, etc. can be directly borne by the mutual fund scheme. However, in some cases competition in the marketplace could force an AMC to bear some of these costs, which would otherwise have been borne by investors in the schemes.
So long as the income earned through management fees more than covers its expenses, an AMC is economically viable.
Given the nature of its activity, a certain minimum establishment and infrastructure is necessary for an AMC’s functioning. Since costs cannot be reduced below a base level, every AMC needs to have a reasonable corpus of assets under management (AUM), below which it may not be viable.
The break-even level of AUM is a function of cost structure of the AMC and distribution of assets between its different types of schemes. It may be noted that debt schemes and index schemes generally yield a lower management fee. As a thumb-rule, in the Indian context it is difficult for an AMC to break-even if its AUM is below 10,000 crore.
Distributors earn a commission for bringing investors into the schemes of a mutual fund. This commission is an expense for the scheme, although there are occasions when an AMC may choose to bear the cost, wholly or partly.
Depending on the financial and physical resources at their disposal, the distributors could be:
- Tier 1 distributors who have their own or franchised network reaching out to investors all across the country; or
- Tier 2 distributors who are generally regional players with some reach within their region; or
- Tier 3 distributors who are small and marginal players with limited reach.
An investor’s holding in mutual fund schemes is typically recorded by the scheme’s Registrar and Transfer Agent (RTA). Some AMCs prefer to handle this role in-house, i.e. on their own instead of appointing an RTA. The registrar or the AMC as the case may be, maintains an account of the investor’s investments in and disinvestments (redemptions) from the schemes and handles corporate actions such as dividend payments.
The custodian maintains custody of the securities in which the scheme invests — as distinct from the RTA who records the investment by investors in the scheme. Thus, for investment transactions of the mutual fund, it is the Custodian who receives or gives delivery. This ensures an ongoing independent record of the investments of the scheme. The custodian also follows up on various corporate actions, such as rights, bonus and dividends declared by investee companies.
In one of the securities market scams, a large provident fund investor parted with some of its funds without gaining custody of the securities where they were supposed to have invested. When the scam broke out, they realized that the money was gone, but they did not have the securities. The custodian in the mutual fund structure is in a position to prevent such risks.
The legal structure, which is a source of comfort for investors because SEBI regulates the mutual fund sector in India. However, RBI, as regulator of banks, would need to authorize the commencement of mutual fund operations by a banking entity. Further, since it is the regulator of money supply in the economy, it has control over the money market and foreign exchange market. Measures that it announces for the money market and foreign exchange market could impact mutual fund operations. Besides such areas of overlap with other regulators, all regulation of mutual funds is by SEBI.
The guidelines applicable to mutual funds are set out in the SEBI (Mutual Funds) Regulations, 1996 (“the regulations”). SEBI has prescribed a legal structure with inbuilt checks and balances in the form of independent agencies for the various critical roles, namely trusteeship, asset management and custody of investments.
In general, investors pay tax on a year-to-year basis. So if they were to earn and then re-invest any income, what they would re-invest is the amount that is available after paying tax.
Mutual fund schemes, on the other hand, do not pay any tax on their income. So, the same earning in a mutual fund scheme could facilitate a higher re-investment.
This differential tax treatment offers an opportunity to investors to multiply their money within a scheme, without paying tax in the interim. The incidence of taxation can be postponed until the investor needs the money — at which point of time the income can be structured as a long-term capital gain (through re-purchase, i.e. sale of units by the investor to the scheme), with the incidental tax efficiencies.
There are as many risk-level options among mutual fund schemes as the water level options in the milk sold by the unorganised milk sector in India! The choice of water level is entirely that of the buyer. The investor can either savour the water (risk) or drown in it!
Each mutual fund scheme promises a certain water (risk) level, and is expected to stick to it. Mutual fund schemes that do not stick to their promise are not worth investing in.
In the case of milk, the buyer would be happy with a water level that is lower than what was promised. However, with mutual funds, variation from promised risk level is unethical, irrespective of whether it is higher or lower than the promise. The trustees are responsible for ensuring that the AMC invests as per its committed investment objective, and maintains the promised risk character of the scheme.
Investment is a specialised and full-time activity. AMCs are expected to have the professional people and the establishment to carry out this specialized work. Further, professional managers can take more dispassionate decisions, such as selling in a stop-loss situation, which investors find difficult on emotional grounds.
The facility of making investments through Investor Service Centres as well as through the Internet, a facility offered by most AMCs and large distributors, ensures convenience. Similarly, it is possible for investors to benefit from various facilities that mutual fund schemes offer. Mutual funds that permit switches between schemes without any cost, help investors to manage their exposures economically.
Most mutual fund schemes in the market offer liquidity by letting investors buy or sell units directly from the scheme. This is unlike direct investment in the securities market, where it is possible that the investor does not find a counterparty for her trade.
Some categories of mutual fund schemes do not offer investors the facility of such direct transactions. However, these are listed in a stock exchange and can be traded like other listed securities.
Direct investment in the securities market often comes with a stiff minimum investment requirement. This is particularly so in the Indian debt market, where realistic options for retail investors are only now emerging. On the other hand, mutual fund schemes give investors the option of investing as little as 5,000 with the added assurance of liquidity. Minimum investment is as low as 500 for some schemes. Obtaining wide exposure across a range of sectors and companies, through investment of such small amounts in a mutual fund scheme is a unique benefit that the industry offers.
Given its size, an AMC would be in a position to negotiate better brokerage terms for the sales and purchases of its investments. No doubt the operating costs get loaded to its schemes, and thus charged to the scheme’s investors. But there are regulations on the extent of such loading. So long as the incremental returns through professional management and tax efficiencies are more than the costs charged to the schemes, investors gain by investing through mutual funds.
Fifth point, Is affordability, which gives power to a small investor to start their investment in stock market which is not even possible with this small amount even sum Mutual Fund allow investor to invest in mutual fund with just rupees hundred. So with this Mutual Fund becomes a very favourable investment option for a small investor who don’t have large saving but they can start investing is a small amount to buy starting SIP or a lump sum payment.
You can start your Mutual Fund investment with as low as ₹500. With that money, you could own assets of many corporations, which otherwise is not possible with such small amounts.
And Sixth point, Transparency which I find myself is one of the most important benefits of investing in mutual fund because when I invest my money and put them into risk and ask someone else to manage my money then I was know what exactly happening with money where management is investing my money into to generate Returns and that’s what I really like about mutual fund because they give data of their investment in stock market and other securities in a very transparent manner and releases fact-sheet on monthly basis, which provides complete details of the current investment of the mutual fund in the stock market and other related securities. And not just that it also provides if there are changes done mutual fund portfolio too.
With lots of benefits, I don’t find any reason for a retail mutual fund investor not to invest in mutual fund, and find it as an ideal investment vehicle to reach their financial goals in long term or short term maybe.
And one More important point which would like to add further is flexibility, yes flexibility is the point which I find is very good for mutual fund investor because each investor is different in terms of their behaviour their investment style their choices their preferences and yes one more important thing is their ability to invest and thus, they have different financial goals. and the mutual fund provide complete flexibility to the mutual fund investors to invest according to them and to choose fund according to their choice and to redeem their capital gains according to their requirement and this is great.
Mutual funds allow investors to reinvest their dividends and interest in additional fund units. This helps in timely investment of your dividends and interest giving a compounding effect.