What are mutual funds?
Mutual funds are investment vehicles whereby several investors come together with a common objective and invest certain amount as per their capability. The funds thus collected are managed by fund managers who have expertise in this industry. They invest in securities such as stock, bonds, money market instruments and other assets with an attempt to produce capital gain or income for the fund’s investors. Each investor therefore participates proportionally in the gains or losses of the fund.
Mutual Fund units can typically be purchased or redeemed as needed at the funds current NAV. A fund’s NAV is derived by dividing the total net assets by the total number of units issued.
Why Mutual Funds?
Mutual funds are one of the most preferable investment instrument because of the following advantages:
- Affordable Portfolio Diversification
Units of a scheme give investors exposure to a range of securities held in the investment portfolio of the scheme. Thus, even a small investment of Rs5,000 in a mutual fund scheme can give investors a diversified investment portfolio. With diversification, an investor ensures that all his eggs are not in the same basket. Even if some investments in the scheme portfolio lose money, other investments in the portfolio can make up for the loss. Thus, diversification helps reduce the risk in investment. In order to achieve the same diversification as a mutual fund scheme, investors will need to set apart several lakh of rupees.
- Economies of Scale
The pooling of large sums of money from so many investors makes it possible for the mutual fund to engage professional managers to manage the investment operation and underlying risks. Individual investors with small amounts to invest cannot, by themselves, afford to engage such professional management. Large investment corpus leads to various other economies of scale. For instance, costs related to investment research and office space get spread across investors. Further, the higher transaction volume makes it possible to negotiate better terms with brokers, bankers and other service providers
At times, investors in financial markets are stuck with a security for which they can’t find a buyer; worse, at times they can’t find the company they invested in! Investors in a mutual fund scheme can recover the value of the moneys invested, from the mutual fund itself. Depending on the structure of the mutual fund scheme, this would be possible, either at any time (open-end schemes), or during specific intervals (interval fund), or only on closure of the scheme (closed-end schemes). Closed-end schemes are listed in a stock exchange. Thus, before the scheme matures, the investor can sell the units in the stock exchange to recover the prevailing value of the investment.
- Tax Deferral
Mutual funds are not liable to pay tax on the income they earn. If the same income were to be earned by the investor directly, then tax may have to be paid in the same financial year. Through the growth option in a scheme, the investor can let the moneys grow in the scheme for several years without any incidence of taxation. This helps investors to legally build their wealth faster than would have been the case, if they were to pay tax on the income each year.
- Tax Benefits
The dividend that the investor receives from any mutual fund scheme is tax-free in his hands.
Investment in specific schemes of mutual funds (Equity Linked Savings Schemes - ELSS) can be reduced from the investor’s income that is liable to tax. This reduces their taxable income, and therefore the tax liability.
- Convenient Options
The options offered under a scheme viz. growth and dividend, allow investors to structure their investments in line with their liquidity preference and tax position.
- Investment Comfort
The Know-Your-Customer (KYC) requirements are centralised across the capital markets, including mutual funds. Therefore, based on a single KYC process, investors can invest across the capital market in shares, debentures, mutual funds etc. Further, once an investment is made with a mutual fund, the investor can make further purchases with very little documentation. This simplifies subsequent investment activity.
- Systematic Approaches to Investment
Mutual funds also offer facilities that help investor invest regularly through a Systematic Investment Plan (SIP); or withdraw amounts regularly through a Systematic Withdrawal Plan (SWP); or move moneys between different kinds of schemes through a Systematic Transfer Plan (STP). Such systematic approaches promote an investment discipline, which is useful in long term wealth creation and protection.
- Regulatory Comfort
SEBI has mandated strict checks and balances in the structure of mutual funds and their activities.