Investing directly in financial markets such as stock, commodities, Forex or money markets is not suitable for everyone as it does take a lot of time and effort to make the right pick. At the same time, unless investors have a long term perspective, they cannot hope to secure themselves for the future. The main reason why many market veterans invest almost exclusively in stocks and bonds is the possibility of high rewards, but for novice investors, mutual funds are a much better solution. Thus it is important for prospective investors to know about the basic workings of a mutual fund if they want to make an informed choice.
The term “Mutual fund” is used in reference to a large pool of money in which various investors periodically contribute small amounts in order to create a large investable corpus. Subsequently fund manager(s) supported by a fund management team are introduced to handle those funds and invest them in order to make the investor’s initial investment grow or generate a regular income as per the requirement of the fund’s investors or promoters.
Mutual Funds vs. Shares and Bonds
Investing directly is stocks and bonds follow an individual-based investment approach. In such cases, an investor picks stocks (either by himself/herself or based on the recommendation of a 3rd party) and invests capital into those with the expectation of future profits when prices rise. This activity requires extensive research and effort which might be beyond the ability of most new investors. Picking the wrong direct equity can result in a substantial loss as even the principal invested by the investor is at risk of incurring a loss. What’s more, an individual investor can invest in only a few select stocks, as most investors have only a finite amount to spare for investments. This also limits the ability of the common man to make diversified investments and opens their investment up for further risk during periods of market uncertainty.
The key difference between shares and mutual funds, is that mutual fund schemes typically comprise a huge pool of investable capital something not available to an individual investors. This much larger corpus available to the investment vehicle improves the overall chances of ensuring diversification across multiple sectors while simultaneously ensuring investments that are diversified across equities of multiple market capitalization that provides a balance between the overall risk and returns of various investments. One also needs to keep in mind that mutual funds are managed by fund managers who are financial industry veterans hence they definitely have an edge when it comes to making capital market investments that are profitable. Thus, investing in equities or bonds through mutual funds is definitely a lot safer and less stressful for new investors rather than directly investing in capital or money markets.
Mutual Fund Investment Basics
Just as shares have a face value at the time of their being offered on the stock market as an IPO, mutual funds, too are sold as individual units with a predetermined face value being initially offered through an NFO. Subsequently, the market value of the mutual fund changes and this per unit market price is termed as NAV (Net Asset Value). The NAV of a fund is calculated using the formula, NAV = Total AUM (assets under management) – Liabilities of the fund/Total number of outstanding units of the fund. The NAV of a mutual fund changes from day to day as assets held by the fund (stocks, bonds, futures, cash, etc.) are traded on the stocks or commodities markets which increase or decrease the portfolio value. As the fund’s AUM increases due to good performance the NAV of the fund goes up. On the other hand, poor performance leads to a decrease in the fund’s AUM, which leads to an adverse affect on the NAV of the mutual fund.
How do Equity Mutual Funds Work?
When a fund focuses mostly on investing in equities or equity-related schemes, they are termed as an equity mutual fund. In such cases, up to 100% of the total AUM of the fund is invested in shares or other mutual funds that are invested in equities. However, a smaller amount of the portfolio in this case may be invested in various debt instruments such as government securities and bonds. Equity mutual funds are considered to be among the most risky of all mutual fund investments however they also feature the greatest potential for providing high rates of return on the initial amount invested. There are types of mutual funds that you can invest in – namely large cap funds, midcap funds, small cap funds and thematic funds.
How do Debt Mutual Funds Work?
In case of debt mutual funds or debt funds, the focus is on wealth preservation and income generation. This strategy usually translates into a situation featuring relatively low risk as well as potentially consistent returns. These funds attempt to achieve these objectives through investments made into various debt securities and money market instruments such as bonds, government securities, preference shares, CLBO, fixed deposits, etc. In some cases, a small portion of the debt fund’s portfolio may feature investment in equities in order to infuse a bit of growth in the scheme. For the average investor, debt funds provide a low risk alternative to traditional investment routes such as FDs, PPF, etc. Some key subtypes of debt funds include liquid funds, ultra short term debt funds, short term debt funds, accrual funds and dynamic bond funds.
How do Hybrid Mutual Funds Work?
When a mutual fund scheme invests in both debt securities as well as equities in varying proportions, it is termed as a hybrid fund. This style of fund attempts to leverage the benefits of both types of investments namely equity mutual funds and debt mutual funds. Thus, when stock markets are having a boom, the investor benefits from the capital appreciation generated through the equity investments of the hybrid mutual fund. Conversely when equity markets are performing poorly, the debt investments of the fund are able to at least partially offset the losses occurring in the equity portion of the portfolio. Hybrid mutual funds thus feature lower risk as compared to equity funds while offering returns that are often significantly higher than those provided by debt mutual funds. Key sub types of hybrid funds include balanced funds, equity oriented hybrid funds, debt oriented hybrid funds and arbitrage funds.
How do Mutual Funds Make Money?
Different types of mutual funds utilise different strategies to make the investor’s money grow. A better understanding of the mechanics involved would definitely help investors figure out the investment option that best suits their unique requirements. The following sections discuss some of these key strategies.
How do Equity Mutual Funds Generate Profits?
The primary way in which an equity mutual fund makes a profit is through trades on the capital market. The premise is simple, the fund manager and his team identify and buy shares of listed and unlisted companies through stock markets, NFOs, etc. The selection of these companies is usually made based on key criteria such as the company’s market cap, sector affiliation, future prospects, cash flow conditions, life stage of company and so on. For example, a large cap fund will almost exclusively invest in companies that have the largest market capitalisation among listed companies on the exchange, a thematic or sector fund will invest in companies with specific sector affiliations and so on. Index funds which are also considered to be a sub type of equity funds have a very different method of portfolio selection. These funds follow an index therefore their investments are designed to match their composition as closely as possible.
In a way, buying a share of a specific company is nothing less than a bet being made by the fund manager that it will turn profitable in due course. If the bet works out as expected, the value of the shares that the fund is invested in will increase. This in turn increases the fund’s portfolio value as well as the AUM of the fund. At this point, the fund manager might decide to sell off those shares at a higher value to book profits and invest the proceeds in shares of a new company.
A secondary mechanism of generating profits in case of an equity fund is through the accrual of dividends offered by companies whose shares the fund holds. These dividend payouts also add to the overall value of the fund’s portfolio in the form of cash payouts or bonus shares. A special type of mutual fund known as dividend yield funds primarily focus on making money via this mechanism.
How do Debt Mutual Funds Generate Profits?
Debt funds invest mainly in debt and money market instruments of varying maturities. Depending on the residual tenure of a majority of investments made by the scheme, debt funds are often classified as liquid, ultra short term, short term and so on. One of the most common debt instruments that a debt fund invests in are bonds which are traded on bond markets just like shares of a company are traded on the stock market. The trade of bonds on the bond market causes the price of bonds to increase or decrease and offers the fund managers an opportunity to book profits through buying and selling of various bonds.
Unlike market caps, bonds are classified on the basis of quality that is designated by ratings such as AAA, AA, A+ and so on provided by credit rating agencies such as CRISIL, Brickworks, ICRA, Fitch, etc. Higher quality bonds denote that the issuer is not expected to default on debt commitments hence may be considered as a potentially safe investment. In case a bond features a low rating, it is perceived as potentially high risk investment therefore the bond issuer sweetens the deal for prospective investors by offering a higher rate of return. The rate of return offered by a bond is also known as the coupon rate. Depending on the type of bond, they provide investors with payouts at different intervals of time depending on the coupon rate. These payouts are the preferred source of income generation in case of certain types of debt funds such as accrual funds. A majority of debt funds utilise a mix of both these strategies to generate income on behalf of their investors.
How do Hybrid Mutual Funds Generate Profits?
It follows that as a hybrid fund has the option of investing in both equities and debt instruments, this type of mutual fund can utilise a mix of all the above strategies to generate a profit however, a special case that needs to be mentioned separately are arbitrage funds which utilise a unique technique to mitigate risk and increase the value of their portfolio at the same time.
How do Arbitrage Funds Generate Profits?
Arbitrage funds invest exclusively in equities shares and equity-based schemes such as stock options hence from a taxation perspective they are considered to be equity investments. However, what truly sets Arbitrage Funds apart from other types of mutual funds is their strategy of generating profits. Arbitrage fund strategy involves purchase of equities from the capital market along with the simultaneous purchase of a futures contract of the same equity from the futures exchange. Now there are two possibilities in which the fund will make a profit, if price of the security goes up, the fund makes a profit through sale of the equity on the capital market, while making a loss on the futures market.
Alternately, if the price of the security goes does, the fund would make a profit on the futures market, while a loss will be incurred on the capital market. The only time an arbitrage fund would have a problem making a profit using this strategy is when capital markets are trading flat and that is a relatively rare occurrence. Another strategy that an arbitrage fund may follow is buying securities from one exchange and then selling them for a profit on another thereby taking advantage of the price differential between the two exchanges. However, it is important to note that an arbitrage fund can make a substantial profit only if it conducts hundreds of such arbitrage transactions in a day. One of the key critiques of such funds is thus the fact that they have an extremely high turnover rate as well as a much higher expense ratio as compared to most equity funds. However, if the arbitrage fund is turning a profit even with these apparent drawbacks, it is definitely worth investing in as any capital gains earned on these investments, if held for over 1 year or more prior to redemption/switching are completely tax free.