Mutual Fund Investing for the Layman
This excerpt is from an open source article and is not necessarily the opinion of bostatic.com
These days, the term "Mutual Fund" is known to many; whether or not they have parked their money in this investment avenue. However, for the small investor, the understanding of Mutual Funds is limited to the basic definition of "a pool of money invested in stocks or interest bearing instruments" by a team of experts in the field. But that definition alone is not enough to entrust one’s hard earned savings in the hands of strangers, even though many have invested in the mutual fund avenue and quite a few have seen handsome gains.
So what exactly is a Mutual Fund? In broad terms, it is an investment avenue where you can put in a small amount of money to have access to high-priced stocks and bonds through the medium of collective funding. For example, if the stock of Company A is available in the market at, say, $10 per unit, then with an investment of $100 you can get ten of these units. However, odd lot trading, i.e.; buying and selling in quantities lesser that the "lot size" (Minimum number of units that would readily find buyers owing to market and/or statutory restrictions) is very difficult in most markets. Also, if you have only $100 to invest, it is definitely riskier to put the entire amount in one stock – a downturn in the industry to which it pertains could kill the value of the stock in no time. It is in this scenario that the concept of mutual funds comes into play. With, say, a hundred investors pooling in with $100 each, in all $10,000 is available for investing, thereby giving the pool a lot of leveraging power in terms of the type and number of stocks to invest in. This not only minimizes the risk involved as the money is invested in different stocks; it also eliminates the problems associated with odd lot trading.
Types of Mutual Funds
The stock market has evolved a lot since the days of Dow Jones to the Greenspan of today, and mutual funds have ridden this wave of change as a mode of diversification of risk. Based on the risk return approach, a number of sector intensive funds have come up, which can broadly be categorized as follows:
Equity Funds: These mutual funds invest in equity shares of corporations, and being purely driven by the price movements of stocks, they carry high risks though the potential for profits is also higher. Again, depending upon their industry focus, these mutual funds may be sector oriented (such as technology funds which invest mostly in stocks of emerging technology companies or pharma funds which invest heavily in pharmaceutical companies) or they may have diversified portfolios comprising of stocks from different sectors.
Debt Funds: These funds invest heavily in debt oriented instruments; i.e; instruments which carry periodic interest. Thus, these funds invest in G-Secs (Government papers and Treasury Bills) and Debt Instruments such as Bonds, Debentures, zero-coupon instruments, etc. Since they carry a guaranteed return (in the form of interest), these instruments are relatively low risk, thereby generally keeping the capital of the investor secure. It cannot be said, though, that they are entirely risk free – since a bulk of the returns comes from trading profits on such papers, an element of risk is always inherent, albeit lower than equity funds. The returns from these funds are lower compared to that of equity oriented funds, since they cannot take the advantage of market movements.
Balanced Funds: Balanced funds aim to merge the security of Debt funds with the earning capacity of equity funds, and invest in both debt papers as also equity stock in a predetermined ratio (say 60% in debt and 40% in equities). Thus, a portion of the capital is hedged against downturns in the market by investing in debt instruments, the balance being invested in equities to gain the advantage of market movements.
While each of the above funds have their own merits and demerits, the question of where to invest is best answered by the risk orientation of the investor. For a person who is looking at high returns and is not averse to risk, equity funds are the best option. For someone who is highly risk averse, Debt funds are ideally suited.
Now that we have a basic idea of the various types of mutual funds, we need to understand how the prices of the fund units are determined. Broadly, the income of mutual funds is derived from Interest / Dividends and Trading. While in the case of debt securities, interest income is assured, the same is not true in the case of equity stocks as the quantum of dividend depends upon the profits earned by the company concerned, aside from a whole lot of other factors. Again, while the interest income is assured in the case of debt securities, the investor need not go to a mutual fund if he can earn the same amount himself by investing in bonds / debentures. The investor puts his money in the fund in anticipation of a higher earning than ordinary debt papers would fetch him. And that is where a mutual fund is required to trade aggressively in securities. In the case of equity funds, trading is based on the Fund Manager’s perception of the risks and rewards of the stocks in his portfolio and he takes into account several factors such as the impact of the technological/ legislative changes, market competition, etc on his portfolio. In the case of Debt funds, technological changes or market competition carry lesser weightage as the interest stream is not directly linked to profitability; instead, factors such as inflation rate, political stability and the interest rate scenario are ascribed greater importance. For example, if a fund manager is holding G-Secs that carry an interest of, say six percent, and he is expecting that the next issue of G-Secs would carry an interest rate of seven percent, he would try to offload his current holding and invest the proceeds in the new issue. However, since the market in general would also be trying to offload the older G-Secs before the new issue, the laws of demand and supply would hammer the price of the six percent securities down. Whether the Fund Manager can make any gains by offloading his holding of six percent securities would depend entirely on how early he can sell. Similarly, in a falling rate regime, his gains would depend on how early he can take a buying position and/or how late he sells.
Mutual Funds declare their Net Asset Value (NAV) on a daily basis. This NAV is nothing but the difference between the total assets and the outside liabilities (such as Creditors for Expenses, Loans, etc.) of the fund at the end of each day, after adding/deducting therefrom the day’s profits/losses. The Net Asset Value is expressed per unit, dividing the total value by the total number of units outstanding. The purchase / sale price is linked to the NAV of the units.
The Investment Decision
With a huge number of mutual funds operating in the market, a thorough study of the funds is essential to make an informed investment decision. But what are the parameters on which an investment decision should be based? Well, while there is no single rule to investing, the following pointers may come in handy while making up your mind:
The Investor’s approach: The first step towards intelligent investing is to know yourself. By knowing yourself I mean understanding clearly and unambiguously the kind of profits that you intend to make and the extent of risk that you are willing to undertake. As already stated, for an aggressive investor, equity funds would be more suited. Again, if this aggressive investor were looking for short run profits and is willing to take a significant risk, he would do well to invest in sector specific funds, which might be riding the boom at that point of time. For example, in the late nineties software and other emerging technology funds were riding the dot com boom, and those investors who managed to get out before the bubble burst made fortunes, while those who stayed on suffered heavy losses.
The Pedigree: The past history of a mutual fund tells a lot about its possible future actions. To look at the dot com example again, some equity funds made steady, moderate profits and were not hit so hard when the bubble burst, while some others lost their capital as fast as they had amassed it. The reason behind different funds performing differently though investing in the same sector is primarily due to the outlook of the fund managers – if a fund manager is conservative, he would not trade as aggressively even in a sector specific fund and vice versa.
Also, the age and size of the fund play an important role in the decision process. New funds or smaller funds may post heavy gains at the beginning when their corpus and portfolio are small, but may not be able to sustain the same rate as the dis-economies of scale crop in. It is always worthwhile to adopt a wait-and-watch policy with regard to new funds unless the promoter group / fund managers are carrying a heavy baggage of reputation with them.
The Financials: Probably the most important factor in decision making vis-à-vis Mutual Fund Investment, the principal things to look into are the past trend of earnings, the effective yield on investments at NAV (and not at Face Value) if the current trend of earnings continues, the percentage of earnings that are eaten away by operating expenses, and the entry/exit loads. Each of these factors are very important; to exemplify, even a 1% difference in operating expenses could bring about a difference of nearly 10% in earnings for the investor over a 10 year period assuming an earning rate of 10%. Again, if there are any entry/exit charges, that much of the earnings is lost.
Diversification: A prudent investor would never put all his eggs in one kitty. Before investing one should always look at the extent of diversification in the portfolio. For example, if you have $10000, it would be unwise to put the entire amount in a sector specific fund. If you are an aggressive investor, you could consider parking say $ 5000 in a sector fund, and the balance could be invested in other equity based funds. A more cautious investor, on the other hand, should invest in partly in debt-oriented funds and partly in equity funds. The key is to invest in a diverse portfolio, so that even if a particular sector suddenly takes a sharp downtrend, the loss is at least partly covered by the investment in the other sectors/categories.
Monitoring: Investing in mutual funds, contrary to the common perception, is not all about letting the experts do their jobs. For one thing, experts are also liable to commit errors, and while a layman is in no position to prevent that mistake from occurring, he can at least analyze the impact the error has on his funds and on his future investment plans. And just how do you go about monitoring your investments? Well, while the periodic accounts are a help, they remain just that – a mere help. For one thing, the accounts reflect the investment pattern and the NAV only on the date of the accounts and no further – the investment pattern might change drastically over as less as a week. Under the circumstances, it is always advisable to follow the NAVs on a daily basis; the cardinal rule being ‘No one appreciates your money as much as you do’.
The above are just a few pointers towards intelligent investing; as already stated, there is no single rule of thumb to guide you along the trend curves. One needs to learn as one goes along, and in this humble investor’s opinion, investing in the intangible markets is a continuous learning exercise.
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