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Before Investing in Mutual Fund

Category : NISM-Mutual Funds

8th Feb. 2012, Mohit Bansal – Intelivisto

 

What is a Mutual Fund?

A mutual fund is just the connecting bridge or a financial intermediary that allows a group of investors to pool their money together with a predetermined investment objective. When you invest in a mutual fund, you are buying units or portions of the mutual fund and thus on investing becomes a shareholder or unit holder of the fund.

Mutual funds are considered one of the best available investments being very cost efficient and also easy to invest in as compare to others. Thus by pooling money together in a mutual fund, investors can purchase stocks or bonds with much lower trading costs than if they tried to do it on their own. But the biggest advantage to mutual funds is diversification, by minimizing risk & maximizing returns.

Mutual funds are set up to buy many stocks as they automatically diversify in a predetermined category of investments, i.e. growth companies, emerging or mid size companies, low-grade corporate bonds, etc. The most basic level of diversification is to buy multiple stocks rather than just one stock.

Regulatory Authorities

To protect the interest of the investors, SEBI formulates policies and regulates the mutual funds. It notified regulations and issues guidelines from time to time. MF either promoted by public or by private sector entities including one promoted by foreign entities is governed by these Regulations.

SEBI approved Asset Management Company (AMC) manages the funds by making investments in various types of securities. Custodian, registered with SEBI, holds the securities of various schemes of the fund in its custody.

The Association of Mutual Funds in India (AMFI) reassures the investors in units of mutual funds that the mutual funds function within the strict regulatory framework. Its objective is to increase public awareness of the mutual fund industry.

Types of returns

There are three ways, where the total returns provided by mutual funds can be enjoyed by investors:

  • Income is earned from dividends on stocks and interest on bonds. A fund pays out nearly all income it receives over the year to fund owners in the form of a distribution.
  • If the fund sells securities that have increased in price, the fund has a capital gain. Most funds also pass on these gains to investors in a distribution.
  • If fund holdings increase in price but are not sold by the fund manager, the fund's shares increase in price. You can then sell your mutual fund shares for a profit. Funds will also usually give you a choice either to receive a check for distributions or to reinvest the earnings and get more shares.

Advantages of Investing Mutual Funds:

  • Professional Management: The basic advantage of funds is that, they are professionally managed by well qualified professional. Investors purchase funds because they do not have the time or the expertise to manage their own portfolio. A mutual fund is considered to be relatively less expensive way to make and monitor their investments.
  • Diversification: By purchasing units in a mutual fund instead of buying individual stocks or bonds, investors’ risk is spread out and minimized up to certain extent. The idea behind diversification is to invest in a large number of assets so that a loss in any particular investment is minimized by gains in others.
  • Economies of Scale: Mutual fund buy and sell large amounts of securities at a time, thus help to reducing transaction costs, and help to bring down the average cost of the unit for their investors.
  • Liquidity: Just like an individual stock, mutual fund also allows investors to liquidate their holdings as and when they want.
  • Simplicity: Investments in mutual fund is considered to be easy, compare to other available instruments in the market, and the minimum investment is small. Most AMCs have automatic purchase plans popularly known as SIP where investor can reap the benefit of mutual fund by investing as little as Rs. 50 per month basis.

Disadvantages of Investing Mutual Funds:

  • Costs: The biggest source of AMC income is generally from the entry & exit load which they charge from investors, at the time of purchase. The mutual fund industries are thus charging extra cost under layers of jargon.
  • Dilution: Because funds have small holdings across different companies, high returns from a few investments often don't make much difference on the overall return. Dilution is also the result of a successful fund getting too big. When money pours into funds that have had strong success, the manager often has trouble finding a good investment for all the new money.
  • Taxes: When making decisions about your money, fund managers don't consider your personal tax situation. For example, when a fund manager sells a security, a capital-gain tax is triggered, which affects how profitable the individual is from the sale. It might have been more advantageous for the individual to defer the capital gains liability.
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