Features
of a mutual fund
Here’s
what you should know before choosing them as an investment vehicle
In recent times, the complaint that mutual funds have underperformed and that they should at least do better than bank deposits, has grown louder. In a year when the second mutual fund in the country, after UTI, celebrates its 25th birthday, perceptions about what mutual funds are, and what they can do, continue to be erroneous. Investors should be aware of the key features of mutual funds before choosing this vehicle to build wealth.
Mutual funds are vehicles to invest in the securities markets. There are two primary ways to channel savings into productive investments. The first is a transactional arrangement, primarily structured as a loan transaction, and banks dominate this segment. A depositor gives a loan to a bank, which in turn lends to other borrowers. The second is a market arrangement, where the entity that needs money issues a marketable security, such as an equity share or a bond, and the investor buys these securities in the market place at the market price. A transactional arrangement, such as a bank deposit, is pre-defined, but is rigid. An investment in the market is more flexible, but is subject to fluctuations in value, based on the market factors. Choosing mutual funds requires the conscious choice and comfort in dealing with the opportunities and risks in the securities markets.
Investing in securities market offers two unique propositions to the investor. First, the upside potential of the investment is not limited to a pre-specified rate. If an investment is made in the equity shares of a company, whose performance exceeds expectations since the shares were first issued, the appreciation in value is available to the investor. The returns from securities are not amenable to pre-definition or accurate forecast, and include both upside and downside.
Second, the downside risk in an investment is not managed on manifestation through the accounting system of provisioning, but through a transfer in the market place. A non-performing loan on a bank balance sheet is classified as such after the default, and is written off from the profits. This is the classical method of risk management. If a bond’s price falls from 100 to 90 due to the possibility of a downgrade in its credit quality, a mutual fund may book the losses and get out of the investment. However, a buyer, at 90, might believe that the bond is cheap given his view on whether the downgrade may actually happen. The security market cares about expectations for the future and builds information in the price. Investing in a mutual fund, therefore, requires a modification in expectations about risk and return.
If we define mutual funds as vehicles to access the securities market, what is the value addition for an investor who can access the market directly? What if he buys a few shares and bonds directly through the broker? It is true that investors can trade in the stock market using electronic platforms, buy equity shares in an IPO, or purchase bonds when they are offered by issuers. Mutual funds are useful only if the investor believes that building long-term wealth through investing requires a formal process. Selecting the right securities, deciding how much to invest in each, constructing a diversified portfolio, reviewing how it is performing, and rebalancing the portfolio are all processes that require expertise, timely attention and execution. Investing in mutual funds requires the willingness to outsource the task of managing a portfolio to another, for a fee.
A low-cost approach to deriving similar benefits comes from indexing. The securities market is commonly tracked by indices that are benchmark portfolios constructed to provide indicative returns from a given class of securities. Passive index funds simply replicate such indices at a low cost. Actively managed funds try to beat such indices with mixed results. There are two elements of mutual fund performance that need appreciation. First, mutual funds, by definition, can deliver only relative returns. An equity fund is not capable of delivering high positive returns if the equity market is delivering a negative return. Second, different funds beat the benchmarks at different points in time, by varying margins, and selecting the right fund is a task in itself.
How can an investor work with mutual funds as an investment choice? First, to earn a possible upside, the downside
risks must also be considered. The investors who demand better returns than bank deposits in a bear market are also pleased when a bull market delivers 25% return on equity funds. Second, investors cannot live by relative return. It is no consolation to a saver if the value of his portfolio falls, even if it is lower than the market benchmarks. The way to achieve a stable positive return at a lower risk is to focus on asset allocation. Those who hold equity, gold, debt, real estate and deposits are likely to do better than those with only deposits or equity funds. Mutual funds are components in asset allocation; they are not the end solution. Third, to invest in the markets is to submit to the unpredictability of the future and move from protection to managing downside risks actively. Fourth, selecting funds that do better than benchmarks most of the time, when measured year on year, is adequate. Clamouring to identify tomorrow’s winner based on the immediate past performance, is bad for both stocks and funds.
UMA SHASHIKANT —The author is Managing Director, Centre for Investment Education and Learning YOI121210
In recent times, the complaint that mutual funds have underperformed and that they should at least do better than bank deposits, has grown louder. In a year when the second mutual fund in the country, after UTI, celebrates its 25th birthday, perceptions about what mutual funds are, and what they can do, continue to be erroneous. Investors should be aware of the key features of mutual funds before choosing this vehicle to build wealth.
Mutual funds are vehicles to invest in the securities markets. There are two primary ways to channel savings into productive investments. The first is a transactional arrangement, primarily structured as a loan transaction, and banks dominate this segment. A depositor gives a loan to a bank, which in turn lends to other borrowers. The second is a market arrangement, where the entity that needs money issues a marketable security, such as an equity share or a bond, and the investor buys these securities in the market place at the market price. A transactional arrangement, such as a bank deposit, is pre-defined, but is rigid. An investment in the market is more flexible, but is subject to fluctuations in value, based on the market factors. Choosing mutual funds requires the conscious choice and comfort in dealing with the opportunities and risks in the securities markets.
Investing in securities market offers two unique propositions to the investor. First, the upside potential of the investment is not limited to a pre-specified rate. If an investment is made in the equity shares of a company, whose performance exceeds expectations since the shares were first issued, the appreciation in value is available to the investor. The returns from securities are not amenable to pre-definition or accurate forecast, and include both upside and downside.
Second, the downside risk in an investment is not managed on manifestation through the accounting system of provisioning, but through a transfer in the market place. A non-performing loan on a bank balance sheet is classified as such after the default, and is written off from the profits. This is the classical method of risk management. If a bond’s price falls from 100 to 90 due to the possibility of a downgrade in its credit quality, a mutual fund may book the losses and get out of the investment. However, a buyer, at 90, might believe that the bond is cheap given his view on whether the downgrade may actually happen. The security market cares about expectations for the future and builds information in the price. Investing in a mutual fund, therefore, requires a modification in expectations about risk and return.
If we define mutual funds as vehicles to access the securities market, what is the value addition for an investor who can access the market directly? What if he buys a few shares and bonds directly through the broker? It is true that investors can trade in the stock market using electronic platforms, buy equity shares in an IPO, or purchase bonds when they are offered by issuers. Mutual funds are useful only if the investor believes that building long-term wealth through investing requires a formal process. Selecting the right securities, deciding how much to invest in each, constructing a diversified portfolio, reviewing how it is performing, and rebalancing the portfolio are all processes that require expertise, timely attention and execution. Investing in mutual funds requires the willingness to outsource the task of managing a portfolio to another, for a fee.
A low-cost approach to deriving similar benefits comes from indexing. The securities market is commonly tracked by indices that are benchmark portfolios constructed to provide indicative returns from a given class of securities. Passive index funds simply replicate such indices at a low cost. Actively managed funds try to beat such indices with mixed results. There are two elements of mutual fund performance that need appreciation. First, mutual funds, by definition, can deliver only relative returns. An equity fund is not capable of delivering high positive returns if the equity market is delivering a negative return. Second, different funds beat the benchmarks at different points in time, by varying margins, and selecting the right fund is a task in itself.
How can an investor work with mutual funds as an investment choice? First, to earn a possible upside, the downside
risks must also be considered. The investors who demand better returns than bank deposits in a bear market are also pleased when a bull market delivers 25% return on equity funds. Second, investors cannot live by relative return. It is no consolation to a saver if the value of his portfolio falls, even if it is lower than the market benchmarks. The way to achieve a stable positive return at a lower risk is to focus on asset allocation. Those who hold equity, gold, debt, real estate and deposits are likely to do better than those with only deposits or equity funds. Mutual funds are components in asset allocation; they are not the end solution. Third, to invest in the markets is to submit to the unpredictability of the future and move from protection to managing downside risks actively. Fourth, selecting funds that do better than benchmarks most of the time, when measured year on year, is adequate. Clamouring to identify tomorrow’s winner based on the immediate past performance, is bad for both stocks and funds.
UMA SHASHIKANT —The author is Managing Director, Centre for Investment Education and Learning YOI121210
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