Friday, April 25, 2008

Mutual Funds: What Are They?

Do you invest in mutual funds? If you do, you know what they are and what they can do for you. If you don’t know about them, it is high time you should. This post gives you from the most basic to the technical aspects of a mutual fund.

Who Needs Mutual Funds?

With the markets rising, as they have in the past four years, everybody wants to take advantage of the markets. There are two or three options available. The first one, but not the easiest, is that you get yourself registered with some broker, set aside some money for buying stocks and you’re on. But most people, with long working hours and stressful jobs do not have the time to monitor markets and that makes one lose a lot of opportunities.

Some people do not have the knowledge or the aptitude for stocks but still want to take advantage of it. The most convenient option for them is to give the money to a friend or an Uncle to invest on their behalf. But these friends or Uncles are sometimes scared to invest on your behalf because they don’t want to ride the guilt of you losing money if one of their decisions went wrong. Alternatively, even if they don’t feel scared or guilty and some of their decisions do go wrong, which inevitably will (because nobody is perfect), you won’t hold them in very high esteem.

The third option, and undebatably the best for such people, is to invest their money with a mutual fund. That way even if the mutual fund loses you money, the only loss of relationship you have is that you won’t invest money in that mutual fund anymore. As it is, you have a lot of other options available.

The third problem that usually comes is that you do not have enough money to properly diversify your portfolio and we all know the advantages of diversification to get good low risk returns. To properly diversify her portfolio, the investor would need to invest at least Rs.2-3 lakhs.

What Is A Mutual Fund?

Let us understand this with a very simple example. Suppose there are 10 investors, each with a capital of Rs.50,000/- to invest. None of them has a big enough capital to properly diversify their portfolio. So, they make a syndicate and invest jointly because then the combined portfolio of Rs.5 lakhs can be well diversified. But the problems that usually come with such a syndicate is that you can never trust the person completely who is in charge of all the funds. Secondly, you will always feel cheated or will always suspect the division of the profits, specially, if the investment amount of each investor is different.

So, they appoint a person who they all trust, and who has the knowledge of the markets and they pay him to invest on their behalf, and who divides the profits equally and fairly among all investors after deducting his own expenses for the time and the effort he has to put in. That, in a way, is a small mutual fund.

But Mutual Funds AMCs (Asset Management Companies) have thousands of investors and have crores of rupees to invest. That gives the fund manager control over his investments and can stay invested in stocks for a longer duration (assuming that not all investors will withdraw funds at the same time). The fund manager has a full research team backing him and he himself is knowledgeable about the markets and the AMC ensures that all profits are divided equally among all investors.

How Are The Profits Divided?

On each day, except Saturdays, Sundays and holidays, a Net Asset Value (NAV) is calculated which is nothing but the value of all the securities held by the mutual fund in its portfolio. Any investor who invests into a mutual fund is allotted units. The number of units to be allotted is calculated by dividing the amount invested by the NAV of that day. For example, if an investor is investing Rs.50,000/- in a mutual fund and the NAV on that day is Rs.150/- then she would be allotted 333.3333 units (50000/150). Unlike shares, where only whole numbers can be purchased, units can be allotted in decimals too.

Since the NAV is calculated on each day, any investor entering on any day can be allotted the exact number of units based on the value of the portfolio on that day. Similarly, any investor exiting on any day can be given the money as per the value of the portfolio on the day of exit. The amount to be paid to this investor is calculated by multiplying the NAV of that day with the number of units held by him. So, in the above example, if our investor decides to exit on a day when the NAV is Rs.200/-, she would be given a cheque of Rs.66,666/67- (333.33333 x 200), thus making a profit of Rs.16,666/67- in the transaction.

NAV Calculation

A very simple example of calculation of NAV. Suppose I have a mutual fund in which 100 people have invested (each investing Rs.10000/-), which gives me a total corpus of Rs.10 lakhs. I allot a total of 1 lakh units, each unit at Rs.10/-. Next day I go out into the market and buy shares worth Rs.9.5 lakhs and keep Rs.50000/- as cash. Suppose the value of the shares after 10 days is Rs.10 lakhs (which has since increased from Rs.9.5 lakhs). Now, the total value of my portfolio is Rs.10 lakhs in shares and Rs.50000/- in cash, thus making Rs.10.5 lakhs. Dividing this by 1 lakh (the total number of units issued) I get an NAV of Rs.10/50- per unit after 10 days.

There is a lot more to know about mutual funds but, I suppose, this post is going to become very lengthy if I delve any deeper into it. I will write another post about mutual funds in the days to come, which will talk about what types of mutual funds are there, what are the costs, what mutual funds to buy and some common mistakes people make when investing in mutual funds.

Update: This article was also published on the business and investing page of Reuters.

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