Investing in Mutual Funds

A mutual fund is a trust that collects money or funds from a group of people with similar investment goals. It then pools their money together and gives it to a professional firm called a money manager or an investment manager to invest. The investment manager invests the money in stocks, bonds, etc. and takes a fee (usually a percentage of the investments) for his service. Mutual funds offer a simple and effective way to put money in a number of financial investments that no one investor could afford. For example, a mutual fund could invest in your favorite stocks, which if you went to buy on your own would cost you thousands. But since several other likeminded investors invest with you in the mutual fund, you get to own many of your favorite stocks without having to invest huge amounts.

A mutual fund provides diversification, professional management and liquidity.

Diversification reduces the risk that negative performance of one type of investment will result in a significant loss to the mutual fund and erosion of your own money in the fund.

Say you buy 100 stocks of a company for $2000. Company reports negative news and the share price falls 20 per cent. You lose $400. If you are like most investors though, you would like to limit your losses.

Mutual funds are managed by professional portfolio managers, who have the education and experience (at least that's what we expect) to research and pick investments with the best potential and those that meet the mutual fund's investment objective. And for a busy person like you, that means less time researching individual stocks and bonds or spending big bucks on an investment adviser.

And let's not forget the liquidity of mutual funds or the ability to get your money back within two or three days.

Unlike fixed deposits with banks or company deposits, mutual funds stocks/units can be sold back to the mutual fund and your funds withdrawn in some cases by just making a phone call. A note of caution though a fund's unit price and return will vary, and you may have a gain or loss on selling your mutual fund units.

The biggest advantage with mutual funds is that you don't need huge amounts to be invested in all your favorite stocks or bonds. Most mutual funds have a minimum investment of $200.

The other advantage of a mutual fund is that you can choose a fund that suits your risk level. For example, if you are conservative you could select one that invests in government bonds. On your own you would not even be able to buy government bonds since they are available

only if you buy large amounts. If you are an aggressive investor, you could find a mutual fund that invests in stocks. And if you are placing your bets on the growth of a certain sector like software, you can simply buy a mutual fund that invests specifically in stocks in the information technology sector.

The mechanics of a mutual fund; A mutual fund is set up as a trust that gives your money (and the money of thousands of other investors who invest in the fund) to a professional manager of investments (a company called an asset management company). For its services, the asset management company gets a fee. (usually 1 - 1.25 per cent of the funds it manages or advises). The asset management company invests the money that the mutual fund collects from investors based on the mutual fund's investment objective. All mutual funds have an investment objective., to invest in stocks, to invest in bonds, to invest in software companies, etc. The AMC will usually buy bonds or stocks of at least twenty or thirty companies and the returns will be paid to investors in proportion to their investments (excluding the fund manager's fee). AMCs also handle all the operations and day to day administration of the fund like marketing, calculating NAVs, keeping accounts and other activities. Each mutual fund family could have a number of investment schemes or funds. For example, the same mutual fund could have an equity fund, a bond fund and a balanced fund. Each scheme may be managed by a separate fund manager or a group of fund managers may manage all or some of the schemes.

The safety aspect Mutual funds are one of the safest investments available today. Money in a mutual fund is not insured. But it is safe. Investor money is held by a third party called a custodian and not by the mutual fund company. In other words, a mutual fund cannot use your money to cover up its financial problems. The money can only be used to make investments conforming to the mutual fund's investment objective.

Even though the value of the fund (called the Net Asset Value or the NAV) may fluctuate based on the change in value of the stocks, bonds or securities that it buys, a mutual fund will rarely go bankrupt. That's because it is diversified into so many different securities that it will require most of the companies it invests in to go bankrupt at the same time which is a very remote possibility. There are many checks and balances in the mutual fund industry to make sure your money is safe. The mutual fund industry is regulated by the Securities and Exchange Board of India and has to maintain a strict separation of functions. The asset management company, also called the fund manager, does not keep custody of the share certificates or securities that it buys for investors. The securities are kept in custody with an independent third party called the custodian. The custodian has no authority to sell or deal in the securities but can only release them or accept them on the instructions of the asset management company. Moreover, SEBI inspects the workings of mutual funds from time to time to make sure that investor funds are being invested with due care.

How to pick the right fund for you; There's one out there to fit your flavor and mood. No one fund is right for all kinds of investors. But with hundreds of funds and schemes out there, you can find a fund that fits your needs in terms of returns and risk. If you have money that you absolutely cannot see losing value, invest it in a money market mutual fund. If you have money that you want to invest in such a way that it gives you a regular and periodic source of income, try a bond fund and more specifically a monthly income plan which will pay you a fixed percentage of your investment every month as a return on your investment. If you are not sure about equity or bond funds, try a balanced fund. A balanced fund invests in both stocks and bonds. And if you like the ups and downs of the markets but don't have time to follow individual stocks buy an equity fund, preferably the one that holds stocks of your preference.

What about liquidity? Mutual funds are the most liquid investments available today and are as liquid as a bank fixed deposit. Most mutual funds give you a check within 72 hours of your request for withdrawal. Your withdrawal is made on the NAV as of the date of your request (make sure your request is in by noon for most mutual funds to give you that day's NAV). Money market mutual funds do even better. They give you a check within 24 hours or many of them allow you to write a check to the extent of your investments.

Mutual funds provide great tax benefits Dividends from mutual funds are tax free. That's a great benefit. No need to find stocks that pay dividends. If you invest in a debt fund, it's like getting tax free interest since dividends from even a mutual fund that invests in debt are not taxable.

Compare before you buy Mutual fund performance data is usually published daily or weekly in the business newspapers. If you don't subscribe to a business newspaper, just browse through the business magazines on sale at your local magazine store. just about every month, a business magazine comes out with a survey of mutual funds. But don't accept everything you read since different magazines may use different methodologies to come up with the best performing funds. You can also try a couple of websites that now carry information on mutual funds. The data, though, is not always updated.

However, compare performance of similar funds. Don't compare bond funds with stock funds. Within bond or equity funds, compare funds that invest in similar securities. For example, it is no use comparing the return on a gilt fund with a regular bond fund. The bond fund will in most cases give higher returns than the gilt fund but may also carry higher risks. Compare a gilt fund from one mutual fund family with a gilt fund from another mutual fund family.

Once you have scanned the performance data and decided to go for a mutual fund, call up the mutual fund and ask them to fax you a write up on the fund, its returns, investment objective, holdings, etc. Most mutual funds publish a monthly newsletter with updates on such information. You must read this information before deciding to buy a fund. If you have access to the internet, you could just go to the mutual fund's website and get this information. If you are buying a mutual fund for the first time, I would also request a fund prospectus from the fund. A prospectus is an information document that gives the investment objectives of the mutual fund, a description of the fund's operation, information on its board and management and other information on investing and withdrawing money from the fund.

One last thing, check with a few people to see how they feel about the mutual fund's service standards. Performance is fine, but a mutual fund that has poor servicing is not worth your money.