Mutual Fund Basics
It’s common knowledge that investing in mutual funds is (or at least should be) better than simply letting your cash waste away in a savings account, but, for most people, that’s where the understanding of funds ends. In this section we endeavor to educate current and potential investors on the basics of mutual funds.
- What is a Mutual Fund?
- What are the benefits of investing in a Mutual Fund?
- What are the different types of Mutual Funds?
- What are the types of risks?
A Mutual Fund is a trust that pools the savings of a number of investors who share a common financial goal. It is essentially a diversified portfolio of financial instruments – these could be equities, money market or fixed income instruments. The money collected in the fund is then deployed in investment avenues that help investors meet predefined investment objectives. The income earned through these investments and the capital appreciation realized are shared by its unit holders in proportion to the number of units owned by them. Thus a Mutual Fund is a suitable investment for the common man as it offers an opportunity to invest in a diversified, professionally managed basket of securities at a relatively low cost.
The benefits of investing in Mutual Funds are as follows -
- Access to professional money managers – Experienced fund managers using advanced quantitative and mathematical techniques manage your money
- Diversification – Mutual Funds aim to reduce the volatility of returns through diversification by investing in a number of companies across a broad section of industries and sectors. It prevents an investor from putting ‘all eggs in one basket’. This inherently minimizes risk. Thus with a small investible surplus an investor can achieve diversification which would have otherwise not been possible
- Liquidity – Open-ended Mutual Funds are priced daily and are always willing to buy back units from investors. This mean that investors can sell their holdings in Mutual Fund investments anytime without worrying about finding a buyer at the right price. In the case of other investment avenues such as stocks and bonds, buyers are not necessarily available and therefore these investment avenues are less liquid compared to open-ended schemes of Mutual Funds
- Tax efficiency – Mutual Fund offers a variety of tax benefits.
- Low transaction costs – Since Mutual Funds are a pool of money of many investors, the amount of investment made in securities is large. This therefore results in paying lower brokerage due to economies of scale
- Transparency – Prices of open ended Mutual Funds are declared daily. Regular updates on the value of your investment are available. The portfolio is also disclosed regularly with the fund manager’s investment strategy and outlook
- Well-regulated industry – All the Mutual Funds are registered with the Securities & Exchange Commission of Pakistan (SECP) and they function under strict regulations designed to protect the interests of investors
- Convenience of small investments – Under normal circumstances, an individual investor would not be able to diversify his investments (and thus minimize risk) across a wide array of securities due to the small size of his investments and inherently higher transaction costs. A Mutual Fund on the other hand allows even individual investors to hold a diversified array of securities due to the fact that it invests in a portfolio of stocks. A Mutual Fund therefore permits risk diversification without an investor having to invest large amounts of money
Mutual Fund schemes may be classified on the basis of their structure and their investment objective.
- Open-ended Funds – An Open-ended Fund is one that is available for subscription all through the year. These do not have a fixed maturity. Investors can conveniently buy and sell units at Net Asset Value (NAV) related prices.
- Close-ended Funds – Closed-end Funds have stipulated / perpetual life based on the constitutive documents of the funds. These funds open for subscription only during a specified period and investors can initially invest in the funds at the time of the subscription and thereafter they can buy or sell the certificates of the funds on the Stock Exchanges. The market price at the stock exchange could vary from the funds’ NAV due to stock market factors.
By investment objective
- Stock Market (Equity) Funds – The aim of Growth Funds is to provide capital appreciation over the medium to long term. Such schemes normally invest a majority of their assets in equities. Growth schemes are ideal for investors who have a long-term outlook and are seeking growth over a period of time.
- Income Funds – The aim of Income Funds is to provide regular and steady income to investors. Such schemes generally invest in fixed income securities such as bonds, term finance certificates and Government securities. Income Funds are ideal for capital stability and regular income. Capital appreciation in such funds may be limited, though risks are typically lower than that in a growth fund.
- Balanced Funds – The aim of Balanced Funds is to provide both growth and regular income. Such schemes invest both in equities and fixed income securities in the proportion indicated in their offering documents. This proportion affects the risks and the returns associated with the balanced fund – in case equities are allocated a higher proportion, investors would be exposed to risks similar to that of the equity market. Balanced funds with equal allocation to equities and fixed income securities are ideal for investors looking for a combination of income and moderate growth.
- Money market Funds – The aim of Money Market Funds is to provide easy liquidity, preservation of capital and moderate income. These schemes generally invest in safer short-term instruments such as Treasury Bills, bank deposits and cash. Returns on these schemes may fluctuate depending upon the interest rates prevailing in the market. These are ideal for investors as a means to park their surplus funds for short periods.
Risk is an inherent aspect of every form of investment. For Mutual Fund investments, risks would include variability, or period-by-period fluctuations in total return. The value of the scheme’s investments may be affected by factors affecting capital markets such as price and volume volatility in the stock markets, interest rates, currency exchange rates, foreign investment, changes in government policy, political, economic or other developments.
- Market risk – At times the prices or yields of all the securities in a particular market rise or fall due to broad outside influences. When this happens, the stock prices of both an outstanding, highly profitable company and a fledgling corporation may be affected. This change in price is due to ‘market risk’.
- Inflation risk - Sometimes referred to as ‘loss of purchasing power’. Whenever the rate of inflation exceeds the earnings on your investment, you run the risk that you will actually be able to buy less, not more.
- Credit risk – In short, how stable is the company or entity to which you lend your money when you invest? How certain are you that it will be able to pay the interest you are promised, or repay your principal when the investment matures?
- Interest rate risk – Changing interest rates affect both equities and bonds in many ways. Bond prices are influenced by movements in the interest rates in the financial system. Generally, when interest rates rise, prices of the securities fall and when interest rates drop, the prices increase.
- Investment risks - In the sectoral fund schemes, investments will be predominantly in equities of select companies in the particular sectors. Accordingly, the NAV of the schemes are linked to the equity performance of such companies and may be more volatile than a more diversified portfolio of equities.
- Liquidity risk - Thinly traded securities carry the danger of not being easily saleable at or near their real values. The fund manager may therefore be unable to quickly sell an illiquid bond and this might affect the price of the fund unfavorably. Liquidity risk is characteristic of the fixed income market.