<p style="text-align: left;">Mutual funds offer retail investors a way to invest in a variety of securities at a relatively low cost, while leaving the investment decisions to a professional manager. This article explains what mutual funds are, how they work, their advantages, the expenses they charge and the risks involved.</p> <h3 style="text-align: left;">What are Mutual Funds?</h3> <p style="text-align: left;">A mutual fund is a collective investment vehicle that collects and pools money from a number of investors and invests it in equities, bonds, government securities and money market instruments.</p> <p style="text-align: left;">The money collected in a mutual fund scheme is invested by professional fund managers in stocks, bonds, etc., in line with the scheme's investment objective. The income / gains generated from this collective investment scheme are distributed proportionately among the investors, after deducting applicable expenses and levies, by calculating the scheme's "Net Asset Value" or NAV. In return, the mutual fund charges a small fee.</p> <p style="text-align: left;">In short, a mutual fund is a collective pool of money contributed by several investors and managed by a professional Fund Manager.</p> <p style="text-align: left;">Mutual Funds in India are established in the form of a Trust under the Indian Trusts Act, 1882, in accordance with the SEBI (Mutual Funds) Regulations, 1996. The fees and expenses charged by mutual funds to manage a scheme are regulated and are subject to the limits specified by SEBI.</p> <h3 style="text-align: left;">How does a Mutual Fund work?</h3> <p style="text-align: left;">When you invest in a mutual fund, you are pooling your money with many other investors. The mutual fund issues "Units" against the amount invested, at the prevailing NAV. Returns from a mutual fund may include income distributions to investors out of dividends, interest, capital gains or other income earned by the mutual fund. You can also have capital gains (or losses) if you sell the mutual fund units for more (or less) than the amount you invested.</p> <p style="text-align: left;">One should avoid the temptation to review the fund's performance each time the market falls or jumps up significantly. For an actively managed equity scheme, one must have patience and allow reasonable time, between 18 and 24 months, for the fund to generate returns in the portfolio.</p> <p style="text-align: left;">Mutual funds are ideal for investors who:</p> <ul> <li>Lack the knowledge or skill / experience of investing in stock markets directly</li> <li>Want to grow their wealth, but do not have the inclination or time to research the stock market</li> <li>Wish to invest only a small amount</li> </ul> <h3 style="text-align: left;">Why invest in Mutual Funds?</h3> <p style="text-align: left;">Investment goals vary from person to person, such as post-retirement expenses, money for children's education or marriage, or a house purchase. The investment products required to achieve these goals also vary. Mutual funds provide certain distinct advantages over investing in individual securities.</p> <p style="text-align: left;">Mutual funds offer multiple choices for investment across equity shares, corporate bonds, government securities and money market instruments. This makes them an excellent avenue for retail investors to participate in, and benefit from, the uptrends in capital markets. The main advantages are that you can invest in a variety of securities for a relatively low cost and leave the investment decisions to a professional manager.</p> <h3 style="text-align: left;">Advantages of Investing in Mutual Funds</h3> <ol> <li><strong>Professional Management:</strong> Investors may not have the time or the required knowledge and resources to conduct their own research and purchase individual stocks or bonds. A mutual fund is managed by full-time, professional money managers who have the expertise, experience and resources to actively buy, sell and monitor investments. A fund manager continuously monitors investments and rebalances the portfolio to meet the scheme's objectives. Portfolio management by professional fund managers is one of the most important advantages of a mutual fund.</li> <li><strong>Risk Diversification:</strong> Buying units in a mutual fund is an easy way to diversify your investments across many securities and asset categories such as equity, debt and gold. This helps in spreading the risk, so you don't have all your eggs in one basket. It proves beneficial when an underlying security of a scheme experiences market headwinds: the risk associated with one asset class is countered by the others. Even if one investment in the portfolio decreases in value, other investments may not be affected and may even increase in value. In other words, you don't lose the entire value of your investment if a particular component of your portfolio goes through a turbulent period.</li> <li><strong>Affordability and Convenience (Invest Small Amounts):</strong> For many investors, it could be more costly to directly purchase all of the individual securities held by a single mutual fund. By contrast, the minimum initial investments for most mutual funds are more affordable.</li> <li><strong>Liquidity:</strong> You can easily redeem (liquidate) units of open-ended mutual fund schemes to meet your financial needs on any business day (when the stock markets and/or banks are open), so you have easy access to your money. Upon redemption, the amount is credited to your bank account within one day to 3-4 days, depending on the type of scheme. For example, in respect of Liquid Funds and Overnight Funds, the redemption amount is paid out on the next business day. However, units of close-ended mutual fund schemes can be redeemed only on maturity. Likewise, units of ELSS have a 3-year lock-in period and can be liquidated only thereafter.</li> <li><strong>Low Cost:</strong> Due to huge economies of scale, mutual fund schemes have a low expense ratio. The expense ratio represents the annual fund operating expenses of a scheme, expressed as a percentage of the fund's daily net assets. Operating expenses of a scheme include administration, management and advertising-related expenses. The limits of the expense ratio for various types of schemes are specified under Regulation 52 of the SEBI Mutual Fund Regulations, 1996.</li> <li><strong>Well-Regulated:</strong> Mutual Funds are regulated by the capital markets regulator, the Securities and Exchange Board of India (SEBI), under the SEBI (Mutual Funds) Regulations, 1996. SEBI has laid down stringent rules and regulations that keep investor protection, transparency, an appropriate risk mitigation framework and fair valuation principles in view.</li> <li><strong>Tax Benefits:</strong> Investment in ELSS up to ₹1,50,000 qualifies for tax benefit under Section 80C of the Income Tax Act, 1961. Mutual fund investments, when held for a longer term, are tax efficient.</li> </ol> <h3 style="text-align: left;">Expense Ratio</h3> <p style="text-align: left;">Under the SEBI (Mutual Funds) Regulations, 1996, mutual funds are permitted to charge certain operating expenses for managing a scheme, such as sales and marketing / advertising expenses, administrative expenses, transaction costs, investment management fees, registrar fees, custodian fees and audit fees. These are charged as a percentage of the fund's daily net assets.</p> <p style="text-align: left;">All such costs for running and managing a mutual fund scheme are collectively referred to as the "Total Expense Ratio" (TER). The TER is calculated as a percentage of the scheme's average Net Asset Value (NAV). The daily NAV of a mutual fund is disclosed after deducting the expenses.</p> <p style="text-align: left;">Currently, in India, the expense ratio is fungible, i.e., there is no limit on any particular type of allowed expense as long as the total expense ratio is within the prescribed limit. The regulatory limits of TER that can be charged to the fund by a Mutual Fund AMC are specified under Regulation 52 of the SEBI Mutual Fund Regulations.</p> <p style="text-align: left;">Effective from April 1, 2020, the TER limit has been revised as follows:</p> <table style="border-collapse: collapse; width: 100%;" border="1"> <tbody> <tr> <td style="width: 40%;" rowspan="2"><strong>Assets Under Management (AUM)</strong></td> <td style="width: 60%;" colspan="2"><strong>Maximum TER as a percentage of daily net assets</strong></td> </tr> <tr> <td style="width: 30%;"><strong>TER for Equity funds</strong></td> <td style="width: 30%;"><strong>TER for Debt funds</strong></td> </tr> <tr> <td>On the first Rs. 500 crores</td> <td>2.25%</td> <td>2.00%</td> </tr> <tr> <td>On the next Rs. 250 crores</td> <td>2.00%</td> <td>1.75%</td> </tr> <tr> <td>On the next Rs. 1,250 crores</td> <td>1.75%</td> <td>1.50%</td> </tr> <tr> <td>On the next Rs. 3,000 crores</td> <td>1.60%</td> <td>1.35%</td> </tr> <tr> <td>On the next Rs. 5,000 crores</td> <td>1.50%</td> <td>1.25%</td> </tr> <tr> <td>On the next Rs. 40,000 crores</td> <td>Total expense ratio reduction of 0.05% for every increase of Rs. 5,000 crores of daily net assets or part thereof</td> <td>Total expense ratio reduction of 0.05% for every increase of Rs. 5,000 crores of daily net assets or part thereof</td> </tr> <tr> <td>Above Rs. 50,000 crores</td> <td>1.05%</td> <td>0.80%</td> </tr> </tbody> </table> <p style="text-align: left;">In addition, mutual funds have been allowed to charge up to 30 bps more if the new inflows from retail investors from beyond the top 30 cities (B30) are at least (a) 30% of gross new inflows in the scheme or (b) 15% of the average assets under management (year to date) of the scheme, whichever is higher. This is essentially to encourage inflows into mutual funds from tier-2 and tier-3 cities.</p> <p style="text-align: left;"><strong>TER has a direct bearing on a scheme's NAV: the lower the expense ratio of a scheme, the higher the NAV.</strong> Thus, TER is an important parameter while selecting a mutual fund scheme.</p> <p style="text-align: left;">As per the current SEBI Regulations, mutual funds are required to disclose the TER of all schemes on a daily basis on their websites as well as on AMFI's website.</p> <h3 style="text-align: left;">Risks in Mutual Funds</h3> <h4 style="text-align: left;">Standard Risk Factors</h4> <ul> <li>Mutual Fund Schemes are not guaranteed or assured return products.</li> <li>Investment in Mutual Fund Units involves investment risks such as trading volumes, settlement risk, liquidity risk and default risk, including the possible loss of principal.</li> <li>As the price / value / interest rates of the securities in which the Scheme invests fluctuate, the value of the investment in a mutual fund Scheme may go up or down.</li> <li>In addition to the factors that affect the value of individual investments in the Scheme, the NAV of the Scheme may fluctuate with movements in the broader equity and bond markets. It may also be influenced by factors affecting capital and money markets in general, such as, but not limited to, changes in interest rates, currency exchange rates, changes in Government policies, taxation, political, economic or other developments, and increased volatility in the stock and bond markets.</li> <li>Past performance does not guarantee future performance of any Mutual Fund Scheme.</li> </ul> <h4 style="text-align: left;">Specific Risk Factors: Risks associated with investments in Equities</h4> <ul> <li><strong>Risk of losing money:</strong> Investments in equity and equity-related instruments involve a degree of risk. Investors should not invest in equity schemes unless they can afford to take the risk of possible loss of principal.</li> <li><strong>Price Risk:</strong> Equity shares and equity-related instruments are volatile and prone to price fluctuations on a daily basis.</li> <li><strong>Liquidity Risk for listed securities:</strong> The liquidity of investments made in equities may be restricted by trading volumes and settlement periods. Settlement periods may be extended significantly by unforeseen circumstances. While securities that are listed on the stock exchange carry lower liquidity risk, the ability to sell these investments is limited by the overall trading volume on the stock exchanges. The inability of a mutual fund to sell securities held in the portfolio could result in potential losses to the scheme, should there be a subsequent decline in the value of securities held in the scheme portfolio. This may lead to the fund incurring losses till the security is finally sold.</li> <li><strong>Event Risk:</strong> Price risk due to a company- or sector-specific event.</li> </ul> <h4 style="text-align: left;">Specific Risk Factors: Risks associated with investment in Debt Securities and Money Market Instruments</h4> <p style="text-align: left;">Debt securities are subject to the risk of an issuer's inability to meet principal and interest payments on the obligation on the due date(s) (Credit Risk). They may also be subject to price volatility due to factors such as interest rate sensitivity, market perception of the creditworthiness of the issuer and general market liquidity (Market Risk).</p> <p style="text-align: left;">The timing of transactions in debt obligations, which will often depend on the timing of purchases and redemptions in the Scheme, may result in capital appreciation or depreciation, because the value of debt obligations generally varies inversely with the prevailing interest rates.</p> <ul> <li><strong>Interest Rate Risk:</strong> The market value of fixed income securities is generally inversely related to interest rate movement. Generally, when interest rates rise, prices of existing fixed income securities fall, and when interest rates drop, such prices increase. Accordingly, the value of a scheme portfolio may fall if market interest rates rise and may appreciate when market interest rates come down. The extent of the fall or rise in prices depends upon the coupon and maturity of the security. It also depends upon the yield level at which the security is being traded.</li> <li><strong>Credit Risk:</strong> This is the risk associated with default on interest and / or principal amounts by issuers of fixed income securities. In case of a default, the scheme may not fully receive the due amounts, and the NAV of the scheme may fall to the extent of the default. Even when there is no default, the price of a security may change with expected changes in the credit rating of the issuer. A government security is a sovereign security and is safer. Corporate bonds carry a higher amount of credit risk than government securities. Within corporate bonds also there are different levels of safety, and a bond rated higher by a rating agency is safer than a bond rated lower by the same rating agency.</li> <li><strong>Spread Risk:</strong> Credit spreads on corporate bonds may change with varying market conditions. The market value of debt securities in the portfolio may depreciate if the credit spreads widen, and vice versa. Similarly, in case of floating rate securities, if the spreads over the benchmark security / index widen, the value of such securities may depreciate.</li> <li><strong>Liquidity Risk:</strong> Liquidity risk refers to the ease with which securities can be sold at or near their valuation yield-to-maturity (YTM) or true value. Liquidity conditions in the market vary from time to time. The liquidity of a bond may change depending on market conditions, leading to changes in the liquidity premium attached to the price of the bond. In an environment of tight liquidity, the necessity to sell securities may have a higher than usual impact cost. Further, the liquidity of any particular security in the portfolio may lessen depending on market conditions, requiring a higher discount at the time of selling.<br><br>The primary measure of liquidity risk is the spread between the bid price and the offer price quoted by a dealer. Trading volumes, settlement periods and transfer procedures may restrict the liquidity of some of these investments. Different segments of the Indian financial markets have different settlement periods, and such periods may be extended significantly by unforeseen circumstances. Further, delays in settlement could result in temporary periods when a portion of the assets of the Scheme is not invested and no return is earned on it, or the Scheme may miss attractive investment opportunities.<br><br>At the time of selling the security, the security may become illiquid, leading to a loss in value of the portfolio. The purchase price and subsequent valuation of restricted and illiquid securities may reflect a discount, which may be significant, from the market price of comparable securities for which a liquid market exists.</li> <li><strong>Counterparty Risk:</strong> This is the risk of failure of the counterparty to a transaction to deliver securities against consideration received, or to pay consideration against securities delivered, in full or in part or as per the agreed specification. There could be losses to the fund in case of a counterparty default.</li> <li><strong>Prepayment Risk:</strong> This arises when the borrower pays off the loan sooner than the due date. This may result in a change in the yield and tenor for the mutual fund scheme. When interest rates decline, borrowers tend to pay off high-interest loans with money borrowed at a lower interest rate, which shortens the average maturity of Asset-backed securities (ABS). However, there is some prepayment risk even if interest rates rise, such as when an owner pays off a mortgage when the house is sold, or an auto loan is paid off when the car is sold. Since prepayment risk increases when interest rates decline, this also introduces reinvestment risk, which is the risk that the principal may only be reinvested at a lower rate.</li> <li><strong>Re-investment Risk:</strong> Investments in fixed income securities carry re-investment risk, as the interest rates prevailing on the coupon payment or maturity dates may differ from the original coupon of the bond (the purchase yield of the security). This may result in the final realised yield being lower than that expected at the time of investment. The additional income from reinvestment is the "interest on interest" component. There may be a risk that the rate at which interim cash flows can be reinvested is lower than that originally assumed.</li> </ul>