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Mutual Fund Investment in India

Mutual Fund Investment in India

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Published by: Jenipher Carlos Hosanna on Nov 24, 2009
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Investment in Mutual Funds
Mutual fund companies [also known as Asset Management Companies (AMCs)]collect funds from public (mainly from small investors) and invest such funds inmarket and distribute returns/surpluses in the form of dividends. Surpluses can alsobe reflected in higher Net Asset Value (NAV) of the scheme. In simple words, amutual fund company collects savings of small investors (pool their money); the fundmanagers of the concern invest such pool of funds to market (securities); whenreturns are generated from such investment, passed back to the investors. This is how a mutual fund works. First an offer document (containing details of the scheme, its investment horizon and class(es) of securities it intends to investetc.) is issued to the public. Then the collected money is pooled together toconstitute a fund. This fund is managed by fund managers of AMC who take majorinvestment decisions. A trust takes care that the mutual fund investments are inaccordance with the scheme of the fund and is being managed in the interest of theinvestors. The returns from such investment activities are distributed in accordancewith the scheme of the fund.NAV of a mutual fund (or in other words NAV per unit) refers to the total assetmanaged by the fund at its market value divided by the number of outstanding(issued and sold) units of the fund. For instance, a fund having net asset worth of Rs.100 crores and Rs.10 crore units are outstanding then the NAV per unit of the fundwould be Rs.10. The NAV of a scheme depends on the market value of itsinvestments and hence it fluctuates with the fluctuating share prices of itsinvestment. An increase in NAV means capital appreciation for investors.Since mutual funds are managed by professionals who have requisiteexperiences and qualifications in the areas of stock market, as far as a new entrant inthe stock markets are concerned, these funds act as a safe vehicle for investment.Moreover, as mutual funds invest in a number of scrips, the impact of risksassociated with individual securities is minimized. To put in financial language, theaim is to diversify the unsystematic risk in the portfolio. Also, since the pooled fundsare invested in different sectors and stocks, there is a diversification effect reducingoverall risk of the portfolio.Since mutual funds generally trade in large number of securities at the same time,there is advantage of economies of scale. In other words, there is savings intransaction costs.According to the investment objective, mutual funds can be classified as: (a)growth funds, (b) income funds and (c) balanced funds. Growth funds invest majorityof their pooled amount with the objective of achieving long term capital appreciation.Income funds provide periodic returns to investors in the form of dividends. Balancedfunds are a midway between growth funds and income funds. They balance theirinvestment in such a way that investors not only get periodical return, but theircapital also tends to appreciate which is reflected in higher NAV.If you are an investor who seek for a suitable fund, then it depends on yourrisk bearing capacity (your risk profile). If you are a highly risk averse investor whorequires periodic return, then you should always prefer investment in income funds.If you have a high risk taking capability and you have surplus funds to invest, then gofor growth funds. If you want a small periodic return along with capital appreciation,then go for balanced funds.Investment in mutual funds should never be looked upon from the point of view of return. It is the risk return paradigm which can help us to optimize our returnover a period of time. Another point you should remember is that, you should neverattempt to compare two schemes of mutual fund with different investment objectiveson the basis of the returns provided by them, if you do so, it would be like comparingapples with mangoes.
Sharpe ratio and Treynor Ratio are the tools to measure the performance of mutual funds over a period of time. Sharpe Ratio is obtained by dividing thedifference between return of the portfolio and risk free rate of interest to thestandard deviation of the portfolio return. This ratio takes into account surplus returnearned by the fund over risk free rate of interest and then divides it by standarddeviation of the portfolio return (which is basically a representative of risk whichmeasures deviation of actual return of the portfolio with respect to mean return).Higher the return better is the fund. Treynor Ratio also takes into account surplusreturn earned over risk free return but the measure of risk here is beta (a measure of systematic risk) rather than standard deviation. Thus, Treynor ratio is obtained bydividing the difference between return of the portfolio and risk free rate of interest tothe beta (market risk/systematic risk) of the portfolio. There are some absolute performance measures such as
 Jenson’s Alpha
Fama’s Measure
Expense Ratio
which provide an indication about theperformance of a mutual fund as a whole.
 Jenson’s Alpha Measure
helps us inidentifying whether the fund has been able to outsmart its expected return. The expected return of a security is equal to:R
= R
+ β(R
– R
)Where, R
is the risk free return, β is the systematic risk and R
is the return onmarket index (return earned by the fund).Fama’s measure is obtained by the following formula:Fama’s Measure = R
– [R
+ (σ
– R
)]Where, R
= actual return of portfolio; R
= risk free return, R
= return on marketindex, σ
= standard deviation of portfolio return, σ
= standard deviation of marketindex return. Thus, instead of β, which takes into account only systematic risk, this measure takesinto account standard deviation of stock return as well as standard deviation of market returns.Expense ratio refers to the total amount of expenses of the fund as apercentage of total assets of the fund. The expenses include all the charges in theform of administrative overheads, salary of staff etc. However, expenses do notinclude brokerage. The return on mutual funds is never equal to the return on securities whichthe investor can earn if he invests directly in those securities since there are frontend load, back end load and annual expenses which will be deducted from the fund.Front end fee is charged by the AMC at the time of initial investment in the fund. Exitload is the amount of fees charged at the time of redemption (surrender) of unit.Generally, funds which charge front end fees do not charge back end fees/exit load.Moreover, there are expenses which are deducted annually for meetingadministrative and other expenses of the fund.Mutual fund schemes can be in the form of open ended schemes or closedended schemes. In closed ended schemes, a fixed number of units are issued by thefund and thereafter this number remains constant till the maturity of the scheme. The option available to the investors in this case is that they can buy and sell theunits in secondary market. The open ended schemes are without any fixed number of outstanding units. Any investor can invest money in accordance with the NAV of thescheme any time. Similarly investors get an opportunity to redeem their units anytime. The logic here is that since there are no fixed total number of units, mutualfund not only accepts money for investment purpose later on after the scheme islaunched but also redeems units of holders as and when required by them.Finally, there are index funds, ETFs and Fund of Funds, which should also beanalyzed. Index funds are those funds which create a portfolio which replicate thecomposition of a particular index. For instance, an index fund on NIFTY will invest inall those securities which are a part of that index and the proportion is also similar tothe weights which the individual securities have in that index. Thus these funds tend

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