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Mutual Fund & ETF

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Mutual fund-Definition

 

An open-ended fund operated by an investment company which raises money from shareholders and invests in a group of assets, in accordance with a stated set of objectives. mutual funds raise money by selling shares of the fund to the public, much like any other type of company can sell stock in itself to the public. Mutual funds then take the money they receive from the sale of their shares (along with any money made from previous investments) and use it to purchase various investment vehicles, such as stocks, bonds and money market instruments. In return for the money they give to the fund when purchasing shares, shareholders receive an equity position in the fund and, in effect, in each of its underlying securities. For most mutual funds, shareholders are free to sell their shares at any time, although the price of a share in a mutual fund will fluctuate daily, depending upon the performance of the securities held by the fund. Benefits of mutual funds include diversification and professional money management. Mutual funds offer choice, liquidity, and convenience, but charge fees and often require a minimum investment. A closed-end fund is often incorrectly referred to as a mutual fund, but is actually an investment trust.


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What's a mutual fund?

A mutual fund, also referred to as an open-end fund, is an investment company that spreads its money across a diversified portfolio of securities -- including stocks, bonds, or money market instruments. 

Shareholders who invest in a fund each own a representative portion of those investments, less any expenses charged by the fund. 

Mutual fund investors make money either by receiving dividends and interest from their investments, or by the rise in value of the securities. Dividends, interest and profits from the sale of any securities (capital gains) are passed on to the shareholders in the form of distributions. And shareholders generally are allowed to sell (redeem) their shares at any time for the closing market price of the fund on that day. 

Why invest in mutual funds?

There are a variety of reasons why investors might choose mutual funds over other investments, such as individual stocks and bonds. The number one reason is diversity, which can both increase your potential returns and decrease your overall risk. 

Mutual funds allow an investor to spread out his or her money across as few as a handful to as many as several thousand companies at one time. 

Funds can be especially advantageous for small investors who would be forced to pay enormous transaction fees if they bought the securities individually, and for investors who either don't have the time to research their own investments or who don't trust their own investment expertise. (For more on asset allocation, see "Build Your Own Mutual Fund Portfolio" tool). 

That said, mutual funds aren't necessarily low-cost investments. Many of them charge one-time "load fees" to new purchasers that can exceed 5 percent of the investment, and all mutual funds take on average take 1.3 percent of assets a year for operating expenses, expressed as the "expense ratio." 

As a result, "index" funds (see below) have surged in popularity in recent years because, on average, they provide a much lower expense ratio than managed funds. Also an index fund's risk is limited to that of the benchmark index that it tracks, such as the Standard & Poor's 500. 

Finally, the rapid emergence of 401(k) plans as the retirement vehicle of choice for millions of Americans means that mutual funds are here to stay. 

Professional management can be both a benefit and a liability of actively managed mutual funds. Several studies show that, over time, the average, actively managed fund has underperformed the overall stock market. Still, by picking funds with good long-term track records, managers you trust and low expenses, investors can build a portfolio with the potential for steady, long-term returns that match their own investment goals and tolerance for risk. 

Liquidity -- the ability to readily access your money -- is another benefit of mutual funds. Funds can be sold on any business day at that day's closing price – or at the following day’s close if the sell order is placed after the market closes. 

The price per share at any given time is known as the net asset value, or NAV, which is the current market value of all the fund's assets, minus liabilities, divided by the total number of outstanding shares. As new investors buy into a fund, the number of outstanding shares goes up, as does the market value of assets, but the NAV remains the same.


Types of  Funds

STOCK FUNDS

Also known as equity funds, these funds invest primarily in the shares of publicly traded companies. There are numerous types of stock funds. 

A blend fund, sometimes known as a core fund, invests across all levels of companies -- small, mid-size and large -- and unless indicated otherwise, across both growth companies and value companies. 

Small-cap, midcap and large-cap funds invest only in companies that fit those definitions, which are based on the market "capitalization," or total stock value, of the companies they invest in. 

Growth funds stick to companies with potential for better-than-average profit growth, while value funds stick to companies with a low stock price relative to their earnings or such measures. 

Investors should note that each fund family and each fund manager has his or her own definition of a "value" or "growth" stock, a small-cap stock and what is an acceptable level of ownership of a certain asset class to meet a fund's category. 

BOND FUNDS

Bond funds invest primarily in the debt instruments of companies and governments. They make money both by selling bonds at a profit and through income from the coupon payments of the bonds they hold. These coupon payments also are distributed to shareholders, thus generating income in addition to potential capital gains. 

Bond funds tend to be less volatile than stock funds, though there are several types of bond funds, some riskier than others. Junk bond funds, also known as high-yield bond funds, invest primarily in corporate bonds rated below what's considered "investment grade" by the major ratings agencies, Moody's and Standard & Poor's.

Municipal (or muni) bond funds invest in debt sold by U.S. cities, counties and states, while government bond funds invest mostly in U.S. Treasury bonds. Likewise, international bond funds invest in non-U.S. government and corporate debt. Investors should note that bond funds tend to go up in value when interest rates decline, and vice-versa.

BALANCED FUNDS

Balanced funds, also called hybrid funds, hold a mixture of stocks and bonds, and typically also a small amount of cash or money-market instruments.

MONEY MARKET FUNDS

Invest in short-term, interest-bearing securities. Money market funds are generally less risky than either stock funds or bond funds. The fund industry's trade association, Investment Company Institute, says "money market funds are most appropriate for short-term investment and savings goals or in situations where you seek to preserve the value of your investment while still earning income." Money market funds are designed to trade at a constant $1 a share.

INDEX FUNDS

Index funds can be either bond funds or stock funds. They invest in companies that make up a given index, such as the S&P 500 or the Nasdaq 100, in an attempt to mimic the returns of that index. Their advantage to shareholders is that they usually have lower costs than managed mutual funds because index funds do not have to hire staffs of research analysts and money managers to pick their stocks. Most also come without load fees.

SECTOR FUNDS

Stock mutual funds that invest in a specific industry sector, such as technology, health care, or energy. Sector funds are usually much more volatile than general equity funds, because sectors of the economy tend to go in and out of favor among investors, often for reasons that confound the average investor. However, they can also generate higher returns, such as the triple-digit performance of dozens of tech funds during 1999.

GLOBAL & INTERNATIONAL FUNDS

They sound like the same thing, but they're not. International funds invest solely in companies based outside the U.S., while global funds can invest in both U.S. and foreign companies. It's an important distinction, because if you're picking such funds to diversify your U.S. portfolio, a global fund might have some overlapping investments to your existing domestic funds.

CLOSED-END FUNDS

These are technically not mutual funds, although many investors consider them as such and they’re often compared with mutual funds as investment alternatives. Closed-end funds differ from open-end (mutual) funds in that they issue a set number of shares and are usually listed on exchanges, like stocks. 

Like mutual funds, they invest in the stock of a number of different companies, but unlike mutual funds they do not issue and redeem new shares. Because the share prices are dictated by the market, they often trade at discounts, and in some cases premiums, to their net asset value.

EXCHANGE TRADED FUNDS

These too are not mutual funds but are often compared with them for investment purposes. Exchange-traded funds are, as their name suggests, traded on stock exchanges. Most represent shares in the companies that make up a recognized index. 

The first such fund, Standard & Poor's Depository Receipts (SPY), commonly referred to as a SPiDeR, launched in 1996. At the end of April 2001, the ETF industry had grown to nearly $76 billion in assets spread across 114 funds. 

Their increasing popularity among investors stems from certain advantages over mutual funds. They're priced throughout the day, options can be written on them, they can be sold short, and they have no minimum investment amount beyond the price of the individual share. 

The ETF structure is also considered more tax-efficient than mutual funds because they limit the exposure to capital gains distributions that can occur when fund managers are forced to sell securities to meet redemptions. 

Some of them also have lower expense ratios and better tax efficiency than comparable mutual funds. However, unlike mutual funds, investors must pay transaction fees to brokers when they purchase exchange-traded funds, which can be especially costly for investors looking to put a set amount of money in them each month. 

Currently, ETFs only mimic specific indexes. But plans are underway to introduce actively managed exchange-traded products. The Securities and Exchange Commission plans to publish a "concept release" on the subject this summer.

Mutual Fund History India

Unit Trust of India(UTI) was the first mutual fund set up in India in the year 1963. In early 1990s, Government allowed public sector banks and institutions to set up mutual funds. UTI has an extensive marketing network of over 40,000 agents all over the country.

In the year 1992, Securities and exchange Board of India (SEBI) Act was passed. The objectives of SEBI are – to protect the interest of investors in securities and to promote the development of and to regulate the securities market.

In 1995, the RBI permitted private sector institutions to set up Money Market Mutual Funds (MMMFs). They can invest in treasury bills, call and notice money, commercial paper, commercial bills accepted/co-accepted by banks, certificates of deposit and dated government securities having unexpired maturity upto one year.

As far as mutual funds are concerned, SEBI formulates policies and regulates the mutual funds to protect the interest of the investors. SEBI notified regulations for the mutual funds in 1993. Thereafter, mutual funds sponsored by private sector entities were allowed to enter the capital market. The regulations were fully revised in 1996 and have been amended thereafter from time to time. SEBI has also issued guidelines to the mutual funds from time to time to protect the interests of investors.

All mutual funds whether promoted by public sector or private sector entities including those promoted by foreign entities are governed by the same set of Regulations. There is no distinction in regulatory requirements for these mutual funds and all are subject to monitoring and inspections by SEBI. The risks associated with the schemes launched by the mutual funds sponsored by these entities are of similar type.

What are Load Funds / No Load Funds ? 

A Load Fund is one that charges a percentage of NAV for entry or exit. That is, each time one buys or sells units in the fund, a charge will be payable. This charge is used by the mutual fund for marketing and distribution expenses. Suppose the NAV per unit is Rs.10. If the entry as well as exit load charged is 1%, then the investors who buy would be required to pay Rs.10.10 and those who offer their units for repurchase to the mutual fund will get only Rs.9.90 per unit. The investors should take the loads into consideration while making investment as these affect their yields/returns. However, the investors should also consider the performance track record and service standards of the mutual fund which are more important. Efficient Mutual funds may give higher returns in spite of loads.

A no-load fund is one that does not charge for entry or exit. It means the investors can enter the fund/scheme at NAV and no additional charges are payable on purchase or sale of units.

What are Tax Saving Schemes?

In India, Tax Saving Schemes schemes offer tax rebates to the investors under specific provisions of the Income Tax Act, 1961 as the Government offers tax incentives for investment in specified avenues. e.g. Equity Linked Savings Schemes (ELSS).

Pension schemes launched by the mutual funds also offer tax benefits. These schemes are growth oriented and invest pre-dominantly in equities. Their growth opportunities and risks associated are like any equity-oriented scheme.

What is Assured Return Scheme? 

In Mutual Funds, Assured Return Schemes are those schemes that assure a specific return to the unitholders irrespective of performance of the scheme.

A scheme cannot promise returns unless such returns are fully guaranteed by the sponsor or AMC and this is required to be disclosed in the offer document.

Investors should carefully read the offer document whether return is assured for the entire period of the scheme or only for a certain period. Some schemes assure returns one year at a time and they review and change it at the beginning of the next year.

Can Mutual Fund Change Schemes ? 

Yes. They Can However, no change in the nature or terms of the scheme, known as fundamental attributes of theMutual Fund e.g.structure, investment pattern, etc. can be carried out unless a written communication is sent to each unitholder and an advertisement is given in one English daily having nationwide circulation and in a newspaper published in the language of the region where the head office of the mutual fund is situated. The unitholders have the right to exit the Mutual Fund at the prevailing NAV without any exit load if they do not want to continue with the scheme. The mutual funds are also required to follow similar procedure while converting the scheme form close-ended to open-ended scheme and in case of change in sponsor.

The mutual funds are required to inform any material changes to their unitholders. Apart from it, many mutual funds send quarterly newsletters to their investors.

At present, offer documents are required to be revised and updated at least once in two years. In the meantime, new investors are informed about the material changes by way of addendum to the offer document till the time offer document is revised and reprinted.

ETF

The ABCs of ETFs are straightforward.
"E" is for exchange, as in stock exchange. ETFs are listed like any stock, with a ticker symbol and a bid and ask price. Investors can do anything with ETFs that can be done with a listed security, such as borrowing shares and going short or buying on margin. Also, options are available on about half of listed ETFs.
"T" is for traded. ETFs are bought and sold throughout a trading day, whereas mutual funds are priced once daily at the market close. Because of their intraday trading capabilities, ETFs drew early attention from short-term traders. But ETFs also appeal to long-term investors -- more on that later.
"F" is for fund -- in this case an index fund. ETFs track segments of the U.S. and global securities markets by following benchmarks like the S&P 500,, the Dow Jones Industrial Average , and the Lehman Aggregate Bond Index. If you want exposure to health-care, mid-cap value, or Brazilian stocks, there is an ETF to accommodate your needs. And like index funds, ETFs generally carry low expense ratios
Is there a limit to ETF trading?
No. That's why ETFs are useful tools for market-timing investors who move rapidly in and out of economic sectors, rather than using individual stocks.
Why not just trade mutual funds instead?
Most mutual funds aren't friendly to whipsaw traders, and are less so in the wake of the fund industry's market-timing scandal. Some fund companies slap redemption fees on short-term trading -- or simply bar market timers outright.
In addition, since ETFs can be leveraged or sold short, investors use them to implement complex trading strategies based on the market's technical signals.
I'm a buy-and-hold investor. Can I use ETFs?
Yes. ETFs' broad index diversification, low cost, and tax efficiency make them appropriate for long-term investors.
Do ETFs have advantages over active mutual-fund management?
Over a longer-term investment horizon, fund managers who actively manage portfolios through stock selection have had difficulty outperforming a benchmark index.
For example, two-thirds of active large-cap funds trailed the S&P 500 over the three years ending June, according to Standard & Poor's. Meanwhile, almost eight of every 10 actively managed mid-cap funds, and three-fourths of comparable small-cap funds, fared worse than their relevant S&P benchmark.
Aside from high expense ratios, active managers are saddled with transaction fees from stock trading. Taken together, these costs are ankle weights that make it tough for many active managers to keep up with the indexes.
How expensive are ETFs?
ETFs carry an average expense ratio of about 0.46 percent, less than one-third the cost of a typical actively managed U.S. stock fund, which levy a 1.50 percent fee.
Importantly, however, ETFs incur brokerage commissions to buy and sell shares. Also, some index funds are waiving management fees to undercut rival ETFs. When choosing an ETF, compare its expenses against index funds tracking a comparable benchmark.
Are ETFs tax efficient?
Yes. Most ETFs have much lower turnover than actively managed peers.
Accordingly, ETFs distribute fewer capital gains.ETFs have another advantage over traditional index funds in the tax-efficiency department: Long-term fund investors are often penalized when short-term shareholders cash out. The fund must sell stock to meet the redemptions, and taxable gains are passed on to remaining shareholders.
Since ETF shares trade on exchanges, and because of a unique "in-kind" creation and redemption process, ETF investors are unaffected by others' trading activity at tax time, in the same way as common stockholders.
What are the disadvantages of ETFs?
Since they trade like stocks, investors pay brokerage commissions to buy and sell shares. Some discount brokers are reducing fees to accommodate buy-and-hold investors. Even still, with so-called "dollar-cost averaging" -- contributing a certain amount on a regular basis -- those commissions can negate ETFs' lower expense.
Are there bond ETFs?
Yes. There are fixed-income ETFs tracking a total U.S. bond-market index, corporate bonds, Treasury Inflation Protected Securities (TIPS) and U.S. Treasury bonds. Like their stock cousins, bond ETFs are generally cheaper than similar mutual funds.
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