What is a mutual fund?

These days you are hearing more and more about mutual funds as a means of investment. If you are like most people, you probably have most of your money in a bank savings account and your biggest investment may be your home. Apart from that, investing is probably something you simply do not have the time or knowledge to get involved in. You are not the only one. This is why investing through mutual funds has become such a popular way of investing. What is a Mutual Fund?

A mutual fund is a pool of money from numerous investors who wish to save or make money just like you. Investing in a mutual fund can be a lot easier than buying and selling individual stocks and bonds on your own. Investors can sell their shares when they want.

Professional Management.

Each fund's investments are chosen and monitored by qualified professionals who use this money to create a portfolio. That portfolio could consist of stocks, bonds, money market instruments or a combination of those.

Fund Ownership.

As an investor, you own shares of the mutual fund, not the individual securities. Mutual funds permit you to invest small amounts of money, however much you would like, but even so, you can benefit from being involved in a large pool of cash invested by other people. All shareholders share in the fund' s gains and losses on an equal basis, proportionately to the amount they've invested.

Mutual Funds are Diversified

By investing in mutual funds, you could diversify your portfolio across a large number of securities so as to minimise risk. By spreading your money over numerous securities, which is what a mutual fund does, you need not worry about the fluctuation of the individual securities in the fund's portfolio.

Mutual Fund Objectives

There are many different types of mutual funds, each with its own set of goals. The investment objective is the goal that the fund manager sets for the mutual fund when deciding which stocks and bonds should be in the fund's portfolio.

For example, an objective of a growth stock fund might be: This fund invests primarily in the equity markets with the objective of providing long-term capital appreciation towards meeting your long-term financial needs such as retirement or a child' s education.

Depending on investment objectives, funds can be broadly classified in the following 5 types:

  • Aggressive growth means that you will be buying into stocks which have a chance for dramatic growth and may gain value rapidly. This type of investing carries a high element of risk with it since stocks with dramatic price appreciation potential often lose value quickly during downturns in the economy. It is a great option for investors who do not need their money within the next five years, but have a more long-term perspective. Do not choose this option when you are looking to conserve capital but rather when you can afford to potentially lose the value of your investment.
  • As with aggressive growth, growth seeks to achieve high returns; however, the portfolios will consist of a mixture of large-, medium- and small-sized companies. The fund portfolio chooses to invest in stable, well established, blue-chip companies together with a small portion in small and new businesses. The fund manager will pick, growth stocks which will use their profits grow, rather than to pay out dividends. It is a medium - long-term commitment, however, looking at past figures, sticking to growth funds for the long-term will almost always benefit you. They will be relatively volatile over the years so you need to be able to assume some risk and be patient.
  • A combination of growth and income funds, also known as balanced funds, are those that have a mix of goals. They seek to provide investors with current income while still offering the potential for growth. Some funds buy stocks and bonds so that the portfolio will generate income whilst still keeping ahead of inflation. They are able to achieve multiple objectives which may be exactly what you are looking for. Equities provide the growth potential, while the exposure to fixed income securities provide stability to the portfolio during volatile times in the equity markets. Growth and income funds have a low-to-moderate stability along with a moderate potential for current income and growth. You need to be able to assume some risk to be comfortable with this type of fund objective.
  • That brings us to income funds. These funds will generally invest in a number of fixed-income securities. This will provide you with regular income. Retired investors could benefit from this type of fund because they would receive regular dividends. The fund manager will choose to buy debentures, company fixed deposits etc. in order to provide you with a steady income. Even though this is a stable option, it does not go without some risk. As interest-rates go up or down, the prices of income fund shares, particularly bonds, will move in the opposite direction. This makes income funds interest rate sensitive. Some conservative bond funds may not even be able to maintain your investments' buying power due to inflation.
  • The most cautious investor should opt for the money market mutual fund which aims at maintaining capital preservation. The word preservation already indicates that gains will not be an option even though the interest rates given on money market mutual funds could be higher than that of bank deposits. These funds will pose very little risk but will also not protect your initial investments' buying power. Inflation will eat up the buying power over the years when your money is not keeping up with inflation rates. They are, however, highly liquid so you would always be able to alter your investment strategy.

Closed-End Funds

A closed-end fund has a fixed number of shares outstanding and operates for a fixed duration (generally ranging from 3 to 15 years). The fund would be open for subscription only during a specified period and there is an even balance of buyers and sellers, so someone would have to be selling in order for you to be able to buy it. Closed-end funds are also listed on the stock exchange so it is traded just like other stocks on an exchange or over the counter. Usually the redemption is also specified which means that they terminate on specified dates when the investors can redeem their units.

Open-End Funds

An open-end fund is one that is available for subscription all through the year and is not listed on the stock exchanges. The majority of mutual funds are open-end funds. Investors have the flexibility to buy or sell any part of their investment at any time at a price linked to the fund's Net Asset Value.

Courtesy :Franklin Templeton.


The Power of Compounding

Compounding is the financial equivalent of a snowball rolling downhill. With each revolution, the snowball gets bigger because it picks up even more snow every time around. Compounding produces a snowball effect with money because the earnings each year contribute a little more to earnings the following year. As time passes, the earnings contribute more and more to the total value of an investment.

The longer the period of your investment, the more you accumulate, because of the power of compounding... which is why it makes sense to start investing early.

The secret is to start early

Meet Suresh and Manoj. Suresh invests Rs.5 OOO while Manoj invests twice as much. As illustrated in the table below, even though the amount invested by Suresh is half of what Manoj puts , his investment final amount is becomes twice as much as Manoj's, simply because he started earlier - a clear instance of the benefits of compounding. This is the power of compounding.

Compounding Favours the Early Starter
  Suresh Manoj
Investment Amount Rs. 5000 Rs. 10,000
Investment Duration 20 Years 10 Years
Final Amount Rs. 81,833 Rs. 40,456

Assumed annual rate of return - 15% with dividends and capital gains reinvested. For illustrative purposes only

The key therefore lies in starting earlier, and giving your investments a longer time to grow.

Reinvest earnings and put your money to work

You may have noticed that our example assumes that dividends and capital gains aren't taken in cash. Reinvesting your distributions increases the value of your portfolio which, in turn, increases the amount of interest earned each year.

Just like our snowball growing larger with each roll, the value of the investment increases by a greater amount each year as the earnings are put back in. As time passes, earnings generated by the reinvested interest can rival or surpass the earnings that come from the initial investment alone.

The longer you have, the better compounding works

Money starts multiplying, more towards the end, as can be seen in the following graph:

The Power of Compounding

Growth of a monthly saving of Rs.1000 over a 30 year period

(Total savings: Rs.3.6 lacs)

Assumed rate of return - 12% For illustrative purposes only

Growth on top of compounding

The basic principles of compounding apply to any mutual fund. Namely, reinvesting earnings (dividends and capital gains for non-money market funds) over time can lead to potentially large increases in value.

If a fund's share price rises, your initial investment grows independently of the effects of compounding. Although there's no guarantee that a fund's share price will increase, coupling this kind of growth potential with compounding has been an effective strategy for many long-term investors.

Courtesy: Franklin Templeton.