Wednesday, November 11, 2009

Part 8: A primer on mutual funds

We have seen how to keep money aside, without which there can be no investments.  We also looked at how investments are evaluated viz., on the parameters of Risk, Return and Liquidity.  The Return of course has to be above the inflation rate, otherwise our money slowly becomes worthless.  Now comes the next question: what are the possible investment options?

I have heard many people say “Equity Shares, Fixed Deposits, and Mutual Funds”!  It’s like saying I like to drink milk, colas and the bottle!  Mutual Funds are not an asset class; they are just the vehicles to invest in some asset classes.  You can have Mutual Funds that invest in Equity, Funds that invest in Debt, in Gold, in Real Estate, and Funds that invest in other Funds!  This is a good time for us to understand what  Mutual Funds are – we need to know that if we want to invest in today’s times.  Not also forgetting the fact that we owe our living to the Fund business!

A group of people get together to give their money to a professional to manage.  Who then invests it in certain investments as per the mandate given to her.  Thus she could invest the money in Equity, Bonds, Art, Silver or even Antique Motor Cars (if you know of any Fund that does this, let me know).  Let’s say each of them invests a lakh of rupees.  The fund manager takes away 3% (say) on entry towards marketing and other expenses and invests 97,000 into the fund – and there are 100 people who have thus invested. She thus starts with a corpus (Assets under Management in Fund parlance) of Rs.97 lakhs.

She invests it, say, in rare stamps since it happens to be a philatelic fund.  At the end of two months, she has bought stamps worth Rs.57 lakhs and has cash worth 40 lakhs still left over, which she has parked in very short-term instruments – these instruments are currently yielding 4% p.a.  Now, ten more people, friends of those who have invested, want to join – will they each pay one lakh?  The premise is that once they are in, they are on par with the existing people, who are known as Unitholders (Shareholders in the U.S.).

That’s of course not fair.  The Fund Manager will carry out a valuation of the Fund’s assets on that day and decide what each of the current units is worth. Let’s say the market value of the stamps has gone up to Rs.65 lakhs; and the total cash lying with the Fund is Rs.43 lakhs.  That’s Rupees one lakh eight thousand per Unit Holder.  This number, 108,000 is called the Net Asset Value (NAV) of the Fund on that particular day.  The ten new people are invited to join the fund at Rs.108,000 plus an entry load of 3% - hence, they each pay Rs.111,240.  What if one of the existing unitholders wants to leave on that day?  He of course cashes out at Rs.108,000 less exit load if any.

That broadly is how a fund works. 

Let’s look at some common kinds of funds.  Equity Funds invest in Equity i.e., Equity Shares of companies.  Debt Funds invest in a mix of debt instruments, i.e. instruments that yield a fixed interest rate.  Within these, of course, you have several flavors.

A Diversified Equity Fund invests in whichever equities the fund manager feels like investing in.  An index fund invests in shares that constitute the index (the Sensex or the Nifty) in the same proportion; hence its performance will reflect the index within a small range of variation that is called a tracking error.  A Sector Fund invests in shares of companies in a particular sector, say, Infrastructure, IT, or Power.  A large-cap fund invests in companies with large market capitalizations; as opposed to mid-cap and small-cap funds. Some fund houses have come out with “multi-cap” funds which essentially means nothing - the fund manager invests in whichever equities he feels like.  Usually, all funds have a minimum market-cap below which they will not invest – this is due to the fact that a large pot of money always has to look at investments that are highly liquid, i.e., can be sold easily when the time comes.

There are funds which believe in “value-investing” which follow a “bottom-up” stock picking approach. These are funds that research individual companies and believe in the philosophy that a share should be bought when its market value drops far below the intrinsic value. The art lies in, of course, how the intrinsic value is computed.  Your number will always be different from mine!  There are funds which believe in “momentum” investing which try to time the market – they will buy any share that they think will go up in the short to medium term and sell or short what they think will go down in price.  Most individual investors like to believe that they follow the value investing approach; while, in reality they are momentum investors buying when prices are going up and selling when prices are going down. Which doesn’t necessarily mean that they make money.

Talking of making money in Equities, I am told the formula is very simple.  Buy Low and Sell High!  If you know how to do that consistently, go join Warren Buffett or Rakesh Jhunjhunwala.  You don’t need to read any articles on investments, least of all mine!

The Fund Manager is employed by a Fund House or Asset Management Company (AMC) to manage a particular fund under its umbrella of funds.  Some of the big AMC’s which manage several funds are Franklin Templeton,  Prudential, Fidelity, Vanguard, Reliance, etc.

How do Equity Funds get their revenues?   They charge a fee which is a percentage of the Assets under Management; in other words, a percentage of your NAV every year.  In India it varies within a slab rate mandated by the Securities and Exchange Board of India (SEBI – the regulator), but you can assume that the fund management fee is roughly 2% per annum on Equity Funds.  This is deducted from the returns the Fund makes; hence the NAV that you see is after deducting the fund management fee.  It should be obvious to you that, from the fund house’s perspective, a minimum level of Assets under Management (AUM) is required in order to survive in the long run. Funds that don’t manage to grow to a large enough size usually get absorbed into other funds of the same fund house, or get sold to another AMC.

My word limit for the article has been reached.  My apologies to those who knew all this already – I have to cater to a diverse audience!  And if you have reached this far, then at least I have managed to retain your interest!

More on Funds in the next issue.  See you later!

Dinesh Gopalan
Fidelity India Finance
mobile: 9845257313