Wednesday, December 9, 2009

Part 9: More on Mutual Funds

You have an option to invest in either of two equity mutual funds.  Both are diversified equity funds, with broadly similar portfolios.  Let’s say Fund A has an AUM of Rs.100 crores and its NAV is Rs.20.  Fund B has a corpus of Rs.500 crores and its NAV is Rs.200. If you invest Rupees one lakh you can buy 5000 units of Fund A, or 500 units of Fund B. Which fund would you invest in? 

Actually, it makes no difference. Since their portfolios are broadly similar, your money would grow/shrink (depending on the market) in the same proportion once you are invested.  Think about it.

Why then the ads that we see saying “Your only chance to invest at Rs.10! Subscribe to the IPO now!”  It doesn’t make sense!  Another gimmick is to advertise “dividends” from a fund.  For a moment ignoring taxation aspects, what difference would that make? Would not the dividends come from your own corpus?

Continuing with our discussion on the different types of mutual funds, let’s talk about debt funds.  These are also known as “income” funds.  Money market or liquid funds are for investing short term surpluses.  These funds invest in overnight call money markets (banks and institutions lending to each other for a day or very short periods) or in very short duration securities maturing in less than 90 days.  Short term bond funds invest in short term bonds primarily with a duration of between 90 and 365 days.  Gilt funds invest in Gilts which are Government Securities, of varying durations, which could extend to a few years.

There are funds which could invest in a mix of securities including Gilts, Certificates of Deposits, call money markets, etc.  Certificates of Deposit are basically tradable debt of banks or companies which may differ in their maturities.  In all these cases the investments carry a credit risk / counter-party risk viz., the risk that the borrower would default.  The funds aim to minimize this risk through proper selection of the securities they buy. Bear in mind that to earn higher interest, the fund manager may invest in slightly lower rated securities as well. As we saw already, risk and return are inversely correlated. The risk is also minimized through diversification, i.e., putting the eggs in more than one basket.

There is another risk that we saw, which is the interest rate risk.  We saw how as interest rates go up, bond prices could go down, and vice versa.  This is especially true of longer duration securities, since the time period involved is larger.  Gilt funds, especially, always carry an interest rate risk.  If your money is invested in a long-duration gilt funds, and the interest rates in the economy go up, your NAV could see a drop.

I reproduce here the section from Part 4 that spoke about interest rate risk. “There is another kind of risk called ‘interest rate risk’.  Let’s assume you lend someone one lakh rupees and he gives you a ten-year ten-percent bond (that means he will pay you ten thousand rupees a year for the next ten years and then repay your principal – if he is still alive).  If you sell this bond to your friend after two years you expect him to give you one lakh rupees for it.  He will, provided the interest rates in the market are ruling at 10% then.  What if the new ten-year bonds in the market yield an interest of 12.5%, i.e., give an interest of rupees twelve thousand five hundred every year on one lakh of investment? He would then obviously pay you Rupees Eighty thousand for your bond – such that the rupees ten thousand interest on it works out to a yield of 12.5%.  Thus, if interest rates go up, prices of existing bonds in the market go down; if interest rates go down, bond prices go up.” 

Your best bet would be to invest in a large “income” fund which invests in a mix of all the above.  It would be the fund manager’s call to manage the maturity profile and mix of his investments in order to optimize both the above risks.  If, however, you have very short term funds which you may need soon and at short notice, you could look at investing in money market / liquid funds.  These funds are supposed to be without any (or very little) credit risk since their lending is only to large and reputed institutions, and that too, for a few days at a time.

So far we have looked at funds that are “open ended” i.e., you can buy units or redeem units of the fund at any time based on the prevailing NAV.  What if the same fund were to collect money which would be “locked in” for a specified number of years?  The fund in this case would not allow you to buy fresh units or redeem them except during some pre-defined windows.  This would give the fund manager more scope to invest for the long term without worrying about fluctuating inflows and outflows.  Such a fund is called a “closed ended” fund. However, in such a fund how would you invest or divest in case you need to?  This is done through listing.  The fund is listed on a Stock Exchange and unitholders can buy or sell the units among themselves, just like they would buy or sell shares.  The price at any point in time is expected to be very close to the underlying NAV of the units; however, in actual practice this may not happen. Several times, the prices are much below, or even slightly above the NAV’s.  Since they are traded on the Exchange, they are also called Exchange Traded Funds.

However, the term Exchange Traded Funds is generally used to denote a specific type of fund that trades on the Exchange. We shall see more about that in the next issue.

And we of course have Fund of Funds.  This would be a fund that invests in other funds.  There could of course be some additional charges involved! In return, you get the benefit of additional diversification.

That covers quite a bit of ground on Mutual Funds.  I’ll stop here – bye till next time!

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