Understanding Mutual Funds

Bharat Kalluri / 2020-07-20

I'm not a qualified financial advisor, but if you walk up to me and ask what's my suggested way of investing long term. I would without any hesitation say mutual funds. They are mostly passive, long term and do not require a lot of thought or time. Another advantage is that most good mutual funds over time perform better than the current inflation rate of the country. So just by investing money in a fund, you'll be saving yourself from burning money. If you are not aware about inflation, please read and understand it deeply. It is one of the most important economic concepts and will fundamentally change how you view investments.

Note that new vocabulary will be marked. Every new field comes along with some jargon / vocab, getting comfortable with this helps us communicate ideas faster.

What are mutual funds how do they work?

Its a beautifully simple idea. If a company / person has a lot of wealth to manage, they hire a fund manager who manages the entire financial portfolio. The amount of money managed by a fund manager is called assets under management, and for doing all this work they get paid either a fixed salary or more often than not a percentage of the profits made.

But the other 98+% of folks cannot afford a fund manager for a salary and the return on profits would be pretty small for the fund manager to be interested in. So instead, fund managers instead pool money directly from the public (people like us) and manage the entire AUM (assets under management) using their expertise. In exchange, they take a chunk of profits. This chunk of profits is called as expense ratio and it usually is around 0 to 0.8%.

For the fund manager to sell the mutual fund, the entire funds assets are subtracted from the liability / cost of running the fund (salaries & other expenses) and then broken down into units. This is called NAV (net asset value) and this is the cost per unit.

There is one more concept in the mutual fund world called index funds. Indexes in India are SENSEX & NIFTY (look them up if you are un-aware). If the country is growing in a positive direction, the indexes almost always tend towards a positive trend. This is probably the safest bet there is since the index returns are stable & predictable. Since index funds just track indexes, there is no expertise required, hence the expense ratio of these funds is close to zero. But if the index is changing, then the funds also should be changing the AUM. There would be a minor hit in terms of reaction time, this is called as tracking error. For example, Tarus nifty fund can have a return of 15% over the last year but DSP nifty fund may have 18%. Since they track the same index, there should ideally be no difference in return. But since there would be some tracking error, the numbers would be different.

Once the money is pooled, the fund manager then starts thinking how he can invest it in the best way either long or short term for maximum returns. Let's suppose the fund manager thinks a stock might go down in the next month but over the year it will definitely trend upwards and invest money into it. But then a significant chunk of customers withdraw the money in the same month they deposited, now the fund managers hands are tied and he has to sell the stock at a loss. This is a huge problem is the AUM is constantly shifting underneath. That being said, withdrawing money from a mutual fund is natural. Hence mutual funds generally have a exit load, its the percentage of profits retained by the fund if money is withdrawn before an arbitrary amount of days (usually one year).

Types of funds

Different styles/types of funds exist to suit different needs of users.

  • Debt: These funds are maintained by Banks. When someone like the government, or a private sector organization takes money from a bank, they take it at a fixed interest rate over a period of time. So, what is basically happening is that banks pool money through mutual funds and lend it to various gov/private org. and the return on the fund is the interest rate the org pays the bank back. This is usually a safe bet since most of the companies don't completely default. But if they do, then the fund loses money, which means you lose on your returns/money.
  • Equity: These funds just straight up invest in stocks, there are a couple of types here like
    • Large Cap
    • Small Cap
    • Mid Cap
    • Multi Cap
  • ELSS (Equity linked savings scheme) : This is mostly popular for its tax saving properties. It is mandatory for this fund type that 80% of the investments are in equity. The simple reason why people prefer equity is that the returns are usually higher. But also it means risk is higher.
  • Growth funds have stocks which are high in terms of their growth but less in terms of the amount of dividend (money paid occasionally by the company to the shareholder). You might find companies you might have never heard of, but the manager of the fund thinks are a good growth investment.
  • Index Funds: They invest in the index they refer to (SENSEX / NIFTY). No manager since they just track the index, so no expense.
  • Hybrid: They do both Equity and debt funds

It might seem a bit complex on the face of it, but its a fascinating world.

Hand crafted by Bharat Kalluri