Understanding Collective Investment Schemes-Mutual Funds By Mark Darko

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A mutual fund is a type of financial vehicle made up of a pool of money collected from many investors to invest in securities like stocks, bonds, money market instruments, and other assets. Mutual funds are operated by professional money managers, who allocate the fund’s assets and attempt to produce capital gains or income for the fund’s investors. A mutual fund’s portfolio is structured and maintained to match the investment objectives stated in its prospectus.

Mutual funds give small or individual investors access to professionally managed portfolios of equities, bonds, and other securities. Each shareholder, therefore, participates proportionally in the gains or losses of the fund. Mutual funds invest in a vast number of securities, and performance is usually tracked as the change in the total market cap of the fund—derived by the aggregating performance of the underlying investments.

KEY ISSUES

A mutual fund is a type of investment vehicle consisting of a portfolio of stocks, bonds, or other securities.

Mutual funds give small or individual investors access to diversified, professionally managed portfolios at a low price.

Mutual funds are divided into several kinds of categories, representing the kinds of securities they invest in, their investment objectives, and the type of returns they seek.

Mutual funds charge annual fees (called expense ratios) and, in some cases, commissions, which can affect their overall returns.

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The overwhelming majority of money in employer-sponsored retirement plans goes into mutual funds.

Understanding Mutual Funds

Mutual funds pool money from the investing public and use that money to buy other securities, usually stocks and bonds. The value of the mutual fund company depends on the performance of the securities it decides to buy. So, when you buy a unit or share of a mutual fund, you are buying the performance of its portfolio or, more precisely, a part of the portfolio’s value. Investing in a share of a mutual fund is different from investing in shares of stock. Unlike stock, mutual fund shares do not give its holders any voting rights. A share of a mutual fund represents investments in many different stocks (or other securities) instead of just one holding.

That’s why the price of a mutual fund share is referred to as the net asset value (NAV) per share, sometimes expressed as NAVPS. A fund’s NAV is derived by dividing the total value of the securities in the portfolio by the total amount of shares outstanding. Outstanding shares are those held by all shareholders, institutional investors, and company officers or insiders. Mutual fund shares can typically be purchased or redeemed as needed at the fund’s current NAV, which—unlike a stock price—doesn’t fluctuate during market hours, but it is settled at the end of each trading day. Ergo, the price of a mutual fund is also updated when the NAVPS is settled.

The average mutual fund holds over a hundred different securities, which means mutual fund shareholders gain important diversification at a low price. Consider an investor who buys only Google stock before the company has a bad quarter. He stands to lose a great deal of value because all of his dollars are tied to one company. On the other hand, a different investor may buy shares of a mutual fund that happens to own some Google stock. When Google has a bad quarter, she loses significantly less because Google is just a small part of the fund’s portfolio.

How Mutual Funds Work

A mutual fund is both an investment and an actual company. This dual nature may seem strange, but it is no different from how a share of AAPL is a representation of Apple Inc. When an investor buys Apple stock, he is buying partial ownership of the company and its assets. Similarly, a mutual fund investor is buying partial ownership of the mutual fund company and its assets. The difference is that Apple is in the business of making innovative devices and tablets, while a mutual fund company is in the business of making investments.

Investors typically earn a return from a mutual fund in three ways:

Income is earned from dividends on stocks and interest on bonds held in the fund’s portfolio. A fund pays out nearly all of the income it receives over the year to fund owners in the form of a distribution. Funds often give investors a choice either to receive a check for distributions or to reinvest the earnings and get more shares.

If the fund sells securities that have increased in price, the fund has a capital gain. Most funds also pass on these gains to investors in a distribution.

If fund holdings increase in price but are not sold by the fund manager, the fund’s shares increase in price. You can then sell your mutual fund shares for a profit in the market.

If a mutual fund is construed as a virtual company, its CEO is the fund manager, sometimes called its investment adviser. The fund manager is hired by a board of directors and is legally obligated to work in the best interest of mutual fund shareholders. Most fund managers are also owners of the fund. There are very few other employees in a mutual fund company. The investment adviser or fund manager may employ some analysts to help pick investments or perform market research. A fund accountant is kept on staff to calculate the fund’s NAV, the daily value of the portfolio that determines if share prices go up or down. Mutual funds need to have a compliance officer or two, and probably an attorney, to keep up with government regulations.

Most mutual funds are part of a much larger investment company; the biggest have hundreds of separate mutual funds. Some of these fund companies are names familiar to the general public, such as Fidelity Investments

There are certain myths associated with investing in mutual funds. In this article, we would like to clarify five of the most common myths associated with investing in mutual funds.

Myth 1: You need a large sum to invest in mutual funds.

This is an erroneous perception. You need not have a lot of money to start investing in funds. You can start with a sum as low as $500 when investing in equity linked saving schemes (ELSS) or $1,000 every month when investing in a mutual fund through systematic investment plans (SIPs).

Myth 2: Buying a top-rated MF scheme ensures better returns.

Mutual fund ratings are dynamic and based on performance of the fund over time. So, a fund that is rated highly today, may not necessarily maintain its rating a year later. While a highly rated fund is a good first step to short list a scheme to invest in, it does not guarantee better returns eternally. Investments in mutual funds need to be tracked with respect to its benchmark to evaluate its performance to stay invested or exit.

Myth 3: Investing in mutual funds is the same as investing in stock market.

Not all mutual funds invest only in stocks. In fact, even the most diversified equity funds have a mix of equity and debt. Also, the sheer variety of mutual funds means that there is a fund for every type of investor, spanning a risk spectrum of low to high and spreading investments that are significantly high in equities to those which have no exposure to equities.

Myth 4: A fund with lower NAV is better.

This is a popular misconception. A mutual fund’s NAV represents the market value of all its investments. Any capital appreciation will depend on the price movement of its underlying securities. Say, you invest $10,000 each in fund A (whose NAV is  $20) and fund, B (whose NAV is $100). You will get 500 units of fund A and 100 units of fund B. Let’s assume both schemes have invested their entire corpus in exactly same stocks in same proportions. If these stocks collectively appreciate by 10%, the NAV of the two schemes should also rise by 10%, to $22 and $110, respectively. In both cases, the value of your investment increases to $11,000.

Therefore, always remember that existing NAV of a fund does not have any impact on the returns.

Myth 5: You need a demat account to invest in mutual funds.

You do not need a demat account when investing in mutual funds. You may just fill up an application form, attach a cheque of the desired amount and submit the form at the mutual fund office or to your financial adviser.

Now that you have more clarity on investing in mutual funds, we are sure you will make prudent investment decisions while panning your financial portfolio.

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Mark Darko

MANAGING DIRECTOR (AFRICA)-EVRENSEL CAPITAL PARTNERS

PRESIDENT-ASIAN-AFRICAN CHAMBER OF COMMERCE AND INDUSTRY, GHANA CHAPTER

EXECUTIVE DIRECTOR-AFRICAN RATING AGENCY

SENATOR-WORLD BUSINESS ANGELS INVESTMENT FORUM (WBAF)

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