direct investment in stocks vs investment in mutual funds

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When the concept of companies initially formed, people who knew each other and were willing to take the risk of 

the venture used to put in the share capital of the company. Slowly, entrepreneurs realized that many are

interested in investing financially in the company but do not want to take the day-to-day hassle of managing the

company. Thus began the concept of passive investing in companies: with shareholders and executives

separated.

Similarly, in the case of mutual funds, people are not interested in the day-to-day management of the funds but

are interested in the final outcome of the investment. Hence, they pool their money together, hire an investment

manager who manages funds for them and expect to earn a return on them.

Interestingly, while the process started from the point of view of the investor and the fund was the outcome, in

today's time, it is hard to see the reality this way. With rampant (mis?)marketing of the mutual funds, it seems as

if the funds came in first and they want the investor money to increase their assets under management.

How do the funds raise money? 

The asset management companies (AMCs) that manage the mutual funds define avenues where they think

profitable opportunities exist. For example, currently many AMCs believe that small and medium cap stocks will

yield significant return over the medium to long term. Hence, they launch a 'fund' (called a new fund offer: NFO)

which seeks to bring all those investors together who believe similarly.

The AMC releases a prospectus wherein it details the objective of the fund, the credentials of the company and

the fund manager and the avenues where the money will be invested. Based on this information, the investor 

needs to decide whether this fund meets his objective or not. If the investor (or his advisor) believes that the new

fund fits his required risk-return profile, the investor invests in the fund.

You might wonder that you have never seen a prospectus but only an application form for investing. Well,

sometimes you give the authority to your financial advisor to choose what is best for you (and sometimes, when

you lose control, s/he just chooses on your behalf!)

Where do mutual funds invest? 

Mutual funds, unlike companies do not take the risk of a business directly. For example, Reliance faces the risk

of change in refining margins and Hindalco faces the risk of fall in aluminium prices. Companies take the risk

head-on and craft strategies to maximize their competitive position and profits.

Mutual funds, however, take one step back and invest in the companies which take on business risks. Funds

which invest in the shares (or equity) of the company are called 'equity mutual funds.' Funds like PruICICI Power 

or Reliance Growth are examples of such funds.

Similarly, funds can invest in government securities (bonds issued by central or state governments, PSUs or 

other government entities) or corporate debt (issued by companies and banks). These funds are called 'debt

funds.' Funds like Reliance Income Fund invest primarily in medium and long-tenor debt. Again, there are funds

that invest in very short term loans (typically overnight to up to three months): these funds are called money

market mutual funds. Examples include HDFC Cash Management - savings plan.

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While the above three are the basic avenues for the funds to invest, many funds combine the three types in

various proportions and produce 'hybrid or balanced funds.' HDFC Prudence and SBI [ Get Quote ] Magnum

Balanced are examples.

Based on where the funds invest, they expect returns and have corresponding risks. Equity funds are the most

risky followed by debt funds; cash funds are considered almost risk less. Based on the standard theory of finance, the riskiest funds are expected to deliver the highest returns over the long run.

In the next article, we will look at the various styles and themes on which mutual funds raise money.

Hi Guest

Mutual funds, demystified 

Part I: What are mutual funds? Where do they invest? 

We have seen the basic types of assets into which a mutual fund might invest: equity and debt, and how this

choice impacts the risk and return characteristics of the funds.

However, you would have noticed funds which have now evolved and try to provide you with more fine-tuned

products in a specialised niche. Equity funds, in particular, like to identify newer or better avenues of investment

and hence they create products around those new avenues.

Style of a mutual fund: 

Equity  

 An equity fund can invest in a large-cap, mid-cap or a small-cap stock. You might have heard these words being

thrown around rather liberally by all the new funds on offer. 'Cap' refers to market capitalisation (M-cap) of a

stock. M-cap is defined as the total market value of the equity of a company.

For example, if a company has 1,000 shares outstanding and the price of each share is Rs 20, the market value

of the total equity of the company is Rs 20,000 (1,000*20). To exemplify, the market capitalisation of Reliance [is

approx Rs 200,000 crore (Rs 2,000 billion), while that of Hero Honda is around Rs 15,000 crore (Rs 150 billion).

Large cap, hence, refers to companies which have a large market capitalisation (usually above Rs 5,000 crore).

Mid-cap refers to companies whose market value lies between Rs 1,000 crore to Rs 5,000 crore.

 Any company with market capitalisation of less than Rs 1,000 crore is called a small cap company. Now different

fund houses have different definitions of where a 'cap' ends and where the other begins but these are rough

bench-marks. One of the biggest selling points currently of the new fund offers is that the small cap companies of 

today will increase in value so much that they will become the next mid-cap or large-cap companies.

Looking at managing equities differently, we say that the fund manager may pick a growth or a value stock.

Growth companies are typically ones which are witnessing high amount of growth in their profits (due to growth in

underlying demand, increase in prices, new technology, etc).

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These firms command a valuation which is superior to firms with a lower growth potential. Value companies, on

the other hand, are in mature industries where they offer more stable cash flows and a reasonable valuation to

buy them. Note that in a market downturn, a growth stock can become a value stock if it is available cheap!

 A fund manager may decide to invest exclusively in growth or value stocks or in a combination of both.

Based on whichever style is chosen, the fund can be 'boxed' into the 3*3 matrix below:

Growth  Blend  Value Long

term 

Medium

term 

Short

term 

Large

Cap 

High

credit

quality 

Mid

Cap 

Medium

credit

quality 

Small

Cap 

Low credit

quality 

Debt  

Debt funds can similarly be classified in to long, medium and short tenor funds. While the definitions are flexible

again, long funds typically invest in instruments with maturity greater than 5 years, while short-term funds invest

in instruments with less than one year of maturity; medium-term funds invest in the 1-year to 5-year range.

Note that the longer the duration (roughly average maturity) of the investments, the more sensitive it is to interest

rate movements. Also remember that the price of bonds varies inversely with interest rates.

On the other axis, a debt fund can invest in high quality instruments like government of India [ Images ] bonds,

bonds issued by healthy PSUs, top-notch corporates, etc. It can progressively lower its investment quality by

investing in not-so-stable corporates or in fixed deposits of co-operative banks. The advantage of lowering credit

quality is higher expected returns (with the increased risk of default).

Based on whichever style is chosen, the fund can be 'boxed' into the 3*3 matrix above.

Theme of a mutual fund: 

 A mutual fund can create an investment philosophy around which it wants to invest. In India, this is typically seen

around equity funds. A theme serves both the parties: it provides the investor with a specific or new opportunity

while providing a new 'buzz' to the asset management company. Some of the themes are as follows:

y  Sector-specific investments: investment in companies of a particular sector, like pharma or banks or IT

y  Investments in a specific segment of the market: large-cap, mid-cap or small-cap

y  Investment in a specific asset type: real estate mutual funds will invest in property

y  Specific opportunity: The India Growth and Economic Reforms (TIGER) fund of DSPML plays on thisopportunity where they bet on companies that will benefit from either India's growth or general economicreforms or both.

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y  Tax-related investments: investment with a specified lock in and investing in equities to take advantageof tax incentives.

Styles and themes have their own risk-return profile which is more fine-tuned than the broad asset class. You

need to be careful when you choose the style or theme: ensure that these meet your risk-return requirement.

Dependent variable: it is depend upon scale of operation of an investor for eg. If the investor ishaving less amount of investment then he could go directly in to the cash market because the

brokerage charges and risk highly involved he can either go for mutual fund than into cash market

comparatively where big investor can enter into cash market as the scale of operation is high he can

allocate the funds in various sectors and can increase the probability of profits and low risk