In recent times, the complaint that mutual funds have underperformed and that they should at least do better than bank deposits, has grown louder. In a year when the second mutual fund in the country, after UTI, celebrates its 25th birthday, perceptions about what mutual funds are, and what they can do, continue to be erroneous. Investors should be aware of the key features of mutual funds before choosing this vehicle to build wealth.
Mutual funds are vehicles to invest in the securities markets. Every saver knows that there is a demand for his money from companies, government and banks. There are two primary ways to channel savings into productive investments. The first is a transactional arrangement, primarily structured as a loan transaction, and banks dominate this segment. A depositor gives a loan to a bank, which in turn lends to other borrowers.
The second is a market arrangement, where the entity that needs money issues a marketable security, such as an equity share or a bond, and the investor buys these securities in the market place at the market price.
A transactional arrangement, such as a bank deposit, is pre-defined, but is rigid. The investment has to be for a specific period, earns a predetermined return, and is not transferable. An investment in the market is more flexible, but is subject to fluctuations in value, based on the market factors. This is why mutual fund investments are subject to market risks. Choosing mutual funds requires the conscious choice and comfort in dealing with the opportunities and risks in the securities markets. Investing in the securities market offers two unique propositions to the investor.
First, the upside potential of the investment is not limited to a pre-specified rate. If an investment is made in the equity shares of a company, whose performance exceeds expectations since the shares were first issued, the appreciation in value is available to the investor. The returns from securities are not amenable to pre-definition or accurate forecast, and include both upside and downside.
Second, the downside risk in an investment is not managed on manifestation through the accounting system of provisioning, but through a transfer in the market place. A non-performing loan on a bank balance sheet is classified as such after the default, and is written off from the profits. This is the classical method of risk management. If a bond's price falls from Rs 100 to Rs 90 due to the possibility of a downgrade in its credit quality, a mutual fund may book the losses and get out of the investment.
However, a buyer, at Rs 90, might believe that the bond is cheap given his view on whether the downgrade may actually happen. The security market cares about expectations for the future and dynamically builds information in the price. Investing in a mutual fund, therefore, requires a modification in expectations about risk and return. This is also the reason that the NAV of a mutual fund fluctuates, reflecting the current market price of the securities it holds.
If we define mutual funds as vehicles to access the securities market, what is the value addition for an investor who can access the market directly? What if he buys a few shares and bonds directly through the broker? It is true that investors can trade in the stock market using electronic platforms, buy equity shares in an IPO, or purchase bonds when they are offered by issuers. Mutual funds are useful only if the investor believes that building long-term wealth through investing requires a formal process.
Uma Shashikant
Mutual funds are vehicles to invest in the securities markets. Every saver knows that there is a demand for his money from companies, government and banks. There are two primary ways to channel savings into productive investments. The first is a transactional arrangement, primarily structured as a loan transaction, and banks dominate this segment. A depositor gives a loan to a bank, which in turn lends to other borrowers.
The second is a market arrangement, where the entity that needs money issues a marketable security, such as an equity share or a bond, and the investor buys these securities in the market place at the market price.
A transactional arrangement, such as a bank deposit, is pre-defined, but is rigid. The investment has to be for a specific period, earns a predetermined return, and is not transferable. An investment in the market is more flexible, but is subject to fluctuations in value, based on the market factors. This is why mutual fund investments are subject to market risks. Choosing mutual funds requires the conscious choice and comfort in dealing with the opportunities and risks in the securities markets. Investing in the securities market offers two unique propositions to the investor.
First, the upside potential of the investment is not limited to a pre-specified rate. If an investment is made in the equity shares of a company, whose performance exceeds expectations since the shares were first issued, the appreciation in value is available to the investor. The returns from securities are not amenable to pre-definition or accurate forecast, and include both upside and downside.
Second, the downside risk in an investment is not managed on manifestation through the accounting system of provisioning, but through a transfer in the market place. A non-performing loan on a bank balance sheet is classified as such after the default, and is written off from the profits. This is the classical method of risk management. If a bond's price falls from Rs 100 to Rs 90 due to the possibility of a downgrade in its credit quality, a mutual fund may book the losses and get out of the investment.
However, a buyer, at Rs 90, might believe that the bond is cheap given his view on whether the downgrade may actually happen. The security market cares about expectations for the future and dynamically builds information in the price. Investing in a mutual fund, therefore, requires a modification in expectations about risk and return. This is also the reason that the NAV of a mutual fund fluctuates, reflecting the current market price of the securities it holds.
If we define mutual funds as vehicles to access the securities market, what is the value addition for an investor who can access the market directly? What if he buys a few shares and bonds directly through the broker? It is true that investors can trade in the stock market using electronic platforms, buy equity shares in an IPO, or purchase bonds when they are offered by issuers. Mutual funds are useful only if the investor believes that building long-term wealth through investing requires a formal process.
Uma Shashikant
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