Saturday, November 15, 2008

Drawbacks of Mutual Funds:

Inspite of all the advantage the MFs provide, there are still certain points the investor needs to keep in mind before taking the decision to invest.

· Management Risk

By investing in MFs, investors need to depend on the fund managers to make the right decisions regarding the fund's portfolio. If the manager does not perform well, then the investments may not generate as much returns as expected. Thus, investors lay at the discretion managers.

· Costs Involved

For an AMC, the main source of income is the entry and exit load which they charge from investors. Also, funds do normally change administrative fees to cover their day-to-day expenses.

· Dilution

As the funds have small holdings across different companies, high returns from a few investments often don't make much difference on the overall return.

Advantages of Investing in Mutual Funds

Mutual funds provide a great deal of advantages as an investment avenue. They make saving and investing simple, accessible and affordable. MFs present an attractive investment option over direct equity. MFs provide an attractive and simple way of tapping the potential of various investment options like equity, debt and money market investments.

Fig. 1.12 Advantages of investing in Mutual Funds

Some of the advantages of investing in MFs are:

· Professional management

While a single individual may not be able to afford the advantages of a professional fund manager, it becomes one of the main advantages enjoyed by mutual fund investor who enjoy the services of experienced and professional fund managers who manage the portfolio of securities on a full time basis and decide which securities to be bought and sold based on extensive research.

· Diversification

Mutual Funds help provide diversification of investments which help to reduce the risk an investor by investing in single security. MFs provide diversification to an investment portfolio by holding a wide variety of securities. It provides the opportunity to invest in many markets and securities.

· Variety

With a variety of scheme available, investors can very specifically select the stock, bond or money-market funds they would like to invest in considering their investment objective and risk taking capacity. It offers different types of schemes to investors with different needs and risk appetites. Investors now have the opportunity to invest in many markets and securities. And also they can select funds based on their investment objective, i.e., whether they want regular income or capital appreciation or liquidity.

· Low Cost

MFs involve investments by a large number of investors because of which they are able to provide the benefits like diversification and professional management at a fraction of cost of making such investments independently. They involve buying and selling large amounts of securities at a time thus helping to reduce the transaction cots and bring down the average investment cost per unit, thereby helping in achieving economies of scale.

· Liquidity

Liquidity is the ability to readily access your money in an investment. MFs provide the benefits of liquidity as they have the ability to get in and out with relative ease. Investors are able to sell their MFs in a relatively short period of time without there being much difference between sale price and market price.

· Simple

Investment in MFs is considered to be simple as compared to other available instruments in the market. The minimum investment is also considered to be affordable.

· Tax Benefits

MFs also seem to be an attractive investment avenue to many because of the tax benefits they provide. Dividends declared by MFs are tax free in the hands of investor.

Benefits of Mutual Funds

· Affordability A mutual fund invests in a portfolio of assets, i.e. bonds, shares, etc. depending upon the investment objective of the scheme. An investor can buy in to a portfolio of equities, which would otherwise be extremely expensive.

· Diversification It simply means that one must spread their investment across different securities (stocks, bonds, money market instruments, real estate, fixed deposits etc.) and different sectors (auto, textile, information technology etc.). This kind of a diversification may add to the stability of returns.

· Variety Mutual funds offer a tremendous variety of schemes. It offers different types of schemes to investors with different needs and risk appetites and it offers an opportunity to an investor to invest sums across a variety of schemes, both debt and equity.

· Professional Management When one person buys in to a mutual fund, they are handing their money to an investment professional that has experience in making investment decisions.

· Regulations Securities Exchange Board of India (“SEBI”), the mutual funds regulator has clearly defined rules, which govern mutual funds. These rules relate to the formation, administration and management of mutual funds and also prescribe disclosure and accounting requirements. Such a high level of regulation seeks to protect the interest of investors.

· Liquidity In open-ended mutual funds, one can redeem all or part of their units any time they wish. Some schemes do have a lock-in period where an investor cannot return the units until the completion of such a lock-in period.

· Convenience An investor can purchase or sell fund units directly from a fund, through a broker or a financial planner. The investor may opt for a Systematic

investment Plan or a Systematic Withdrawal Advantage Plan.

· Flexibility Mutual Funds offering multiple schemes allow investors to switch easily between various schemes. This flexibility gives the investor a convenient way to change the mix of his portfolio over time.

· Transparency Open-ended mutual funds disclose their Net Asset Value (“NAV”) daily and the entire portfolio monthly. This level of transparency, where the investor himself sees the underlying assets bought with his money, is unmatched by any other financial instrument. Thus the investor is in the know of the quality of the portfolio and can invest further or redeem depending on the kind of the portfolio that has been constructed by the investment manager.

History of Mutual Fund Industry in India

The origin of mutual fund industry in India is with the introduction of the concept of mutual fund by UTI in the year 1963. Though the growth was slow, but it accelerated from the year 1987 when non-UTI players entered the industry.

In the past decade, Indian mutual fund industry had seen dramatic improvements, both quality wise as well as quantity wise. Before, the monopoly of the market had seen an ending phase; the Assets under Management (AUM) were Rs. 67bn. The private sector entry to the fund family raised the AUM to Rs. 470 billion in March 1993 and till April 2004; it reached the height of 1,540 bn.

Putting the AUM of the Indian Mutual Funds Industry into comparison, the total of it is less than the deposits of SBI alone, constitute less than 11% of the total deposits held by the Indian banking industry.

The main reason of its poor growth is that the mutual fund industry in India is new in the country. Large sections of Indian investors are yet to be intellectuated with the concept. Hence, it is the prime responsibility of all mutual fund companies, to market the product correctly abreast of selling.

The mutual fund industry can be broadly put into four phases according to the development of the sector. Each phase is briefly described as under.

First Phase - 1964-87

Unit Trust of India (UTI) was established on 1963 by an Act of Parliament. It was set up by the Reserve Bank of India and functioned under the Regulatory and administrative control of the Reserve Bank of India. In 1978 UTI was de-linked from the RBI and the Industrial Development Bank of India (IDBI) took over the regulatory and administrative control in place of RBI. The first scheme launched by UTI was Unit

Scheme 1964. At the end of 1988 UTI had Rs.6, 700 crores of assets under management.

Second Phase - 1987-1993 (Entry of Public Sector Funds)

Entry of non-UTI mutual funds. SBI Mutual Fund was the first followed by Canbank Mutual Fund (Dec 87), Punjab National Bank Mutual Fund (Aug 89), Indian Bank Mutual Fund (Nov 89), Bank of India (Jun 90), Bank of Baroda Mutual Fund (Oct 92), LIC in 1989 and GIC in 1990. The end of 1993 marked Rs.47, 004 as assets under management.

Third Phase - 1993-2003 (Entry of Private Sector Funds)

With the entry of private sector funds in 1993, a new era started in the Indian mutual fund industry, giving the Indian investors a wider choice of fund families. Also, 1993 was the year in which the first Mutual Fund Regulations came into being, under which all mutual funds, except UTI were to be registered and governed. The erstwhile Kothari Pioneer (now merged with Franklin Templeton) was the first private sector mutual fund registered in July 1993.

The 1993 SEBI (Mutual Fund) Regulations were substituted by a more comprehensive and revised Mutual Fund Regulations in 1996. The industry now functions under the SEBI (Mutual Fund) Regulations 1996.

The number of mutual fund houses went on increasing, with many foreign mutual funds setting up funds in India and also the industry has witnessed several mergers and acquisitions. As at the end of January 2003, there were 33 mutual funds with total assets of Rs. 1, 21,805 crores. The Unit Trust of India with Rs.44, 541 crores of assets under management was way ahead of other mutual funds.

Fourth Phase - since February 2003

This phase had bitter experience for UTI. It was bifurcated into two separate entities. One is the Specified Undertaking of the Unit Trust of India with AUM of Rs.29,835 crores (as on January 2003). The Specified Undertaking of Unit Trust of India, functioning under an administrator and under the rules framed by Government of India and does not come under the purview of the Mutual Fund Regulations.

The second is the UTI Mutual Fund Ltd, sponsored by SBI, PNB, BOB and LIC. It is registered with SEBI and functions under the Mutual Fund Regulations. With the bifurcation of the erstwhile UTI which had in March 2000 more than Rs.76,000 crores of AUM and with the setting up of a UTI Mutual Fund, conforming to the SEBI Mutual Fund Regulations, and with recent mergers taking place among different private sector funds, the mutual fund industry has entered its current phase of consolidation and growth. As at the end of September, 2004, there were 29 funds, which manage assets of Rs.153108 crores under 421 schemes.

Technical Aspects

Technical Aspects

With the plethora of schemes to choose from, the retail investor faces problem in selecting funds. Worldwide, good mutual fund companies over are known by their AMCs and this fame is directly linked to their superior stock selection skills. For mutual funds to grow there must be some performance indicator that will reveal the quality of selection of various AMCs.

While searching and selecting the mutual funds, the investor should also take into account both the quantitative and qualitative aspects, although the qualitative side is important, an investment consultant will ultimately use same quantitative measure such as ratio, statistics or risk adjusted measure of performance to validate the qualitative component of search and selection.

Factors such as investment strategy and management style are qualitative, but the funds record is an important indicator too. Though past performance alone cannot be indicator of future performance, it is, frankly, the only quantitative tool to adjudge how good a fund is at present.

However, return alone cannot serve as the sole criteria of being the measurement of performance of a mutual fund scheme; it is equally important to consider the risk taken by fund manager to measure whether the risk taken have paid off adequately or not.

Risks associated with a fund:

The risks associated with a fund could be defined based on the fluctuations of the returns generated by it. The higher the fluctuations in returns, in a given period, the higher the risks associated with it. These fluctuations are results of two forces:

i. General market fluctuations, which affects all the stocks in the market. This can be called as market risk or systematic risk.

ii. Risks associated with the stocks in the portfolio of a fund. This is called unsystematic risk.

A fund manager could reduce the unsystematic risk by diversifying the investments. Systematic risks, on the other hand, cannot be reduced and is dependent on the macro economic factors.

Sharpe Ratio

A ratio developed by Nobel laureate William F. Sharpe to measure risk-adjusted performance. The Sharpe ratio tells us whether a portfolio's returns are due to smart investment decisions or a result of excess risk. This measurement is very useful because although one portfolio or fund can reap higher returns than its peers, it is only a good investment if those higher returns do not come with too much additional risk. The greater a portfolio's Sharpe ratio, the better its risk-adjusted performance has been.

A variation of t
he Sharpe ratio is the Sortino Ratio, which removes the effects of upward price movements on standard deviation to measure only return against downward price volatility.

It is calculated by subtracting the risk-free rate - such as that of the 10-year U.S. Treasury bond - from the rate of return for a portfolio and dividing the result by the standard deviation of the portfolio returns.

The Sharpe ratio is calculated as follows:

Sharpe Ratio=

The ratio is subject to certain limitations. It does not serve as an absolute measure but relatively does well. It gives no meaningful information on its own, but it is useful to rank and compare MFs that are being evaluated for investment.

Measures of Risk-Return

Since risk is inherent to the investment process, mutual fund investors must be adequately and consistently rewarded for the risks they assume. Prudent research means searching for fund managers who consistently produce returns justifying the risks they have taken. This can be justified with the help of Risk- Return Ratio.

The Risk- Return Ratio is a measure of the relation between the risks inherent in a position compared to its potential gain. It is a key factor which helps in deciding where an investor should invest by estimating which funds provide greatest amount of return with the least amount of risk.

The idea is to measure the rate of return achieved by a fund relative to the amount of risk taken en-route. By using this risk-return relationship, we try to compare the comparative strength of the mutual fund in a better way.

This project therefore attempts to study a few statistics which makes it possible to more precisely quantify the relationship between risk and return. These measurements help determine:

Ø A funds volatility (Standard Deviation)

Ø How closely a fund mirrors a particular market index (R2)

Ø How volatile a fund is compared with that market index (Beta)

Ø How much of funds risk- adjusted return is created by a talented manager (Alpha)

Ø Excess return for each unit of risk taken by the fund (Sharpe Ratio)

Ø Excess returns a fund generates for each unit of market risk it takes (Treynor Ratio)

Ø Skill of fund manager (Information Ratio)

Ø Added value that depends on the relative risks of the funds (M2)

Ø Excess return per unit of risk based on downside semi-variance (Sortino Ratio)


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