Once upon a time all small businessmen from a particular city were having their monthly meeting. This Merchant Association used to have such regular meetings to discuss the common problems faced by the members.
The problem in hand today was that each of them had small cash daily but did not know how to make best use of it by investing it. The money was so small individually that none of the scheme accepted that money as investment. The Merchants association decided to form a Committee of 5 members who would solve this problem.
In the next monthly meeting, the committee proposed the solution. Let us combine/pool the money, and invest this money and return shall be divided as per the proportion of investment. All members welcomed the idea. What an idea Sirji, but where would you invest the money? The group had some knowledge that money will give good returns, if invested in shares but had a faint idea about equity investment. Someone suggested lets lend the money to someone and earn interest on it. But overall no one had the knowledge, so they decided to contact a wise man in the city who is well versed in the field of investments. So this, Wiseman accepted the challenge and came to the meeting next month.
But some members had doubts on this idea. Firstly, who would keep a check on the wise man and how they know that their investment is making money or running loses. The concerns were genuine and again the committee started thinking. They came out with the general rules on investing the money. The Wiseman had to take a prior approval from the committee before investing and a few other rules on managing the money. But second concern still remained, which was solved by the wise man himself. He said each day I would calculate and declare the value of investment.
The scheme was launched and it was an instant hit. The news spread to all parts of country. People from other merchant associations were also allowed to join. Soon the committee realized that they had to manage the record of so many people and solve their queries. They appointed a team of literate people and called it Record Keeping Team whose job was to keep the record of the investors and handle the investor queries. Similarly a team was appointed to assist the wise man in ensuring the safe custody of shares and other investments.
Till now, the merchant association was handling all the related jobs and paying salaries. But now that the scheme is a hit, the association told the committee to charge a fee from the investment to pay for the wise man and the other team members. This was a good idea. The committee laid rules for charging the fees on the investments. All the participants benefited in the long term through this collective investment.
This is exactly how a mutual fund works. Let us see it in detail:
In the above story the members of the association are the investors like us, and the Committee is the Asset Management Company (AMC), who runs the entire affairs of the mutual fund. Since this committee is appointed and answerable to the Merchant association, the Association is the Sponsor of the Mutual Fund. The wise man appointed, is the Fund Manager. The Rules laid are nothing but Objectives, which are set for each schemes and the basic guidelines about the investment made under the scheme. The Value of investment that the wise man is reporting is helpful in calculating the Net Asset Value (NAV). NAV is the unit value of the asset and is calculating by dividing the net assets by the numbers of unit holders. The Record Keeping Team is Registrar & Transfer Agent. And finally, the team appointed for ensuring safe custody of investments is called the Custodian, who shoulders the responsibility of keeping records and possession of all the physical asset of the scheme. And fees that the scheme is charging are called the Asset Management Fees.
This is how a Mutual Fund company works.
Benefits of investing in Mutual Fund
The biggest advantage is the Diversification. Each units holder contributing in small proportion becomes the owner of a large portfolio comprising of different assets. He therefore minimizes his risk by dividing his investments in many securities.
Other advantages are, though mutual fund you get expert management of your investment. Also you can invest in small amounts. Since this is a collective investment, the cost of management is very low and most important the liquidity aspect. Mutual Funds have schemes as per the time horizon of your investment. So you can get money back when the need arises.
You can invest a fixed amount regularly (SIP) and save for your long term goals. This concept of Rupee Cost Averaging will help you in averaging your cost of purchase and has given good returns historically.
Taxation point of view also, mutual funds scores over other investments. Profits from sale of equity mutual funds after one year from the date of purchase are considered as long term capital gains and are tax free. So, this is wonderful investment for long term wealth creation.
There are n numbers of mutual funds in the market to confuse the investors. Some of the oldest funds in India have given CAGR of 22% for the last 15 years!
How to select good funds? We will cover this issue in the next article.