Beginner's Guide on What is Fund Management, and it's Importance

What do we understand by fund management? Let us say, you have a corpus of Rs.5 lakhs or you have a monthly surplus of Rs.10,000. Either ways, you are in a position to invest money smartly, but you don’t know how to go about it. One way is to give the funds to a professional fund manager like a mutual fund or a portfolio manager to handle your money. These fund managers come with special skills and they handle your money with a lot of tools, techniques and a more scientific approach such that you get the best risk-adjusted returns over a period of time.

What are some of the big advantages of managing funds via mutual funds?

  • Mutual funds bring professional management to the table. With access to information and top-end analysis and supported by the services of fund managers, traders and analysts, mutual funds transmit the benefits of scientific investment to investors at a very nominal cost.

  • Mutual funds bring the benefit of diversification to your investments. For example, as an individual investor you will have limitations on the amount you can invest and the number of stocks you can buy. Mutual funds overcome the problem. By creating a centralized portfolio of quality equities, an equity fund gives an investor the benefit of diversification. This diversification across assets gives the investor the benefit of reduced risk in the market.

  • Mutual funds help you to build enormous wealth over the long term. In fact, the power of compounding works best with respect to equity mutual funds. Equity mutual funds are for the long term if you want to generate wealth and it can actually be a worry-free method of generating wealth over the long term.

  • Transparency is the biggest advantage with a mutual fund. For example, when you invest in a corporate bond or in a bank FD, you exactly do not know what the company or bank is doing with your money. In case of an equity mutual fund or a debt mutual fund, you have complete details of how every penny collected by the fund is invested, what is the actual worth of your fund each day and a monthly factsheet with provides a lot of analytical risk and return metrics.

  • Mutual funds are liquid. This is unlike your holdings in a company bond, company fixed deposit or even a bank deposit. You can liquidate mutual funds are short notice. While you get your equity funds money in T+2 days, your money in case of debt funds and money market funds will be credited on T+1 day itself.

  • Mutual funds are regulated by SEBI and that gives an additional level of comfort for the investor. Additionally, there is a board of trustees consisting of eminent people which ensures that interests of the mutual fund investors are adequately protected. Transparency is an added advantage for mutual funds.

  • From a financial planning perspective, mutual funds offer solutions for every need. Consider the following. Equity funds meet the need for growth while debt funds meet the need for stability with additional returns. Liquid funds meet the need for liquidity while ELSS funds met the need for tax planning. There are dedicated mutual funds which are focused on specific needs like retirement, children’s education etc. This makes the mutual fund product extremely flexible and amenable.

When you invest your funds in a mutual fund, a professional manager invests this pool of funds into various securities, debts, and related instruments as per set goals of the fund to reach the desired goal for the investor.

What exactly are active funds or active fund management?

At a very complex level, active fund manager is the search for alpha. Let us simplify this. When you invest in equities for example, you need to earn more than debt. That is obvious. You also need to earn more than the index like Nifty or Sensex as if that is not happening then you are better off investing in the index funds or index ETFs. Finally, you must also be compensated for the risk you take in the fund. If the fund manager is able to actively manage the funds in such a way as to earn more than all these limits, they are generating alpha for the investor.

Hence, the typical active fund manager will try to run the fund in such a way that they are able to outperform an index like the Nifty or Sensex or any other appropriate benchmark. For that you pay annual management fee, which is charged along with other management and administrative costs in the form of total expense ratio (TER).

Broadly there are 3 types of active funds available in the market.

  • The most common are the open-ended fund or unit trusts. The overall fund corpus is divided into units and investors are issued units against their invested funds based on the applicable NAV after adjusting for costs. Similarly, when such units are sold, then the units are redeemed and extinguished. Open ended active funds offer round the year purchase and sale at NAV linked price. They are also called unit trusts in UK, but in India they are more popular as open ended funds.

  • Then there are closed-ended funds, which are also actively managed. Let us understand what exactly is a closed ended fund. A closed-ended fund is mandatorily listed on the stock exchange as per SEBI regulations. That is because unlike an open ended fund, the closed ended fund does not offer continuous buying and selling at NAV linked prices. The corpus is fixed in closed ended fund after the initial New Fund Offer (NFO) of the closed ended fund. Then any purchase in the market is only possible if there is a seller. Similarly, sale in the market is only possible if there is a willing buyer. The structure of a closed ended is very different from an open-ended fund, but the two sorts of funds often invest in similar ways, buying and selling shares in other companies to outperform the index and give alpha, since they are active funds.

  • There are also interval funds that are a mix of open ended funds and closed ended funds. Such interval funds start off as closed ended funds with listing on the stock exchanges. However, over time, they offer continuous buying at regular intervals and then revert back to being closed ended. These funds are not too popular in India.

What are passively managed funds or passive funds

This brings us to passively-managed funds. You would have heard of index funds, index ETFs etc. These are passive funds or passive investments in the sense that the intent here is not alpha. The fund manager just tries to match the returns on the index like Nifty or Sensex. Since, this does not need too much of active management, the costs are much lower and that the cost differential between an active equity fund and passive index fund can be as high as 1.5% annually.

That means the index fund tends to do better than most of the funds in the market as active funds struggle to consistently beat the index. The only thing that passive fund managers have to do is to managing the tracking error and keep it to the bare minimum. That is the only challenge in passive funds. These passive funds are becoming quite popular in India over the last few years.

Comparing your goals to the investment objectives of the mutual fund…

We have seen previously that mutual funds are a very important and powerful tool to achieve your long term financial objectives like retirement, children’s education etc. One of the key things you need to understand about a mutual fund is the objectives of the fund, which is clearly enunciated in the fact sheet of the fund which is available for download on the fund website. Ensure that your goals and the fund objectives are in sync with one another. Here are a few examples of syncing your goals with fund objectives…

  • If your goal is long term wealth creation, then you should opt for a diversified equity fund that has diversified wealth creation as its objective

  • If your goal is short term liquidity, then you need to focus on a money market fund or a short term debt fund with an objective to focus on the short end of the maturity range of the term curve

  • If your goal is stability of returns, then you must focus on debt funds that can give stable alpha without taking undue risk

  • If your goal is maturity syncing over the next 3 years, then you should focus on a Monthly Income Plan (MIP) with an investment objective to keep the maturity profile of the MIP in sync with your liability maturity

How and when to invest in mutual funds?

There can be no hard and fast rules because mutual funds are not about timing the market but time in the market. Here are a few basic guiding principles…

  • It is always better to start early. The earlier you start investing in mutual funds the more time you have to enjoy the power of compounding.

  • You do not need to worry about timing the market. A better way is to opt for a systematic investment plan (SIP). Here time matters more than timing.

  • Do not look at your mutual fund investments in isolation. Look at them as part of your overall financial plan and ensure that your mutual fund investments sync with your long term goals.