What are Mutual Funds?


Mutual Funds have emerged as a major investment vehicle for Indian investors today. With an AUM of Rs.38 trillion and an equity AUM of more than one-third of the total corpus, mutual funds have surely come a long way. What exactly is a mutual fund and how do they fit into the investment structure in India?

Can you explain the concept of Mutual Funds for me?

A mutual fund is a vehicle to mobilize money from investors. The money collected is invested in equities, bonds, short term liquid instruments, gold etc to give the investors the benefit of growth, wealth creation, stability, regular income, liquidity or a mix of all. Every mutual fund scheme has an objective and its core purpose is to adhere to this objective. The objective in defined clearly in the memorandum of the fund and the trustee ensures that the fund adheres to the core principles laid out in the memorandum.

By investing in a mutual fund, an investor can get access to markets that may otherwise be unavailable to them and avail of the professional fund management services offered by an asset management company. The concept of mutual fund is based on the twin ideas of diversification of risk and professional management. Direct equity investing is limited by the size of your corpus and by collating funds from thousands of individuals, the mutual fund overcomes that problem.

What is the special role that Mutual Funds play in investing money?

Mutual funds perform different roles for the different constituents that participate in it. Here are some of the important roles played by them.

  • Primary role of the mutual fund is to assist investors in earning an income or building their wealth.
  • Mutual funds are flexible and can structure a scheme for different kinds of investment objectives. It can target needs like wealth creation, regular income, liquidity, tax efficiency, macro defence etc.
  • The money raised from investors helps the markets to get quality inflows, the investors to earn wealth and the market overall benefit by the surge in the equity cult among the investors.
  • Mutual funds also help companies raise funds through debt by investing in their debt instruments. This facilitates capital allocation and ensures that productive projects are able to get funds.
  • Mutual funds are in a better position to keep a check on the operations of the investee company, compared to individual investors due to their networks, size and market intelligence.
  • Mutual funds with their large corpus can play the role of stabilizing the volatility in the markets by bringing in the required stability. This is useful at times when there is panic in the market resulting in bouts of volatility.
  • But the most important role that mutual funds play is to create wealth for the investors and allows them to build a reasonable corpus over a period of time.

How exactly do Mutual Funds add value to investors?

There are some key advantages that mutual funds bring for investors. Here are a few of them encapsulated.

  1. Mutual funds offer investors the opportunity to earn an income or build their wealth through professional management of funds.
  2. Investing in equities will require managing multiple relationships such as broking, demat, banking etc. Mutual fund simplifies the process of investing and holding securities.
  3. Portfolio Diversification actually becomes affordable through mutual funds. You can buy into a diversified portfolio by investing as little as Rs.5000 in lump sum or as low as Rs.500 in an SIP.
  4. Investing in the units of a scheme provide investors the exposure to a range of securities held in the investment portfolio of the scheme in proportion to their holding in the scheme.
  5. Diversification of the portfolio ensures that the investor is less likely to lose money on all the investments at the same time. Thus, diversification helps reduce the risk in investment. Similar diversification is hard to achieve through direct equities.
  6. Mutual funds also bring economies of scale. Due to their sizeable corpus, the funds are able to get better pricing in the market. This ensures that costs are much lower in this case for the investor.
  7. Pooling of large sum of money from many investors makes it possible for the mutual fund to engage professional managers for managing investments. This brings expertise to the fund management process.
  8. Mutual funds give flexibility to investors to organize their investments according to their convenience. For example, you get a variety of choices like SIPs, SWPs, STPs, sweep facility etc that can customize investing to your specific needs.
  9. The problem of liquidity that can be a challenge in many stocks, especially mid cap stocks, is no longer an issue with mutual funds, since purchase and sale at NAV is assured by mutual funds.
  10. Mutual funds can also be tax efficient. The long term capital gains on equity funds are taxed at a concessional rate of 10% only above a threshold of Rs.1 lakh. ELSS funds can enhance post tax yield with the Section 80C exemption.

How is a Mutual Fund structured; is it like any other company?

Mutual funds have only one activity and that is to manage the collected money in the most efficient and effective manner. Mutual funds are designed as a trust to raise monies through the sale of units to the public for the purpose of investing in securities including money market instruments or gold, in line with a well-defined objective. There are some clearly demarcated units in a mutual fund like the sponsor, the AMC, the trustee etc. Let us look at the demarcation below:

  • Mutual funds are constituted as Trusts and are governed by the Indian Trusts Act, 1882. For example HDFC Mutual Fund is a trust.
  • The mutual fund trust is created by one or more Sponsors, who bring in the initial capital for the mutual fund business. HDFC is the sponsor of HDFC Mutual Fund.
  • The beneficiaries of the mutual fund trust are the investors who invest in various schemes of the mutual fund. The collectively become the beneficiaries.
  • The operations of the fund are governed by a Trust Deed executed between the sponsors and the trustees.
  • The role of protecting the interests of the beneficiaries (investors) is that of the Trustees and is governed by the Trust Deed. The role of trusteeship is performed through a duly constituted board of trustees.
  • Regular management of the schemes is handled by an Asset Management Company (AMC). The AMC is appointed by the sponsor or the Trustees e.g. HDFC AMC. The AMC acts within the power vested on it by the trustees.
  • Custody of the assets of the scheme (equity, bonds, structures, gold etc rest with the duly appointed Custodian. The custodians are also appointed by the Trustees.
  • The back-end record of investors and their unit-holding is given by the AMC to the Registrar & Transfer Agent (RTA), which also processes any corporate actions.

    Can you tell me about the role that sponsors of the Mutual Fund play?

    Having understood the broad structure of the mutual fund, let us look at the specific constituents in much greater detail. Here is what is expected of the Sponsors.

    • Sponsors must apply to the SEBI for registration of the mutual fund and subsequently they must invest in the capital of the AMC. Their eligibility criteria is both quantitative and qualitative.
    • The sponsor should have a sound track record and reputation of fairness and integrity in all business transactions and should be in financial services for a minimum 5 years.
    • Their operations should be profitable and the sponsor should have a positive net worth. Loss making units cannot float an AMC.
    • The sponsor should be a fit and proper person as defined by the law. In other words, they should not have been disqualified from operating in the capital markets.
    • Sponsors must contribute minimum 40% of the net worth of the AMC, although the balance can be raised from other sources.

    Can you tell me about the role that trustees of the Mutual Fund play?

    Trustees ensure that mutual funds comply with all regulations in the interests of unit-holders. Some of the conditions are as under:

    • Every trustee has to be a person of ability, integrity and standing and hence persons guilty of moral turpitude or persons convicted for violation of securities law cannot be appointed as trustees.
    • To avoid conflicts of interest, no officer or employee of an AMC shall be eligible to be appointed as a trustee. The same trustee cannot be trustee of multiple funds.
    • Sponsor will have to appoint at least 4 trustees subject to SEBI approval. Trustee companies must to have 4 directors on the Board of which 2/3rd are independent.
    • Trustees have the right to seek any information they require from the AMC. Trustees must also ensure systems are in place and such systems are regularly reviewed.
    • Trustees must ensure that all AMC transactions are in compliance and the interests of unit-holders are not compromised. Any divergence must be reported to SEBI immediately by the trustee, including fundamental changes in the scheme attributes.
    • On a quarterly basis the trustees shall review the transactions of the mutual fund with the AMC and its associates. They shall also review the net worth of the AMC on a quarterly basis and ensure that any shortfall is made up.
    • The trustees must routinely review the investor complaints and ensure redressal, protect trust property and ensure that auditor reports are adhered to. Trustees must also ensure half yearly reporting to SEBI.