• Definition: A mutual fund (MF) is a collective investment vehicle that pools money from investors and invests the same on their behalf (in, bonds, stocks, short-term money market tools, and other securities) as per the stated objective. The returns are fully passed on to the investors after deducting the actual expenses (incurred in the fund management process) and also the fund management charges permissible by law.
  
• Short History: Unit Trust of India (UTI) was the first MF in India, established by an act of parliament in 1963 and its first launch - the Unit Scheme 1964 was extremely popular with investors. Then, other public sector entities like SBI (the first non-UTI Mutual Fund); LIC etc. commenced their operations from 1987. It was only in July 1993 that the first private sector Mutual Fund - Kothari Pioneer - set shop in India. It was also in 1993 that the first Mutual Fund regulations were put in place, and subsequently, replaced with a more comprehensive regulation in 1996.
• Performance in India: During the initial phase, the mutual fund industry in India did not perform well, but then it grew by leaps and bounds over the years with about Rs. 8 lakh crore of assets under management and 37 fund houses as of December 2009. Today, the plethora of mutual fund houses offers investors a variety of products to meet their diverse and evolving needs.
  
  

The typical architecture of Indian Mutual Fund is depicted below:

• Sponsor: This is the entity that sets up the MF business in India. This could be a bank or any other financial institution, either Indian or foreign. Strict eligibility criteria like net worth, experience, track record, etc. are stipulated by the market regulator, the Securities and Exchange Board of India (SEBI), for initiating a MF.
• Trust: The sponsor establishes a trust under the Indian law that takes responsibility of investors' funds and their interests. Trustees oversee the functioning of the fund and ensure that the unit holders' interests are protected and they get their due returns. Sometimes, the sponsor and the trustee are the same entity.
• Asset Management Company (AMC): This entity carries out the day to day activities of managing investors' funds and functions within the framework set up by the trustees in line with the regulation. Expert fund managers take investment decisions and deploy investors' money according to the stated mandate and objectives of the scheme.
• Custodian: This entity has the responsibility of holding investors' physical and financial assets on their behalf and to perform the transactions initiated by the AMC. These transactions can be receipt and delivery of securities, income collection, dividend distribution, etc.
• Bankers: They perform the normal money handling activities like collecting investors' funds, paying for the investments made, collecting sale proceeds of assets, making redemption and dividend payments to investors, etc.
• Transfer Agents: This entity keeps detailed records about investors like their personal details, transactions, current holdings etc on behalf of the AMC. All transactions like purchase, redemptions, and dividend payments are processed by these agents on behalf of the AMC.
• Distributors: These may be individuals, banks or other financial institutions which act as the bridge between the MF house and investors. They perform the function of selling the schemes to the investors and providing them with related services.

The Net Asset Value (NAV) indicates the current worth of a unit of a particular scheme. The face value of units is usually Rs. 10 and the NAV could be higher or lower than this, depending upon the performance history of the scheme.

NAV is calculated as below:

• Open-Ended Funds: These funds are open for purchase and redemption (selling back to the MF) on any working day at the prevailing NAV. These schemes do not have any specific maturity but will continue to function as long as the investors and the AMC desire so. These schemes are highly liquid and investors can access their funds within a short time span.
• Close-Ended Funds: As the name implies, these schemes have a fixed tenure and are usually traded on the stock exchange, in the interim, to provide liquidity. Units are issued by the MF only at the time of the New Fund Offer (NFO) after which the units may be bought and sold only on the stock exchange at the prevailing market prices. On the date of maturity, the units are redeemed with the MF, at the prevailing NAV.

• Growth Funds: The main objective of growth funds is capital appreciation. These funds invest in stocks of companies which have a sound background and offer good future prospects. These funds tend to be relatively more volatile as they have a higher exposure to equity. These are suitable for investors with a higher risk appetite and longer investment horizon.
• Income Funds: These funds invest in fixed income debt instruments, predominantly government securities and hence are relatively less volatile than growth funds. These are suitable for investors with a lower risk appetite and relatively shorter investment horizons. Income funds seek to attain current income over capital appreciation.
• Balanced Funds: These funds invest some of their assets in debt and another portion in equities. True to their name, they try to balance return and risk considerations. These are suitable for investors with moderate risk appetites and medium term investment horizons.
• Fund of Funds (FoF): These funds invest their assets in other MF schemes, either within their own family or in other fund houses to seek better diversification. They take over the investor's task of conducting a study on various MF offerings by investing on their behalf in well researched schemes, as mandated by the objective of the scheme.

There are also schemes like pension plans, children plans etc that cater to a specific investment objective. These are usually hybrid schemes with assets allocated to debt and equity in varying proportions to suit the objective.

• Debt Mutual Fund: These funds invest in a range of fixed income instruments like government securities, corporate bonds, debentures, commercial papers, treasury bills etc. These are less volatile and offer capital preservation along with regular returns.
• Gilt Mutual Funds: These invest chiefly in government securities and treasury bills, thus, eliminating credit risk from the portfolio. Depending on individual investment prospects, one can choose between long-term and short term gilt funds.
• Liquid or Money Market Funds: These funds invest in securities of very short duration (typically 90 days) and thus are very liquid with a lower risk of capital erosion. These funds act more like temporary parking spaces for investors' funds.
• Floating Rate Funds: These funds are designed to eliminate interest rate risks as the underlying portfolio consists of floating rate bonds and interest rate swaps. Hence, there is low volatility in returns as there is no capital gain or loss on the underlying bonds when the market interest rate varies.
• Monthly Income Plans (MIP): These are debt oriented funds which have the freedom to invest a minor portion (typically 15 to 25 per cent) of their assets in equities. They are, therefore, relatively at a higher risk than plain debt funds but with a higher return potential. MIP investors can choose a regular income option where dividends are paid out to them on a monthly, quarterly, half-yearly or annual basis. A growth option is also available, where dividends are not paid out, but are accumulated in the form of capital appreciation.

Equity based Mutual Funds come in a variety of flavours to suit diverse investor profiles as enumerated below:

• Equity Diversified Funds: These funds are free to invest in any sector or across any market capitalisation. The MF uses its discretion to allocate assets in proportions it deems best at that point in time. There are no restraints on where the fund can invest in the equity universe and the fund manager has the freedom to make investment decisions.
• Sector Funds: These funds invest only in sectors specified by the mandate of the scheme. The investor has to take a call on whether he wants to invest in that sector. These are relatively higher risk investments than diversified funds.
• Index Funds: Such funds seek to simply replicate the performance of an equity index and are hence also called tracker funds. The advantage of these schemes is their lower management cost and index hugging returns.
• Exchange Traded Funds (ETFs): These are funds that can be bought or sold only on a stock exchange through a stock broker like any other share. These funds are passively managed at present in India though actively managed ETFs are available abroad. These funds have the lowest management cost and lowest tracking error (which denotes the difference in returns between the scheme and its underlying index).
• Tax-Saving Schemes: An investment of up to ` 1 lakh in these schemes is eligible for a tax deduction under section 80C of the Indian Income Tax Act 1961. These funds have a lock in period of three years, during which the fund cannot be redeemed. After this lock in period, the fund may be redeemed or switched any time. Even the reinvested dividends of this scheme are subjected to the lock in.
• Global Funds: Funds that have the freedom to invest in any country are known as global funds. These funds enable geographical and currency diversification for investors. These come with a higher risk than domestic funds due to regulatory, political and currency risks of investing abroad and hence are suitable only to relatively sophisticated investors who already have sufficient exposure to the domestic market.
• Market Capitalisation Based Funds: These funds invest only in stocks of the identified market capitalization range, as defined by the fund mandate. The stocks listed on a stock exchange may be classified as large, medium or small capitalization based on the aggregate market value of all the shares of that company. There is no common criterion for such a classification and each market participant uses its own criteria. While large cap stocks are highly liquid and hence less risky, small and medium stocks are more volatile due to limited liquidity and the basic nature of their shares.

Mutual funds are an attractive investment avenue as they offer a number of advantages to investors as enumerated below:

• Affordability: As mutual funds are available in units, one can initially opt for a regular investment plan contributing few hundred rupees per month.
• Professional Management: A mutual fund offers the expertise of professional fund managers who, with their skills and knowledge, are able to understand market trends and invest accordingly.
• Diversification: Rather than investing in one or a few instruments, a mutual fund invests in a basket of instruments which matches its investment objective. For instance, in case of an equity diversified fund, the investment is spread across multiple industries / sectors and companies. As a mutual fund investor, you are able to access a diversified investment portfolio with a sum of as little as Rs. 500, which would otherwise not be possible.
• Convenience and Flexibility: Mutual fund operations like purchase, redemptions, switching between funds of the same fund house, etc. are relatively simple. Moreover, Mutual funds offer you the flexibility of tailoring your investment program with facilities like Systematic Investment Plans (SIPs), Systematic Transfer Plans (STPs) and Systematic Withdrawal Plans (SWPs) explained later.
• Cost Effectiveness: Economies of scale, achieved by pooling of investors' funds, lowers the costs of investing for an investor. Such lower costs make a huge impact cumulatively over longer time horizons.
• Liquidity: Mutual fund units are highly liquid, since open ended funds may be redeemed with the Mutual fund on any working day and closed ended funds may be sold in the market at the prevailing prices. Only tax saving and some close ended funds have lock in periods.
• Tax Efficient: Mutual funds offer better tax benefits as compared to many other investment avenues.
• Transparency: Mutual Funds are legally bound to disclose their portfolios at periodical intervals which keep the investor fully informed of where his money has been invested. Moreover, all the mutual funds are registered with SEBI, a regulatory body which ensures that the investors' interests are protected.

The following criteria are useful in selecting Mutual fund schemes to suit your requirement.

• Your Investment Objective and Time Horizon: Investment objectives may be categorized as capital appreciation or income generation or a combination of the two. Investment horizon may be also categorized as short, medium or long term. The following illustration shows how they influence fund selection.
  
  

  	Predominant Objective	Desirable Investment Horizon	Risk	Income Generation
  Debt Oriented Schemes	Preservation of Capital and Income Generation	Up to 1 Year	Low to Medium	Good
  Hybrid schemes	Income Generation in both Debt and Equity Securities	1 to 2 Years	Medium to High	Depends on Scheme
  Equity Oriented Schemes	Growth of Capital	2 to 3 Years	High	Uncertain

• Your Risk Appetite and Tolerance: Risk appetite refers to your willingness to take risks and risk tolerance refers to your capability to take on risks depending on your financial situation and personal circumstances. The above visual depicts the risk grade of various schemes.
• Fund Manager's and Scheme's Track Record: It is important that the scheme has a good track record, for a period of about 2 to 5 years, in order to merit your consideration. The fund manager’s reputation also matters; one should be certain about the background of a mutual fund before investing into it. However, remember that a good track record in no way guarantees future performance of the scheme.
• Cost Factor (Expense Ratio): Expense ratio refers to the proportion of a fund's assets that is consumed in managing it. Thus, the lower the expense ratio, the better it is for investors.

• Dividend Payout: The returns realised by the funds are periodically paid out to investors in the form of dividends. There is, however, no guarantee on the quantum or frequency of dividends declared by Mutual fund. This option is suitable for investors seeking a cash flow.
• Dividend Reinvestment: The declared dividend is ploughed back into the scheme and the investor is compensated for this dividend by way of additional units. This option is suitable for investors seeking compound returns.
• Growth: There is no dividend declared by the scheme and the return generated by the fund is fully reflected in its NAV.
• Bonus: The return generated by the fund is distributed to the investors in the form of bonus units.

The performance of a Mutual fund scheme may be compared on objective or subjective parameters as explained below:

• Objective Parameters: These are quantitative parameters capable of numerical interpretation. Some of them are:
  • Returns: The returns achieved by a scheme over varying periods can be compared with those of its peers or its benchmark. But care needs to be taken to check that the benchmark is appropriate to the scheme and that the peer group consists of schemes with similar investment objectives, asset allocation etc.
  • Risk Metrics: Certain statistical measures like Beta, the Sharpe ratio, Treynor ratio, Jensen ratio, Information ratio, Sortino ratio, etc facilitate comparison of fund performances on a risk adjusted basis.
• Subjective Parameters: These are qualitative factors like service standards, transparency, style, integrity, etc., which need to be judged on a subjective basis.
• Information Sources: Websites of fund houses, third party websites, newspapers, dedicated magazines etc provide excellent information for investors to evaluate Mutual fund performance. There are even specialist agencies which provide professional evaluation on a chargeable basis.

• SIP: Systematic Investment Plan - This is a facility offered by a Mutual fund scheme which enables you to make automatic investments of fixed amounts at fixed intervals, which could be monthly or quarterly. The payment could be made by post dated cheques, ECS or direct debit to bank account.
• SWP: Systematic Withdrawal Plan - Through this facility you can make automated withdrawals of fixed amounts at monthly or quarterly intervals. The benefit of this provision is that even after the investor withdraws an amount regularly, the balance remains invested and obtains further returns.
• STP: Systematic Transfer Plan - This is a combination of an SIP and SWP which allows you to transfer fixed amounts at periodical intervals (daily, weekly, monthly or quarterly) from one scheme to another of the same fund house. Usually it is done between a debt and an equity scheme or vice-versa.