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Introduction to Mutual Funds – Benefits of Mutual Funds

Article Number 2 in the Mutual fund series (For the previous article click here)

In the previous article I had given a brief introduction to mutual funds.  As a brief recap we had seen that mutual funds basically pool money from many investors and invest that money in shares, bonds, money market instruments, commodities like gold, among other things. In this article lets continue from there and see the various benefits that mutual funds have to offer. I will list the various benefits as points so that it would be easy for you to follow.

1) Professional Management

First and foremost, as I said in the previous article, mutual funds are managed by a professional money manager so you can basically find some comfort in knowing that whoever is managing your money is a professional and knows what he is doing. The manager does research with due diligence and only then makes a decision whether it be to buy/sell shares in a company or to invest in corporate bonds of a company or be it to invest in government bonds or to just sit tight in cash.

2) Diversification (Depends of the type of Mutual Fund)

Typically mutual funds don’t invest all their money into one stock or bond. They rather diversify by buying shares, bonds etc of various fundamentally strong companies. As a rule of thumb, diversification helps to decrease the risk. The more diversified the investment portfolio the less risky it is. However though all mutual funds diversify their investments to some extent the degree of diversification varies a lot and depends on the objectives of the mutual fund.

Imagine you invest in a sectoral mutual fund which focuses say, on the banking sector (that is the fund comprises of shares of various banks) while there is diversification in the sense that the fund comprises of investments in many banks the diversification is somewhat misleading. If there were to be some problem in the economy, say as the ongoing European sovereign debt crisis or the previous sub-prime mortgage crisis, all the banks are more or less affected and the mutual funds NAV decreases even though its diversified.

3) Lower Costs (Again Mutual Fund specific)

Imagine you wanted to diversify your investment and hence planned to buy shares of the top 30 to 50 companies in your country. (Say like the Dow Jones Industrial Average in the US or the Nifty/Sensex in India). How would you go about doing that? It would be quite expensive and would require a large outflow of money.

However mutual funds make that easy. By spending just $50 (or say Rs 100 in India) you can get the benefits of diversifying in 30-50 companies by investing in index funds.

It must be noted here that actively managed funds cost a lot more than passive index funds and might actually be detrimental to you. (More on that in the next article on disadvantages of mutual funds)

4) Convenience

Investing in shares via mutual funds is also very convenient as you don’t have to worry about various corporate actions like stock splits, bonuses, warrants, options, mergers, dividends etc. You also don’t need to keep track of individual shares in the fund as the fund manager does that for you. You are only required to keep track of your funds NAV periodically.

4) Transparent and Well regulated 

Mutual funds, unlike hedge funds are required to be transparent and are regulated by the SEC (in the US) and SEBI (in India). In other words, you can know in what way & how much proportion of your money is being invested by getting regular letters from the mutual fund itself. If you don’t feel satisfied with any of the changes the fund may have made you can simply exit that fund and invest in another one.

5) Liquid assets

Most mutual funds especially the equity oriented funds don’t require a lock-in period and hence are liquid. (lock-in period refers to the time period during which investors are not allowed or are penalised for redeeming/selling their shares in the fund)  Some debt oriented funds & tax saving funds may require a lock-in such as say 6 months to one year or more. This is because fund managers require some time to put the money to work (especially if they had invested in illiquid assets).

6) Variety of funds

There is no shortage of variety in mutual funds. There are lots of types of mutual funds (which I will discuss in the coming articles) to suit pretty much any investors need.

7) Returns

The bottom line of any investment is the returns. The mutual funds returns depend on which asset class it invests in. Typically equity based funds give higher returns but are more risky. Corporate debt funds are less riskier than equity but more risky than Gilt funds and money-market funds. As a general rule of thumb, the more the returns expected from the fund the more risky the investment is.

8) SIP

SIP stands for systematic investment plan. Its a wonderful method of investing in mutual funds in which you set aside a portion of money and invest it systematically at regular intervals. (Say once a month) This form of investing holds many benefits and is a whole topic altogether which I will be dealing with in later articles. Most mutual funds have an SIP option in which instead of investing lump-sum at one go you can invest slowly and regularly. Its a very effective way of utilizing mutual funds.

These are some of the major benefits of mutual funds. In the next article, I’ll talk about some of the disadvantages of mutual funds.

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Image credit – 401(K) 2013