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How Do Mutual Funds Make Money?

How Do Mutual Funds Make Money?

Ever seen the “Mutual Funds Sahi Hai!” ads? Have no idea what we are talking about? Check out the ads here!!

We, at Trade Brains, happen to see a lot of these advertisements. In fact, we even love them because although comical and mere advertisements and these ads educate the public about mutual fund investments in a more touching way than what we could ever do.

(Source: Mutual fund Sahi Hai)

But those of you who have seen these ads must have wondered for a long time about how these guys make money? Why give so much wealth away for free? After all, economics says that there are no free lunches, right?

Well, to be honest economics is right. There are no free lunches and mutual funds are not free. This post is aimed to provide a basic insight into answering the above questions. Here are the topics that we’ll cover in this post:

What are mutual funds?
What are the sources of revenue for a mutual fund?
The different costs involved in running a mutual fund.
Industry trends and closing thoughts

Overall, it’s going to be a very interesting post for the mutual fund enthusiasts. Therefore, let’s get started.

1. What are mutual funds?

Mutual funds are investment vehicles managed by professionals that seek to pool investments from many people together before investing them into markets within the financial ecosystem such as equity markets or debt market or a hybrid of both debt and equity. These vehicles are normally managed by professional fund managers or are programmed to follow certain broad indices pertaining to a certain industry or a country.

In general, mutual funds are thought to be best platforms for investors to get the benefits of capital appreciation from the equity markets even if they are not confident to manage their own money in the markets or if they are not able to dedicate time for their own research.

Some retail investors who invest on their own also happen to invest mutual to provide some diversification in their portfolio or reduce the volatility of returns since a lot of the times retail investors tend to have a concentrated portfolio of around 8-20 stocks.

2. How Do Mutual Funds Make Money? And what are the sources of revenue for a mutual fund?

The biggest source of revenue for mutual funds is usually the fees that they charge from their investors. This usually comes out in the range of 1.5%-3% of the assets under management. This is commonly known as the expense ratio. Here is the example of the expense ratio for a few popular funds:

However, as of September 2018, it has become legally binding for mutual funds to limit their total expense to 2.25% of the total assets under management.

References:

The other sources of revenues for a mutual fund come in the form of exit load, front loads, and purchase fees etc. (Also read: 23 Must-Know Mutual fund Terms for Investors.)

3. What are the costs involved in running a mutual fund?

Since most funds hire analysts in research positions a good chunk of the revenues is spent as salary expense for most mutual funds. Other expenses include rent of office and facilities, administrative expenses, payments for research material from data sources etc.

The other major expenses include brokerage fees and transaction costs, costs, investment advisory fees, and marketing & distribution expenses.

4. Current Industry trends

Since this industry is very competitive it can be said that when it comes to profits being the industry tends to follow a bell curve with close to 50% of fund houses making a profit in a year. But lately, the trend has been that some firms also generate profits not from their core operations but also by providing research and analytics to clients based offshore.

Another interesting observation to be made is that fund houses which operate a number of mutual fund schemes tend to have higher profitability than their peers. This is due to the fact that a lot of the core setup required for research and administration is pretty much in place and doesn’t need to be set up from scratch each time a fund house launches a new scheme.

Closing Thoughts

Investors in mutual funds could protect their investments if they were to invest in safe fund houses which can generate a decent return from the market even during the worse days. Since it is nearly impossible to get an idea of profitability among mutual fund players, investors could use the financials of the parent companies as a proxy.

Nevertheless, as always, mutual fund investments are subject to market risks. Please read all scheme-related documents carefully before investing.

New to mutual fund investing? Want to learn how to pick the best mutual funds? Then, check out our online course- Investing in Mutual Funds? A Beginner’s Course. Enroll now and start your journey in the exciting world of mutual fund investing today. #HappyInvesting.

Levin Jenson

Levin is a former investment banker and a hedge fund analyst. He is an NIT Warangal graduate with around 5 years experience in the share market.

October 13, 2018 Levin Jenson Mutual Funds 4 comments

The Beginners Guide to Select Right Mutual Funds in 7 Easy Steps.

The Beginners Guide to Select Right Mutual Funds in 7 Easy Steps.

“But I don’t know anything regarding mutual funds…I’m interested to invest in mutual funds, but always confused where to begin?”, Rajat argued.

“That’s the beauty of investing in the mutual funds, Rajat. You do not need to be an expert or even a finance freak to start investing in mutual funds…

…there’s a professional fund manager who will manage your fund and will take all the critical decisions like which securities to buy or sell. Overall, your job as an investor is just to invest your money at the right fund. Rest everything will be taken care of by the fund manager and fund house.”, I explained to Rajat.

“Sounds good, so far? But how to find such funds which match my goals? There are hundreds of mutual fund in the Indian market…”, Rajat looked a little excited and cautious at the same time.

“Yes, there are hundreds of mutual funds in the market. However, there will only be a few good ones that will match your goals, risk appetite and has a good track record of consistent performance. Although it may take a little time to find such funds, once you find a good mutual fund, you can sit back and relax. Moreover, finding a winning mutual fund doesn’t take too long if you know the right approach…”, I was able to see a grin on Rajat’s face after listening to my answer.

*********

Hi Readers. One of the most frequently asked question by our blog readers is how to select right mutual funds to invest in.

Although mutual funds are managed by professional managers, however, not all funds perform are equally well. There are many funds who are not even able to beat the index. That’s why it’s really important for you to select right mutual funds that will fulfill your investment goals.

While researching the best mutual funds to invest, most beginners just look at the past performance. However, two equally other important factors to be checked before selecting any fund is whether the objective of the fund matches your investment goals and what are the different risks associated with the fund.

Moreover, mutual fund investing is a long-term relationship. Unlike the direct investment in stocks, where the people can switch the stocks fast, mutual funds are a long time period commitment. Most people stick with their funds for over 8-10 years. Therefore, it’s important that you choose a right fund and not get stuck with lagging ones which might result in you to lose both time and money.

In this post, we are sharing a beginners guide to select right mutual funds in seven easy steps. This guide will help you to perform exact step-by-step research to find winning mutual funds. Let’s get started.

A Beginners Guide to Select Right Mutual Funds in 7 Easy Steps

Here are the seven essential steps to select right mutual funds that will help you to meet your investment goals.

1. Read the Offer Document Carefully

One of the most comprehensive documents that every mutual fund provides is its offer document (also known as the prospectus). The first and probably the biggest step while choosing a mutual fund is to read the offer document carefully.

The offer document contains all the important details regarding the mutual fund like its objective, scheme type, past performance, details about the asset management company, classes of the underlying assets etc. (Quick note: If you are not familiar with these terms, check out this post regarding the must-know mutual fund terms). There is a strict instruction by SEBI regarding the filling of offer letter offered by the mutual funds- which you can find here.

In short, begin your research by reading the offer document of the mutual fund. Moreover, it’s not really difficult to understand these documents.

2. Match the objective of the fund with that of yours.

Every mutual fund has a specific objective. And based on the objective, they decide different factors like asset allocation (equity to bond weight), risks, dividend payouts, tax benefits, theme/sector focus etc.

You need to read the offer document of the fund and attentively identify whether the fund objectives meets your investment needs in terms of the above-mentioned factors. If the objectives are not relevant to you, then it might not be a good option to invest in those funds w.r.t. your investment goals.

3. Check Fees and Exit Loads

Mutual fund charges a fee for offering services and to meet different expenses like manager’s fee, operational & administration costs, advertisement costs etc. Generally, this expense ratio for an active fund can be as high as 2-2.5%. Further, some mutual funds may also charge you a fee up front when you invest (entry load), or a deferred sales charge when you sell your shares (exit load).

These pieces of information are present in the offer letter of a mutual fund. As a value investor, you should try to stay away from mutual funds with high fees and loads to avoid unnecessary costs.

4. Evaluate the past performance of the fund

Although the past performance of a fund will not guarantee how well it will perform in the future, however, it will give you a rough idea about the returns and expectations. This is certainly an important factor which must be checked. Moreover, you should compare the funds’ past performance to the benchmark as it will give you a better idea of its actual performance.

You can easily find the information regarding the past performance of any fund vs the benchmark on the financial websites like ValueResearchOnline or moneycontrol. Further, focus on the long-term performance (3 years or greater) and compare it with its competitors and index.

5. Analyze portfolio and holdings

This may be a little tricky for those who have zero knowledge of investing. After all, even if you find out which companies that mutual fund is investing in, how will you understand whether the holdings are good or bad?

Nevertheless, analyzing the portfolio and holdings gives you a general idea about the securities in which the fund is investing. Here, the key point is to make sure that the fund is investing in the type of securities in which you are interested. For example- if you are optimistic about electric vehicles and want to invest a major proportion in the automobile sector, look for a mutual fund which has a high percentage of allocation in the automobile sector. Similarly, if you’re interested to invest in other sectors like energy, infrastructure, finance etc- then studying the portfolio will give you a good idea of whether the fund is right for you or not.

Anyways, there is also small trouble while analyzing the portfolio and holding. The portfolio/holdings can change from time to time as the manager may decide to buy or sell securities at their will in the future. Therefore, if you are not regularly reviewing the fund, the current allocation might be a little different from the time when you invested in the fund. That’s why you should always review your fund every six months or a year after purchasing to confirm that your requirements are still met by the fund.

6. Check the Credentials of the Fund Manager

The fund manager is probably the heart of any mutual fund. He/She is the one who will be making all the important buy/sell decisions on your behalf. Therefore, it’s important to find out more about the fund manager.

A manager with a long tenure may have done the job well and his/her credentials are tried out. On the other hand, the efficiency of a new manager might not have been tested yet. While researching mutual funds, check the tenure of the fund manager to find how long this fund manager is managing the fund.

Another important factor regarding the fund manager is to check which other funds he/she is managing. If the other funds are also doing equally good, then it is a good sign. On the other hand, if just one fund is performing well- while the other funds that he/she is managing are struggling, then it might be a fluff.

7. Check the size and credentials of the fund house

Although it’s not the biggest factor, however, as an intelligent investor- always invest in the fund which has already established a good track record. It’s important that the fund house has strong credentials because mutual funds investing is a prolonged relationship and you do not want to get involved with a troublesome fund house which might give you headaches in upcoming years.

Nevertheless, in a few scenarios, you may invest in comparatively newer plans or fund houses. For example, if there is an exciting new theme based fund house that meets your asset allocation plan, then feel free to invest a small amount in it and later increase the amount depending on the performance.

Quick Note: If you are new to investing and want to learn how to invest in mutual funds from scratch, check out this amazing online course: Investing in Mutual Funds- A Beginner’s course. Enroll in the course now to start your journey in the requisite world of investing today.

Bottomline

The procedure to select right mutual funds to invest requires a careful study of the fund. In this post, we have covered the seven critical factors that you need to check to select right mutual funds to invest.

Besides, you might have noticed that we didn’t talk about the ratings of the fund. This is because of the reason that the ratings vary from websites to the website. It’s quite rare that you’ll find the same fund listed in the top 10 suggested mutual funds on different financial websites. Which one to trust? Better make your own decisions. Anyways, if you’re really interested to check the ratings, then the CRISIL ratings may be a little helpful.

Here is the final tip- Do not rush with investing. There are hundreds of mutual funds in the Indian market. Take your time to analyze them and find out the one that best suits your goals.

That’s all for this post. I hope it was helpful to you. Happy Investing.

Kritesh Abhishek

Hi, I am Kritesh (Tweet me here), an NSE Certified Equity Fundamental Analyst and an electrical engineer (NIT Warangal) by qualification. I have a passion for stocks and have spent my last 4+ years learning, investing and educating people about stock market investing. And so, I am delighted to share my learnings with you. #HappyInvesting

www.linkedin.com/in/kriteshrules/

September 12, 2018 Kritesh Abhishek Mutual Funds 4 comments

How to Measure Risks in Mutual Funds?

How to Measure Risks in Mutual Funds?

Before you jump start your monthly-SIP or lump-sum equity plan, let’s get this clear that these investments are subject to market risk. Now when this statement pops up or scrolls by on the big fat TV Screen, what do you think it means? To put it in layman’s term ‘You cannot expect a fixed return on your fund invested.’ There’s always a risk of market volatility gawking on your funds.

Fret not; you can always research better to invest better and make sound investment decisions when it comes to mutual funds. Let’s quickly come to risk measuring.

Yes, it’s possible and within your means to delve into the true basics of indicators; alpha, beta, and r-squared that tells you what risk is associated with your fund portfolio. Other statistical measures such as calculation of standard deviation and shape ratios are important to calculate or estimate the risk.

Sure, all backs up the estimation values as when it comes to the volatility of the market, no one can put a word to it. Market volatility is altogether a sensitive scenario which depends upon several factors including politics. Let’s know learn how can we calculate/measure risks!

Also read: What is Mutual Fund? Definition, Types, Benefits & More.

Modern Portfolio Theory:

Or should we say a bible for expert investors? Although there are various “SIP-Calculators” and other calculators that track “Mutual Fund’s Growth and Return” but without considering the omnipresent risk factor, one cannot take his pick. Let’s tell you why!

MPT or Modern Portfolio Theory is a theory defined as:

For a given market risk level, the maximization of investment return is supported by the theory of Modern Portfolio.

The objective of these portfolios is to maximize the return (profit) on a fund investment while considering (and hence minimizing) the level of market risk.

As mentioned, the market is not static, it is ever changing. Therefore, to make an estimation of how the market will deviate and how will it affect your own fund. For a desirable return, it’s possible for an investor to construct a portfolio such that he/she could minimize the whole lot of risks.

The question is, how? The answer lies in the introductory part of this piece. There are a handful of indicators and other statistical measures that help us calculate the risk involved. Once we track down the possible risks (in numbers – thanks to the statistical measures), we can find ways to minimize those risks.

One thing to keep in mind is that return of your portfolio is calculated as the weighted sum of the return of the individual assets in your portfolio.

For example, (6% x 25%) + (4% x 25%) + (14% x 25%) + (10% x 25%) = 8.5%

The portfolio is divided into four parts (assets) for which the return is expected as 6%, 4%, 12%, and 10% respectively. The total becomes 8.5% and the risk associated with the assets giving 4% & 6% return is mitigated or balanced.

How to Measure Risks in Mutual Funds?

Alpha:

Risk-adjusted calculation on a fund can be done using the alpha measure.Alpha uses a benchmark index which is the center of calculation for this indicator.

Basically, alpha takes the risk-adjusted return (performance) of a fund investment and compares it with the benchmark index. This comparison yields out the possible value for alpha which specifies the performance or underperformance for a fund.

Alpha is commonly a measure that specifies the security of a fund as per the benchmark index. Let’s say, after the calculation, the value of alpha is 1.0. It means that the fund has outperformed as compared to the benchmark index by 1%.

On the other hand, if the value of alpha is -1.0 – it means that the portfolio fund has underperformed as per its benchmark index (mostly due to the volatility of the market).

Also read: The Best Ever Solution to Save Money for Salaried Employees

Beta:

The next indicator to measure the risk associated with a mutual fund is beta. Beta talks general i.e. it takes the whole market into consideration and analyzes the systematic risk associated with a specific fund portfolio. Just like alpha, the values of beta or “beta coefficient” also tell us a “market-compared” result.

However, the value of Beta can be calculated using advanced statistical analysis technique known as “Regression Analysis”. Beta is affected by the movements in the market. By the standards, the market has a value of 1%.

If the value of beta comes out to be less than 1, the volatility of the fund will be lesser than that of the market. Similarly, if the value of Beta is captured to be more than, say 1.1% then the volatility of the fund is 10% more as compared to the volatility of the market.

What’s favorable for the fund with least risk associated? – Low beta.

Standard Deviation:

The calculation of Standard Deviation has a plethora of applications around the globe in various sectors. And luckily, one in the sector of Finance. Standard Deviation graphically shows how scattered a particular distribution is. In plain and simple words, SD or Standard Deviation makes use of the historical data to put an analysis over the current funds.

Generally, an SD-graph would tell how deviated is your “annual rate of return” from what it is expected from the historical sources. Using this calculation, the future predictions can be made most naturally.

A volatile stock has a higher Standard Deviation.

Mean is a measure of central tendency which holds an importance while calculating the values of Standard Deviation. SD tells how much dispersion of data is there from its mean. Various expert investors make use of this indicator to minimize the risk factors in a portfolio.

Also read: Where Should You Invest Your Money?

Summary:

As we have seen, there are various possible ways through which one can estimate the risks in mutual funds.

A portfolio consisting of different assets would have different risk factors associated individually. Therefore, to make the best decision and to minimize the individual risks in your portfolio, the indicators mentioned above can lend you a helping hand.

For a finance newbie, these things might be no less than a rocket science right now. However, eventually one can get a hang of it. After all, a good investment is most naturally important for a good return.

April 8, 2018 Sonali Sharma Mutual Funds, Personal Finance 1 comment

What is Mutual Fund? Definition, Types, Benefits & More.

A mutual fund is a collective investment that pools together the money of a large number of investors to purchase a number of securities like stocks, bonds etc.

When you purchase a share in the mutual fund, you have a small stake in all investments included in that fund. Hence, by owning a mutual fund, the investor participates in gains or losses of all the companies in the fund. For instance, you can take a mutual fund as a basket of investments. When you purchase a share of that mutual fund, you are buying one share of this basket and hence has an ownership in the all the investments in one such basket.

Image source: Corporatefinanceinstitute.com

Major Types of Mutual Funds:

Based on Asset Class

Equity Funds: These funds invest the amassed money from investors in equities i.e. the stocks of different companies. The associated risks for these funds are comparatively higher as they invest in the market. However, they also provide higher returns.
Debt Funds: These funds invest in debt instruments like bonds, securities, fixed income assets, the company’s debentures etc. They provide a safer investment option for investors looking for small regular returns with low risk.
Hybrid Funds: As the name suggests, Hybrid or balanced funds invests in both equity and debt instruments like stocks, bonds etc. This ratio can be variable or fixed depending on the fund. This fund helps to bridge the gap between entirely equity or debt fund and suitable for investors looking to take higher risk than debt funds in order to get bigger rewards.
Money Market Funds: These funds invest in liquid instruments such as bonds, T-bills, certificate of deposits etc. The risks associated with these funds are relatively low and suitable for short-term investments, less than 12 months.

Based on Structure

Open End Funds: The majority of mutual funds in India are open-end funds. These funds are not listed on the stock exchanges are available for subscription through the fund. Hence, the investors have the flexibility to buy and sell these funds at any time at the current asset value price indicated by the mutual fund.
Closed-End Funds:- These funds are listed on the stock exchange. They have a fixed number of outstanding shares and operate for a fixed duration. The fund is open for subscription only during a specified period. These funds also terminate on a specified date. Hence, the investors can redeem their units only on a specified date.

(Image Credits: Kotak Securities)

Benefits of Mutual funds:

There are a couple of benefits in investing in a mutual fund.

For example, if there is an investor who wants to invest in stocks but has no time to analyze and create a portfolio. Then he can be benefited from the mutual fund. This investor just has to buy a mutual fund and hence, in a single purchase he gets an investment similar to purchasing the entire portfolio of stocks.

The various benefits of investing in a mutual fund are described below:

A simple way to make a diversified investment: A mutual fund has a number of securities like stocks, bonds, fixed etc already in its portfolio. Therefore, buying a mutual fund is a simple way to make a diversified investment. Further, diversification also reduces risk which is an added benefit of buying a mutual fund.
Managed by a financial professional: The Fund manager or managers actively manage a mutual fund. They try to give the maximum returns to the investors using their professional expertise. Hence, those investors who don’t have time to invest by their own can get benefits from the expertise of these fund managers.
Allow investors to participate in a wide variety of investments: This is one of the greatest advantages of buying a mutual fund. There are a variety of mutual funds available to invest in equity fund (Index funds, growth funds, etc.), fixed income funds, income tax saver funds, balanced funds etc. An investor can easily select the best one which suits his strategy.
Investors can buy/sell/increase/decrease their mutual funds whenever they want: There is great flexibility to for the investors while investing in mutual funds. They can easily buy, sell, increase or decrease their investment in different funds within seconds. However, please note that it’s suggested to read the mutual fund prospectus carefully before subscribing as some mutual funds have an entry or exit-load.

If you are new to mutual fund investing and want to learn from scratch, I highly recommed you to check out this online course: Investing in Mutual Funds? A Beginner’s Course.

Which mutual fund to buy?

After understanding the benefits of a mutual fund, the next question is which mutual fund to buy? There is a variety of mutual funds available in the market which you can find online. These mutual funds have different ratings & rankings and you can choose a suitable mutual fund according to your goal. Here are the two few sites where you can search online:

Money Control- http://www.moneycontrol.com/mutualfundindia/
Value Research Online- https://www.valueresearchonline.com/
Groww- https://groww.in/
Funds India- https://www.fundsindia.com/

Generally, you need to read the prospectus of a mutual fund which gives a wide variety of information about the fund. The fund prospectus has details like fee & charges, minimum investment amount, performance history, risks, and other particulars. Here are the few examples of mutual funds (provided by moneycontrol website):

Disadvantages of Mutual Funds:

Here are the few disadvantages of buying a mutual fund:

Fees and Expenses: There are a couple of possible fees in mutual funds like expense fee, exit fees etc which might reduce the overall returns.
No Insurance: There is no guarantee of success in the mutual funds. The mutual fund providing companies always state the following in the declaimer in their advertisements:
Mediocre Performance: On an average, a majority of mutual funds are not able to beat the market indices.
Loss of Control: The fund managers are responsible for buying and selling of the securities and you have no say in managing the portfolio. You are trusting someone else with your money when you invest in mutual funds.

How to make money by the mutual fund?

There are basically two ways to make money by a mutual fund –

Appreciation: When the mutual fund appreciates i.e. when the fund grows in value. You can sell the mutual fund at the appreciated value and get a good return on your investment.
Dividend Payment: Mutual funds also provide dividends to the investors when they receive the dividend from the companies they own in their portfolio. Please read the prospectus carefully if you are buying a mutual fund for dividend payments.