Advantages & Disadvantages of Mutual Funds - HDFC Securities

July 25, 2014

Advantages & Limitations of Mutual Funds investing RETAIL RESEARCH \ Why invest in Mutual Funds?

• Professional Management and Informed Decision Making: The biggest advantage that mutual funds offer is greater expertise on the markets, be it the stock market or debt market. The AMC, with its well organized and structured pool of talent, tracks the economy, companies and stock market happenings on a day‐to‐day basis, and investment decisions are made on the basis of this research. It would be far more difficult for a retail investor to undertake research of the same magnitude. Mutual Funds have better access to information than individual investors.

• Investment Flexibility: Mutual fund houses offer various categories of schemes (equity, debt, hybrid etc) with a good number of options such as growth, regular income and so on. You can pick and choose as per your risk appetite; return expectations and overall investment objective.

• Affordability and Liquidity: To start with, one can invest just Rs. 500‐1000 to buy a mutual fund scheme. Further, systematic investment plans allow investors to invest even with as low as Rs. 50, Rs. 100 or Rs. 500. Likewise, Mutual funds are easy to redeem. You can redeem your liquid fund within 24 hours and other funds in up to three days.

• Diversification: With a comparatively small capital investment in a mutual fund scheme, you can gain exposure to a large variety of instruments. In fact, some instruments which form part of a mutual fund’s portfolio, especially in the debt segment, are totally out of the reach of a retail investor due to the high threshold investment limits. Mutual Funds make investments in a number of stocks and sectors, the resultant diversification reduces risk.

• Transparency and Safety and well regulated: No mutual fund guarantees returns but they are transparent in their operations, since they are subject to stringent disclosure norms. SEBI regulates all mutual funds operating in India, setting uniform standards for all funds. In addition, thanks to its three tier structure – clear cut demarcation between sponsors, trustees and AMCs, conflict of interests can be promptly checked. Lastly, the Association of Mutual Funds in India works towards promoting the interests of mutual funds and unit holders. It also launches Investor Awareness Programs aimed at educating investors about investing in mutual funds.

• Tax Benefits: Generally, income earned by any mutual fund registered with SEBI is exempt from tax. However, income distributed to unit holders by a debt fund is liable to a dividend distribution tax. Capital gains tax is also applicable in the hands of the investor, depending on the type of scheme and the period of holding. Dividend earned from equity schemes is currently exempt from tax in the hands of investors. There is no TDS. There is no an Wealth tax or gift tax applicable (See section Tax implications).

• No tax on AMC thereby no tax liability for investors: Mutual funds are not liable to pay tax on the income they earn. If the same income were to be earned by the investor directly, then tax may have to be paid in the same financial year.

Mutual funds offer options, whereby the investor can let the money grow in the scheme for several years. By selecting such options, it is possible for the investor to defer the tax liability. This helps investors to legally build their wealth faster than would have been the case, if they were to invest directly and pay tax on the income each year.

• Part of asset allocation: Mutual funds can be a part of one’s portfolio as they have the inbuilt nature of representing a particular asset class by holding many instruments belonging to them. For example, debt funds. A debt fund holds different instruments from debt asset classes like NCD, Gilt, FD, etc. So. For an investor who has invested maximum in equity shares, a debt fund can be a complement to his portfolio which helps to achieve better asset allocation in his portfolio • Personal finance evaluation (returns requirements and risk profile): As an investment avenue, Mutual funds are best suited for any investors to achieve required returns based on any kind of risk profile. Apparently, investment decisions RETAIL RESEARCH

are based on the risk/return trade‐offs on determining the returns requirements and the quantum of risk required to take to achieve the returns. If you want relatively higher returns then you have to choose the higher risk investments such as equity schemes etc. If you need a lower return with limited risk, then liquid funds would be better option to invest.

• Protection: Some of the mutual funds from debt category such as Liquid funds, etc ensure the capital protection as they invest in low risk money market instruments. However, investors have to be careful and take informed decision while investing in mutual funds.

• Goal based investing: You want to save for retirement. And for your child's education. You also need to save tax. Then there is this long‐cherished dream of owning a house. And your plan to upgrade to a bigger car. That's quite a mix of long‐term, medium‐term and short‐term financial goals. Just as individuals have different goals, there are mutual funds to help achieve these objectives. You could be looking at long‐term wealth creation, or a place to park funds in the short term. There is something for both aggressive and conservative investors, short‐ and long‐term goals, all wallet sizes and all age groups. For example, for risk taking longer time horizon investors equity funds would be the preferred options while FMPs can be suited for low to medium risk profile investors who need money back within short term duration.

• Resolving mismatch between risk profile and need to take risk: A mismatch between investment type and investment horizon can be fixed with the help of mutual funds. For example, mismatch risk would exist in a situation where an investor with a short investment horizon (such as one who is near retirement) invests heavily in speculative hi‐tech stock. Typically, investors with short investment horizons should focus on less speculative investments such as fixed income securities and blue chip equities. Mutual funds are availed with flexi options that are suitable for long term or short term, having lower risk or higher risk, or to generate higher or lower returns. Further, the mutual funds come up with value added service like trigger, value averaging, etc which help investors to maintain their profile as per their requirements.

• Comparatively lower cost product: Though mutual funds levy various fees they are not an expensive proposition. When you invest directly too there are certain expenses that you will have to bear. In fact, the additional charges that you pay towards fund management, etc., end up benefiting you since it results in investment decisions which are better researched and more meticulous monitoring of the performance of your investments on a continuous basis.

• Mutual funds are an efficient way of taking indirect exposure to the respective asset classes (Equity, Fixed income, Gold etc), the other being portfolio management services and Unit linked Insurance plans.

What are the limitations of Mutual Funds investing?

• Impact Cost: Operationally, mutual funds buy and sell in large volumes and voluminous buying or selling of shares often results in adverse price movements. Funds which buy in large volumes end up inflating the prices and when funds sell in large quantities, they tend to depress prices. This could result in high prices while buying and low prices while selling.

This is called as ‘impact cost’. This negatively affects mutual fund owners in three distinct ways. First, individuals receive less favorable prices on certain stocks being bought and sold. This occurs when an investor’s mutual fund manager is buying or selling large quantities of stock that drives the price artificially higher or lower. Second, a fund manager may alter its investment management strategy to avoid excessive market impact costs. This can happen if a manager chooses to enter and exit stock positions over long time horizons in an effort to mitigate sudden short term movements in the securities it is trying to sell or acquire. Last, a mutual fund manager may be forced to include less favorable stocks in its portfolios to alleviate the market impact pressure on its favorite stocks.

• Choice overload: Over 1,400 mutual fund schemes offered by more than 44 mutual funds – and multiple options within those schemes – make it difficult for investors to choose between them. Greater dissemination of industry information through various media and availability of professional advisors in the market should help investors handle this overload.

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• Lead Time: The mutual funds cannot remain fully invested all times due to various reasons. Firstly, they must maintain some part of their corpus in cash, in order to meet redemption pressures. Then there could be a time lag between identification of investment opportunities and actual investment. And finally, it is not possible for a fund house to deploy money in the market immediately after receiving it from investors. This lead time when cash is lying idle with mutual funds results in lower overall returns on the corpus.

• Marketing and Fund management costs or Expense Ratio: In the case of most mutual funds, there is an exit load (fee) applicable while selling mutual fund units. This load, which are a certain percentage of the value of units held, are applied to cover marketing and other costs. In addition to this, the AMC charges annual asset management fees and expenses, those are captured in the expense ratio. Further, investors have to pay these charges to the fund manager irrespective of profit or loss.

• Cost of churning or Turnover Ratio: Some schemes tend to churn their portfolio very often, in keeping with the investment philosophy of the fund manager, i.e., whether he/she believes in long term or short term returns. This means higher transaction costs (brokerage, custody fees etc) and consequently, lower returns.

• Underperformance – Research proves that a large proportion of schemes perennially underperform vis‐à‐vis the benchmarks. Hence selecting the right fund and the right fund manager is important. Though mutual funds levy various fees they are not an expensive proposition. When you invest directly too there are certain expenses that you will have to bear. In fact, the additional charges that you pay towards fund management, etc., end up benefiting you since it results in investment decisions which are better researched and more meticulous monitoring of the performance of your investments on a continuous basis.

• Portfolio risk: In certain cases, there is a possibility that the investment portfolio of the mutual fund may not earn the expected or desired rate of return due to the various factors.

• Investing in certain illiquid financial instruments by the mutual funds may lead to liquidity problems for investors in case of redemption requests.

• Holding derivatives in a portfolio of the mutual fund may increase the risk. However the market regulator has clarified the mutual fund houses to use derivative products only for hedging and balancing of portfolio.

HDFC securities Limited , I Think Techno Campus, Building ‘B’, “Alpha”, Office Floor 8, Near Kanjurmarg Station, Opposite Crompton Greaves, Kanjurmarg (East), Mumbai – 400042, Fax: (022) 30753435. Log on to http://www.hdfcsec.com Disclaimer: This document has been prepared by HDFC securities Limited and is meant for sole use by the recipient and not for circulation. This document is not to be reported or copied or made available to others. It should not be considered to be taken as an offer to sell or a solicitation to buy any security. The information contained herein is from sources believed reliable. We do not represent that it is accurate or complete and it should not be relied upon as such. We may have from time to time positions or options on, and buy and sell securities referred to herein. We may from time to time solicit from, or perform investment banking, or other services for, any company mentioned in this document. This report is intended for non- Institutional Clients only

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