Pros, Cons, and the choice:
Mutual funds offer the following benefits to their participants.
Diversification: The pool of funds collected in a mutual fund scheme is invested in scores of securities. Individual investors can scarcely achieve such diversification on their own. Remember that a diversified portfolio reduces risk.
Professional Management: When you invest in a mutual fund scheme, you are relieved of the chores and tensions associated with managing investments on your own. Mutual funds are managed by professionals who decide what to buy and sell, and when. Their decisions are supposedly guided by investment research and analysis. Individual investors may lack such expertise and / or cannot devote similar time and attention to their portfolio.
Liquidity: Investment in mutual funds is generally fairly liquid. Units or shares of mutual funds can be traded in the secondary market or sold back at the notified repurchase prices.
Assured Allotment: Investors are assured of firm allotment (typically it is total, sometimes it is partial) when they apply for the units or shares of mutual funds. Of course, under the tax saving schemes, there are limits on investment.
Small investments: You can participate in a mutual fund scheme even if you want to make a small investment. Most schemes keep the minimum investment between Rs 1000 and Rs 5000. No other avenue of investment offers such a wide range of choice fir such an affordable sum.
Tax Advantages: Mutual funds offer two major tax advantages. First, mutual funds per se are tax exempt entities. This means that they do not pay taxes on their interest and dividend income as well as capital gains (both short term and long term) second, dividends distributed by mutual funds are tax exempt in the hands of the recipient.
As against these significant tax advantages, mutual fund schemes, other than open ended equity schemes, are required to pay a dividend distribution tax of 12.5 percent.
On the whole from a tax of view
1) debt mutual fund schemes are more advantageous than direct investments in debt instruments if the investor pays more than 12.5 percent in taxes on his income from direct debt instruments and
2) equity mutual fund schemes are more advantageous than direct equity investment if the equity holding period of the investor is less than one year.
Transparency: Mutual funds are perhaps the most transparent financial intermediary. When you invest in a mutual fund scheme you know its investment objective, its asset allocation pattern, its portfolio composition, its net asset value, its expenses, ad so on. You can track its performance periodically. Which other financial intermediary offers this degree of transparency?
The major disadvantage of investing in a mutual fund is that you have to, in effect, bear the expenses of running the mutual fund. As we have seen, these expenses are of two types: initial and recurring. To understand the implication of these, let us assume that the initial expenses are 6 percent and the recurring expenses are 2 percent. This means that if you contribute Rs 100 to a mutual fund scheme, the net amount available fro investment is only Rs 94. Further, on this net investment there is a recurring expense of 2 percent. Hence, if you can earn a rate of return of, say 18 percent by investing on your own, the mutual fund must earn a rate of return of 21.15 percent to provide the same return to you. The following calculation bears this out:
Invest on your own = 100 / Amount invested x 0.18 / Rate of return earned = 18.0 / Annual income.
Invest through the mutual fund= 94 / Net amount invested x (0.2115 / Rate of return – 0.020) Recurring expenses = 18.0 / annual income.
More generally if r1 is the rate of return that you can earn on your own, then r2 the rate of return the mutual fund should earn, is
r2 = 1 / 1 – Initial expenses in decimal terms r1 + Recurring expenses in percentage terms.
This equation is based on the assumption that the initial expenses are 6 percent and the annual recurring expenses are 2 percent.
Another disadvantage of investing in a mutual fund is that will miss the thrill and joy of managing your portfolio.
When should you invest your own? And when should you invest through a mutual fund?
Invest on your own if you:
1) have fairly strong speculative instincts
2) fund the game of investing enjoyable
3) have the time to manage your investments and
4) can earn superior returns
Invest through a mutual fund if you:
1) have a small amount to invest,
2) hold fewer that five stocks
3) think that you need better advice on investing
4) have difficulty in deciding when to sell, and
5) find the paperwork relating to investments cumbersome