MUTUAL FUNDS — REVIEWING THE FUNDAMENTALS...
Regulations for all — even if they are not free...
Apr 02 - 08, 2007
GLOBAL ARENA: MUTUAL FUNDS VS HEDGE FUNDS
Mutual funds and hedge funds differ in numerous ways, particularly the fees charged; leveraging, pricing and liquidity practices employed; the degree of regulatory oversight to which each are subject; and the characteristics of the typical investors who use each investment vehicle. Mutual funds in the US are probably amongst the most stringently regulated financial products all over. These stringent requirements exist in order to assure that their operations are in the best interest of the shareholders (unit-holders). At the same instance there are hedge funds; these are private investment pools subject to far less regulatory oversight.
CHARACTERISTICS MUTUAL FUNDS HEDGE FUNDS REGULATIONS - Registration required
- Periodic report requirements
- Registration not required
- No report requirements
FEES - Management fees restricted - No restriction of charges LEVERAGING PRACTICES - Bound to follow covering techniques - No mandatory binding, hedge wherever... PRICING & LIQUIDITY - Requirement for daily price calculation - Daily calculation not possible; exemption INVESTOR CHARACTERISTICS - Small investors encouraged; diversification - Huge investors are only eligible
LOCAL ARENA: MUTUAL FUNDS VS STOCK INVESTMENT
Any investor having an excess capital (or capital to invest) at least Rs.25,000 can open an account with a stock exchange broker, trade the shares of their own choice, bear the risk at the same, spend time, energy, capability and overlook opportunity costs to earn what he can. But the general outcome of small investors at the stock exchange is generally known to everyone; entrance as a king (possibly) and debt burden to exit with. The author himself is an example of this problem, and hasn't been a lot of time since that happened. Then how can a small investor capitalize on the opportunities that exist in the financial markets?
The opportunities can be capitalized on through hassle and tension free investments, where there is no worry about which stock is under-performing or any market-jerks, etc. Also the fact that it has always been well quoted that, on a general note, the financial markets are no place for a small investor. So there are people with the following characteristics:
* Enormous experience of stock trading
* Huge financial base (people's/individual's money collectively)
* Knowledge of the market performance
* Tremendous analytical skills
* Abilities to grasp the window of opportunity
These people are known as the mutual fund managers; people who create ventures that are long term, get people's money, create a huge financial base and trade all sorts of securities with investment in money market and stock market primarily.
HOW THEY WORK?
The phenomenon is quite simple; all these people do is play around with people's money (investor money), get profits, deduct their management fees and other expenses and declare the remaining as dividend or re-investments as per the policy. The procedure is quite similar to what organizations do when they decide on going public, a similar procedure is applied. Basically, fund investors are share holders of their mutual funds.
RISKS AND RETURNS
The funds managers maintain a vast portfolio containing dozens of securities whose valuation and re-valuations over periods of time give the appropriate Net Realizable Value (NRV) of the units. Risks and returns are directly proportional, however, mutual fund managers try working as much against the theory as possible, primarily, to have a better NRV in the market. It is, therefore, that mutual funds have a vast portfolio so that the risks are averaged.
IMPORTANCE OF REGULATIONS
Since people's money is at stake, it is very important for the government to have regulations enacted that would assure that the hard earned money doesn't get dissolved by some fraudulent groups of mutual funds.
RULES & REGULATIONS GOVERNING MUTUAL FUNDS
Some of the mandatory mutual funds governing regulations would be discussed in this section.
APPOINTING THE ADVISOR
Firstly, it is very important for a mutual fund organization to have efficient, experienced and knowledgeable advisors in order to attain a higher ranking in the client preferences. Only professionals being involved in such a venture actually guarantee the success to its clients. Therefore, there are laws that regulate the appointment of the advisor or board-of-advisors for mutual funds.
There are mutual funds in which everyone can invest. However, in certain conditions (such as stock market funds investors), organizations cannot invest their pension funds and other employee benefit funds to attain profits. This is because of the risky-ness of the fund associated to its structure; the riskier the fund, the more limited its investor eligibility. Therefore, investor eligibility stands not just the responsibility of the investor himself to know where to invest but also the responsibility of the fund managers to assure that no one who isn't eligible to apply, gets fund units allocated.
ELIGIBLE SECURITIES FOR INVESTMENT
Fund managers are also restricted from investing in securities that are highly volatile or tremendously low in cost. The reason for the former is the fact that there are people/investors whose hard earned money is at stake, therefore, investing in extremely volatile shares may result in loss accumulation, which of course can be window dressing for fraudulent bankruptcy. The later is another clause because the fund managers have huge amounts of money to 'throw' in any share. Definitely if a share worth Rs.50 can be bought in a quantity of 1 million, then the same fund-manager may opt for an Rs.5 share, thus buying a quantity of 10 million. Such a mass scale transaction in a small value share may cause investor inclination towards trading that particular stock, allowing its price to shoot drastically in a short spam. The fund-managers may then easily off-load their shares on rising prices, leaving behind an ordinary 'trend-follower' to be stuck with that stock. Therefore, setting the eligibility criteria actually takes care of not just the fund-unit-holders, but also other stake-holders (or stock investors) who might suffer as mentioned above.
THE PORTFOLIO COMPOSITION
Another regulation that has been deployed is the portfolio composition rule. There are several implications in this rule as mentioned below:
1. Not more than a certain percentage of the net portfolio holding can be invested in a single stock.
2. The same proposition also lies in terms of monetary value.
3. There is a pre-defined break-up of maximum allocation based on ratings and past performances.
Clause Nos. 1 and 2 might sound repetitive, however, they are not. Consider two funds - A and B - with finances of 10 million and 100 million, respectively. If there is a percentage restriction, say 10%, B can invest 10 million in a single stock, while A has an implied restriction of 1 million. This would definitely restrict the scope of A in terms of gaining more profits and might give market manipulation power to B. Therefore, the restriction is applied as a monetary value or percentage, whichever stands lower.
As per clause 3, there are bifurcations for each of the sectors prevailing in an economy, and then maximum possible allocated quota for investment within those sectors. This assures a diversified set of investments, to ensure better profits at lesser risks; however, mutual fund managers may also invest abroad.
MINIMUM & AVERAGE RATE OF RETURN
There is not a regulatory requirement for a minimum rate of return that a fund should ensure to its customers; however, there are minimum industry standards for funds depending on the concentration of investments. The minimum yet remains the interest rate that is offered by the banks on PLS accounts as a standard. For example, when investing in the stock advantage fund of a managed advisory, they told me that their benchmark is to outperform the stock market returns that generally vary from 20-30% annually.
SWORD OF THE AUDITOR
Yes... they also have auditors!!! They are not just internal but external auditors as well designated by the government's respective body i.e. responsible for the financial markets. This again is a regulatory measure to ensure that all regulatory requirements are met and things are running smoothly in the best favor of the unit-holders.
Mutual funds are probably the safest play for true sense of investment. The regular reports and analyses sent by the respective fund managers are quite assistive in analyzing the financial and economic state of the industries and the most favorable investment scenarios. Yet among common men, it is considered that the person investing in funds would generally be an old and matured one who wants safe annual returns; and the younger fellows, therefore, head towards the stocks themselves. This probably is the most wrong perception of all time. Mutual funds are for all those who want to make a wise decision in terms of long term investments, and gaining returns without any tension. This strategy works well with the person busy in his schedules and the money keeps growing, just like the fund managers state: "Let the professionals do their jobs...".