Advantages and Limitations of Mutual Funds for Investors

1) Advantages of Mutual Fund

A) Professional Management

Mutual funds offer investors the opportunity to earn an income or build their wealth through professional management of their investible funds. There are several aspects to such professional management viz. investing in line with the investment objective, investing based on adequate research, and ensuring that prudent investment processes are followed.

Investing in the securities markets will require the investor to open and manage multiple accounts and relationships such as broking account, demat account and others. Mutual fund investment simplifies the process of investing and holding securities.

B) Affordable Portfolio Diversification

Investing in the units of a scheme provide investors the exposure to a range of securities held in the investment portfolio of the scheme in proportion to their holding in the scheme. Thus, even a small investment of Rs. 500 in a mutual fund scheme can give investors proportionate ownership in a diversified investment portfolio.

An investor ensures that “all the eggs are not in the same basket”. Consequently, the investor is less likely to lose money on all the investments at the same time. Thus, diversification helps reduce the risk in investment. In order to achieve the same level of diversification as a mutual fund scheme, investors will need to set apart several lakhs of rupees. Instead, they can achieve the diversification through an investment of less than thousand rupees in a mutual fund scheme.

C) Economies of Scale

Pooling of large sum of money from many investors makes it possible for the mutual fund to engage professional managers for managing investments. Individual investors with small amounts to invest cannot, by themselves, afford to engage such professional management.

Large investment corpus leads to various other economies of scale. For instance, costs related to investment research and office space gets spread across investors. Further, the higher transaction volume makes it possible to negotiate better terms with brokers, bankers and other service providers.

Mutual funds give the flexibility to an investor to organize their investments according to their convenience. Direct investments may require a much higher investment amount than what many investors may be able to invest. For example, investment in gold and real estate require a large outlay. Similarly, an effectively diversified equity portfolio may require a large outlay. Mutual funds offer the same benefits at a much lower investment value since it pools small investments by multiple investors to create a large fund. Similarly, the dividend and growth options of mutual funds allow investors to structure the returns from the fund in the way that suits their requirements.

Thus, investing through a mutual fund offers a distinct economic advantage to an investor as compared to direct investing in terms of cost saving.

D) Liquidity

At times, investors in financial markets are stuck with a security for which they can’t find a buyer – worse, at times they can’t find the company they invested in! Such investments, whose value the investor cannot easily realize in the market, are technically called illiquid investments and may result in losses for the investor.

Investors in a mutual fund scheme can recover the current value of the money invested, from the mutual fund itself. Depending on the structure of the mutual fund scheme, this would be possible, either at any time, or during specific intervals, or only on closure of the scheme. Schemes, where the money can be recovered from the mutual fund only on closure of the scheme, are compulsorily listed on a stock exchange. In such schemes, the investor can sell the units through the stock exchange platform to recover the prevailing value of the investment.

E) Tax Deferral

 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 pay tax on the income each year.

F) Tax benefits

Specific schemes of mutual funds (Equity Linked Savings Schemes) give investors the benefit of deduction of the amount subscribed (upto Rs. 150,000 in a financial year), from their income that is liable to tax. This reduces their taxable income, and therefore the tax liability.

The Rajiv Gandhi Equity Savings Scheme (RGESS) offers a rebate to first time retail investors (in direct equity) with annual income upto Rs. 12 lakhs. Mutual funds announce specific equity-oriented schemes that are eligible for the RGESS benefit.

The RGESS benefit is linked to the amount invested (excluding brokerage, securities transaction tax, service tax, stamp duty and all taxes appearing in the contract note). Rebate of 50 percent of the amount invested upto Rs. 50,000, can be claimed as a deduction from taxable income. The investment limit of Rs. 50,000 is applicable for a block of three financial years, starting with the year of first investment.

Thus, if an investor invests Rs. 30,000 in RGESS schemes in a financial year, then he can reduce his taxable income for that previous year by 50 percent of Rs. 30,000 i.e. Rs. 15,000. In the following year, he still has an investment limit of Rs. 20,000 available. The maximum deduction that can be made from the taxable income over the period of three financial years is 50 percent of Rs. 50,000 i.e. Rs. 25,000.

Dividends received from mutual fund schemes are tax-free in the hands of the investors. However, dividends from certain categories of schemes are subject to dividend distribution tax, which is paid by the scheme before the dividend is distributed to the investor. Long term capital gains arising out of sale of some categories of schemes are subject to long term capital gains tax, which may be taxed at a different (and often lower) rate of tax or even entirely tax exempt.

G) Convenient Options

The options offered under a scheme allow investors to structure their investments in line with their liquidity preference and tax position.

There is also great transaction conveniences like the ability to withdraw only part of the money from the investment account, ability to invest additional amount to the account, setting up systematic transactions, etc.

H) Investment Comfort

Once an investment is made with a mutual fund, they make it convenient for the investor to make further purchases with very little documentation. This simplifies subsequent investment activity.

I) Regulatory Comfort

The regulator, Securities and Exchange Board of India (SEBI), has mandated strict checks and balances in the structure of mutual funds and their activities. These are detailed in the subsequent chapters. Mutual fund investors benefit from such protection.

J) Systematic Approach to Investments

Mutual funds also offer facilities that help investor invest amounts regularly through a Systematic Investment Plan (SIP); or withdraw amounts regularly through a Systematic Withdrawal Plan (SWP); or move money between different kinds of schemes through a Systematic Transfer Plan (STP). Such systematic approaches promote investment discipline, which is useful in long-term wealth creation and protection. SWPs allow the investor to structure a regular cash flow from the investment account.

2) Limitations of a Mutual Fund

A) Lack of portfolio customization
Some brokerages offer Portfolio Management Schemes (PMS) to large investors. In a PMS, the investor has better control over what securities are bought and sold on his behalf. The investor can get a customised portfolio in case of PMS.

On the other hand, a unit-holder in a mutual fund is just one of several thousand investors in a scheme. Once a unit-holder has bought into the scheme, investment management is left to the fund manager (within the broad parameters of the investment objective). Thus, the unit-holder cannot influence what securities or investments the scheme would invest into.

B) Choice overload
Over 2000 mutual fund schemes offered by 47 mutual funds – and multiple options within those schemes – make it difficult for investors to choose between them. Greater dissemination of scheme information through various media channels and availability of professional advisors in the market helps investors to handle this overload.

C) No control over costs
All the investor's money is pooled together in a scheme. Costs incurred for managing the scheme are shared by all the Unit-holders in proportion to their holding of Units in the scheme. Therefore, an individual investor has no control over the costs in a scheme.

SEBI has however imposed certain limits on the expenses that can be charged to any scheme. These limits, which vary with the size of assets and the nature of the scheme.