November 22, 2014

How should we explain what a mutual fund is?

I am uncomfortable with the way that the concept of a mutual fund is usually explained to someone who is unfamiliar with it. It is my opinion that most of the explanations put forth in Indian investment literature and marketing materials, do nothing much to actually make a reader understand the concept.  It is also my view that a number of these explanations are so intimidating that these could well put off a prospective investor from investing in a mutual fund scheme.  To make my case, I’d like to start with AMFI’s explanation of what a mutual fund is, as presented on its website: 

Simply put, the money pooled in by a large number of investors is what makes up a Mutual Fund. This money is then managed by a professional Fund Manager, who uses his investment management skills to invest it in various financial instruments.

As an investor you own units, which basically represent the portion of the fund that you hold, based on the amount invested by you. Therefore, an investor can also be known as a unit holder. The increase in value of the investments along with other incomes earned from it is then passed on to the investors / unit holders in proportion with the number of units owned after deducting applicable expenses, load and taxes.

There are three things, in particular, related to this explanation, that bother me.  Firstly, it doesn’t actually explain what a mutual fund is.  Rather, it tells us what makes up a mutual fund and goes on to give us an idea of how a mutual fund works.  Secondly, it assumes an understanding of terms such as ‘fund manager,’ ‘units’ and ‘load.’  Thirdly, it claims to simplify the concept without actually doing so.  In fact, the explanation starts with an uncredited quote, “There's no rocket science involved with Mutual Funds. They are easy to understand.”    That, in my opinion, is a sanctimonious assertion.  Mutual funds are a complex investment option, made even more difficult to understand by explanations such as this. 

AMFI doesn’t quite stop there.  In a separately issued booklet, it chooses to meander through pointless elaboration.

The concept of a Mutual Fund works on pooling resources with one common objective in mind.  In other words, a Mutual Fund is made up of money that is pooled together by a large number of investors.  Their money is given to a professional (referred to as a fund manager) to invest in a basket of stocks and/or other financial instruments such as bonds/commodities.  The objective of every Mutual Fund scheme is clearly defined and explicitly mentioned by a Mutual Fund company, i.e. Asset Management Company (AMC). In simple words, one can think of a Mutual Fund as a company that brings together a group of people and invests their money in stocks, bonds, and other securities.  Each investor owns units, which represent a portion of the holding of the fund, based on the amount invested by the respective investor.

And here is SEBI’s take on explaining the concept:

Mutual fund is a mechanism for pooling the resources by issuing units to the investors and investing funds in securities in accordance with objectives as disclosed in offer document.

Investments in securities are spread across a wide cross-section of industries and sectors and thus the risk is reduced. Diversification reduces the risk because all stocks may not move in the same direction in the same proportion at the same time. Mutual fund issues units to the investors in accordance with quantum of money invested by them. Investors of mutual funds are known as unitholders.

The profits or losses are shared by the investors in proportion to their investments. The mutual funds normally come out with a number of schemes with different investment objectives which are launched from time to time. A mutual fund is required to be registered with Securities and Exchange Board of India (SEBI) which regulates securities markets before it can collect funds from the public.

In contrast, this is how the US Securities and Exchange Commission chooses to define a mutual fund:

A mutual fund is a type of investment company that pools money from many investors and invests the money in stocks, bonds, money-market instruments, other securities, or even cash.

It may not be a perfectly-worded definition but it presents a far more clearer picture, in far fewer words.  It, then, builds upon this definition to explain the working of a mutual fund, and the types of schemes.

The complexity of mutual funds being what it is, I believe any explanation needs to be elaborate.  However, it shouldn’t be done in a manner that renders it incomprehensible.   When explaining any new concept, a commonly used technique is to use a familiar product as a comparison (or point of reference).  I believe that any explanation of what a mutual fund is, would benefit immensely from such an approach.  In addition, unless absolutely necessary, I wouldn’t like to start any explanation with a definition.

For whatever you may find it to be worth, this is how I have opted to explain the concept of mutual funds.

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