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What is a Mutual Fund?

A mutual fund is a pool of money belonging to a group of investors entrusted to a Fund Manager (investment specialist) hired by the group. The Fund Manager invests the money on behalf of the investors and is paid a management fee normally in the range of 1% to 2% per year of the amount of funds under management.

If there is a profit or gain on the investments, it belongs to the mutual fund owners (investors) because they mutually own the pool. On the other hand, if there is a loss, it is a loss suffered by the owners of the pool (investors).

How are Mutual Funds different from Banks?

A bank too manages a pool of money, but the money it receives from investors (depositors) is treated as a loan from the depositors on which the bank pays a fixed rate of return. The bank in turn lends the money to various businesses and earns a higher rate of return. The bank makes money by earning the difference between the rate at which it borrows (from the depositors) e.g the rate at which it lends to the businesses- around 6%. The gross earning of the bank in this example will be 13% minus 6%, i.e., 7% versus 1% to 13% charged by the mutual fund manager.

In the event there is a loss in the lending business, the bank will still pay the depositor the agreed rate. However, in the event that the bank runs into major losses (such as major defaults by its borrowers) and has to close down, the depositors are not likely to get their full principal but will get whatever can be recovered by the liquidators.

Types of Mutual Funds?

Closed-End Funds: A Closed-end fund is a mutual fund that has a fixed pool of money having a specified period of maturity, which is collected when the fund is set up. The fund is set up as an investment company (or closed end scheme) with a certain amount of capital (pool of money). The Fund Manager invests the pool in the capital markets (normally shares of other companies). An investor wishing to participate in the mutual fund, buys shares/certificates of the investment company or closed end scheme at the time of its initial public offer or, as in the case of any other company, the investor may buy shares of the investment company subsequently from the stock market, at the prevailing market price. When the investor wishes to disinvest, he has to sell his shares of the investment company through the stock exchange, at the prevailing price.

As in the case of any other company, the price of the shares of the investment company (closed-end mutual fund) in the stock market will be determined by the supply and demand for such shares, which may be higher or lower (normally lower) than the Net Asset Value (true value of the investment portfolio) of the investment company.

Open-End Funds: An Open-end fund on the other hand does not have a fixed pool of money. The Fund Manager continuously allows investors to join or leave the fund. The fund is set up as a trust, with an independent trustee, who has custody over the assets of the trust. Each share of the trust is called a Unit and the fund itself is called a Unit Trust. The portfolio (pool) of investments of the Unit Trust is (normally) evaluated daily by the Fund Manager on the basis of prevailing market prices of the securities in the portfolio.

This market value of the portfolio is divided by the number of Units issued to determine the Net Asset Value (NAV) per Unit. An investor can join or leave the fund on the basis of the NAV per Unit. However, the Fund Manager may have a small charge called load added to the selling price or deducted from the redemption price of the Units so as to cover distribution costs.

Under the Pakistan law, open-end and closed-end funds are set up under the Non-Banking Finance Companies (NBFC) Rules 2003, NBFC and Notified Entities Regulations 2008, and are regulated by Securities & Exchange Commission of Pakistan.

Which Mutual Funds to Invest in?

  • Well-established and reputable companies.
  • Fund Management Companies that issue timely, transparent and investor friendly reports.
  • Fund Management Companies that follow good corporate governance practices and comply with proper disciplines. The offering document (prospectus) of the particular fund having a clearly defined investment policy and clearly stated potential risks.
  • Choose a Fund, the investment policy of which is suitable for the time horizon of your investment and the level of risk that investment can be exposed to. However, it is recommended that, you should allocate the investment amount between two or more Funds that suit the criteria. This will ensure that you diversify the risk on the fund manager's performance as well.

Why Mutual Funds?

Why Invest through Mutual Funds?

The benefits of investing through mutual funds are elaborated below. The simple fact is that most people do not have time outside their work and family life to scrutinize dozens of stocks and bonds before putting their money in for investment. This job can be left to professional managers. Anyone can pick and buy certain hot stocks and make money in the process. However, this fact should not make us believe that we will always hit a sixer. It is an established fact that majority of part-time speculators lose in the game of speculation. One should not confuse speculation for investment. Investment through mutual funds is an ideal option for those investors who do not have time to explore investment opportunities in today's dynamic and ever-changing capital market conditions.

The benefits of Investing through Mutual Funds?

Mutual funds allow investors to benefit from the collective strength of the group (pool). The benefits include:

Services of Investment Professionals An average investor may not be well-versed with the capital markets, or have access to adequate information to invest successfully or simply may not have the time to acquire information and analyze it. By investing through a mutual fund, the investor is able to acquire the services of a team of professionals dedicated to the investment business, whose cost is spread over the entire pool and thus is very low cost for the investor.

Ability to Diversify An average investor will normally invest small amounts of money and will not be able to achieve an adequate level of diversification if invested directly in the Capital Market. Whereas, even a small amount in a mutual fund will achieve immediate diversification by becoming a part owner of the entire portfolio of the mutual fund.

Ability to invest very small amounts An investor, who wishes to invest very small amounts, even Rs. 1,000, can do so by investing in some mutual funds (normally open-end funds). The same amount of Rs.1,000 will not be entertained by any broker in the capital markets, which are normally the exclusive domain of the rich and wealthy.

Ability to multiply savings If an investor wishes to build up savings of small amounts every month, he does not have to wait to first build up large enough amounts to invest meaningfully. By investing every month in a mutual fund, the investor can make the monthly savings earn and grow as these are accumulated.

Ability to mitigate price volatility riskAt the point in time when an investor has some funds to invest, the market may be rising (bullish) or declining (bearish). He is never too sure if he is entering the market at the right time. By investing small amounts in mutual funds regularly, the investor is able to average out the fluctuations in the purchase price, some investment will be made when the market is high and some when it is low; the average investment is likely to be at the mid-point.

Ability to match investment with risk-taking ability Most investors have their own unique risk-taking ability. Retired persons will normally have a low risk taking ability. On the other hand, younger persons or persons with adequate resources are normally able to take higher risk and should therefore be able to benefit from higher potential rewards. Mutual funds normally offer different investment styles, i.e., there are funds that invest in the stock market and carry a higher potential risk and reward. Apart from stock market funds, there are mutual funds that invest in the debt securities, which expose one to relatively lower risk; and then there are mutual funds that invest in money markets, which expose one to very low risk. By allocating one's savings into several mutual funds, the investor can balance out the investments into a combination that suits the investor's risk-taking ability.

Less volatile By investing in diversified assets, mutual funds are generally less volatile than the average equities portfolio of an individual investor.

Size does matter With the growth in the size of funds under mutual fund management, the reach and dimension of that fund in itself enhances its ability to exploit investment and trading opportunities in the market.

Liquidity Money invested in mutual funds can be redeemed either by selling the shares of a closed-end fund in the market or by simply asking the Fund Manager for redemption (refund at current market price) in the case of an open-end fund. There are no penalties for early termination of the investment, which one may have to suffer in the case of term deposits with banks or other savings schemes

Protection of Regulation If one invests directly in the capital markets, the rule of Caveat Emptor or "buyers beware" applies in its full meaning. However, in case of investing in a mutual fund, one is protected by the government-enforced regulation of mutual funds. In most countries, Mutual Fund Managers are regulated under stringent regulatory rules and investors can rely on the enforcement of good practices by the Fund Managers. In Pakistan, the Securities & Exchange Commission of Pakistan (SECP) is the regulator of mutual funds and is very stringent in issuing licenses to fund management companies, especially in the case of Collective Investment Scheme (CIS). The SECP also carries out continuous monitoring of mutual funds through reports that the mutual funds have to file with the SECP on a regular basis. In addition, SECP conducts on-site inspections of the AMCs.

Protection through the Trustee In the case of collective investment schemes, the trustee, who has to be qualified under the law to act as such, offers additional protection by having complete custody over the assets of the mutual fund. The trustee ensures that the Fund Manager takes the investment decisions within the defined investment policy of the mutual fund. Under Pakistan law, banks and central depository companies, approved by the SECP, can act as trustees.

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