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What is a Mutual Fund; How does it Work

A mutual fund is a collection or assortment of stocks, bonds, money market instruments and similar assets. Broadly speaking, a mutual fund can be a collection of various stocks or stocks & bonds or government bonds & certificates of deposits or stocks & fixed income securities or any other combination of securities that are grouped together as a single investment instrument.

Mutual fund investments are governed by Money Managers or Fund Managers, who invest or manage the funds in a way to create capital gains for income of investors. Mutual funds are operated by Asset Management Companies (AMCs) which exist in the form of public limited companies registered under the Companies Ordinance 1984. A Trust (and Trust Deed) is established by the Asset Management Company through which a mutual fund is launched. The Trustee performs the functions of the custodian of the assets of the fund whereas the Fund Manager takes the investment/ operational decisions regarding the fund.

Why Invest in Mutual Funds:

Mutual funds provide for an optimal investment package to invest into in order to get competitive returns to meet long term or short term financial goals. An investor may have long term financial goals such as arranging funds for child’s marriage or saving for retirement or for child’s education etc. Conversely, an investor may have short term financial goals such as saving for going on a vacation or cruise or buying a new car etc.

It is pertinent to mention that the investor must have his investment objectives outlined for himself as to what is his risk/ return profile, how much can he invest and for how long. These are some basic questions that an investor must know the answers to before making any investments.

Benefits of Investing in Mutual Funds:

By investing in mutual funds, the investor gets the advantage of investing in various securities in one investment package. This allows the investor to have a diversified portfolio of securities and have his investments managed by professionals.

Furthermore, by investing in mutual funds, the investor is also able to avail tax credit. This tax credit is available for individuals on the lower of (a) the amount of actual Cost of Investment, (b) 20% of Taxable Income for the tax year or (c) Rs 1 Mn. The tax credit availed on acquisition of such shares will need to be paid back, if such shares are disposed off within 24 months of the date of acquisition.

For self-employed individuals, the maximum tax credit of Rs 220,417/- is available on annual taxable income of Rs 6 Mn or above at an average rate of 22% whereas Rs 203,571/- is the maximum tax credit available on annual taxable income of Rs 7 Mn or more at an average tax rate of 20%.

For more details on the above, please consult: www.mufap.com.

Types of Mutual Funds:
An investor must be aware of the two broad types of mutual funds. They are:

  1. Closed-Ended Mutual Funds: These funds are traded on the Secondary Market, following an IPO. However, not all closed-ended mutual funds are listed on the Stock Exchange.
  2. Open-Ended Mutual Funds: These funds are issued in the form of Units to investors, which can be redeemed, as well, on the basis of their Net Asset Value (NAV) at any time. These funds can be purchased and redeemed through the Management Company which announces their offer and redemption prices daily. These funds can also be listed on the Stock Market.

Categories of Mutual Funds:

Mutual Funds are of various categories. An investor may invest in the fund that suits his investment strategy, time horizon of investment, how much risk he can tolerate, what are his cash flow requirements or any other investment objectives/ requirements. An investor may consult the Mutual Funds Association of Pakistan (website: www.mufap.com) for further guidance. The categories of funds are listed as follows:

Fund Category Investment In Characteristics & Features

Money Market Fund

Short-term fixed income securities

Lower risk, high liquidity

Income Fund

Money market securities, Term Finance Certificates/ Sukuks, Commercial Paper, & spread transactions.

Less risk, limited capital appreciation. These funds are required to sustain atleast 25% of net assets in cash and/or near cash instruments to meet liquidity requirements

Equity Fund

Stocks

High risk level, high capital appreciation

Balanced Fund

Equities & fixed income securities

Lesser risky with objective of growth & regular income. About 30% to 70% of the net assets are invested in listed equities

Asset Allocation Fund

Equities & fixed income securities

Higher risk, high return. Potential to invest 90% of net assets in equities at any point in time. Varying investment of assets within the fund

Capital Protected Fund

Term Deposit & as per authorised investments in the offering document

The original amount of the investment is protected. These funds have a mutually agreed upon fixed maturity period

Index Tracker Fund

Securities and stocks to mirror a market index such as the KSE 100 Index

The fund’s performance tracks the underlying index’s performance. Atleast 85% of net assets is required to be invested in securities that constitute the selected index or its subset. The balances of net assets are kept in cash or near cash instruments such as bank deposits (excluding Term Deposit Receipts & Treasury Bills not exceeding 90 days maturity)

Aggressive Fixed Income Scheme

Fixed income securities & medium to lower quality of assets 

High return investment. Investment in govt. securities, fixed income debt securities, deposits with bank(s), certificates of investment, & commercial paper etc. Atleast 10% of net assets are kept in cash or near cash instruments such as bank deposits & treasury bills not exceeding 90 days maturity

Commodity Scheme

Commodities such as gold, crude oil, silver, agri commodities

Stable returns investment. Investment in commodity & commodity futures such as gold. Atleast 70% of net assets must be invested in commodity or commodity futures contracts annually, based on average quarterly investment calculated on a daily basis.

Fund of Funds

Other varieties of mutual funds

Balanced returns. Investment in diverse portfolio of equity, balanced, fixed income and money market funds

Shariah Compliant (Islamic) Funds

Shariah compliant securities i.e. shares, Sukuk (Islamic bonds), and GoP Ijara Sukuk etc

All categories of conventional mutual funds have their shariah compliant variants. These funds are approved by Shariah Advisor

Key Points to Remember:

It is important for an investor to remember some key points regarding investment in mutual funds:

  1. Net Asset Value (NAV): Net Asset Value is the market value of the assets of a mutual fund minus its expenses and liabilities. The per unit NAV is the Net Asset Value of the funds divided by the number of units/ certificates outstanding on the Valuation Date. NAV denotes the performance of a mutual fund.

    NAV = (Current Market Value of all Assets – Expenses – Liabilities) / (Total Number of Units Outstanding)

  2. Expense Ratio: Expense Ratio is the mutual fund’s annual fund operating expenses, expressed as a percentage of the fund’s average net assets. An Expense Ratio of 1% p.a. means that each year 1% of the fund’s total assets will be used to cover expenses. Expense Ratios are important to consider when choosing a category of mutual fund as they can significantly affect returns.
  3. Redemption: Units of open-end mutual funds can be partially of fully redeemed at any time as the investor may decide from the Asset Management Company that manages the funds.
  4. Fund Manager Report: This is a monthly report produced by an asset management company in which information on composition and performance of the mutual funds is presented.

 

How to Invest in Mutual Funds:
There are two ways an investor can invest in mutual funds:

  1. Financial Advisors: Most Financial Advisors and Wealth Managers guide an investor to purchase units or shares of mutual funds. A Financial Advisor may be the right channel for an investor to get guidance and buy into mutual funds.
  2. Banks: Most banks offer investment products including mutual funds. An investor may contact a bank to invest in mutual funds.

The documents needed for opening a mutual fund account are as follows:

  1. CNIC Copy
  2. Application/ Account Opening Form/ Purchase of Units Form
  3. Zakat Affidavit (Optional)
  4. KYC Form/ FATCA Form
  5. Cheque/ Pay Order/ Demand Draft (payable to the respective Trustee)

 

Fees & Charges:

An investor must keep in mind the fees and charges involved with investing in mutual funds. Some of these charges are as follows:

  1. One-time Fee: There is a one time fees that an investor pays for investment/ divestment in an open-end fund. Details of these funds are disclosed in the offering documents of mutual funds.
  2. Front-end Load: This is charged to the investor upon purchase of units of the fund.
  3. Backend Load: This is charged whenever an investor redeems his investment in the mutual fund.
  4. Contingent or Deferred Sales Load: This is charged only when there is no front-end load. It is charged on redemption of investment however mutual funds progressively reduce this charge if an investor holds an investment for a longer period of time.
  5. Management Fee: This is the fee charged by the AMC for the management of a fund.  
  6. Trustee Fee: This is the fee charged by the Trustee for the provision of trusteeship and other services for the fund’s assets.
  7. Other Fees: All expenses incurred in connection with formation and registration of open-end mutual funds including but not limited to execution and registration of constitutive documents, fee payable to SECP, auditor’s fee, fee payable to rating agencies, legal costs etc.

 

Applicable Taxes:

The taxes charged against investment in mutual funds are relaxed for the investor. These taxes are, broadly, Withholding Tax and Capital Gains Tax (CGT).

  1. Withholding Tax (on Dividend Income) on Stock Funds: It is 12.5% if the dividend receipts are less than Capital Gain.
  2. Withholding Tax (on Dividend Income) on all other Mutual Funds (except Stock Funds): It is 25%.
  3. Withholding Tax (on Dividend Income) on all other Mutual Funds (except Stock Funds) for Individuals & Other Corporate & Non-Corporate Unit Holders: It is 10% for filers and 15% for non-filers.
  4. CGT where holding period of a security is less than 12 months: 12.5%
  5. CGT where holding period of a security is 12 months or more but less than 24 months: 10%
  6. CGT where holding period of a security is 24 months or more: 0%

Conclusively, it is safe to say that Mutual Funds are an optimal form of investment for many investors as they provide avenues to invest as per individual requirements of investors. Furthermore, they are transparent, liquid, diversified and balanced-risk modes of investment for the savvy investor, in general, and the novice investor in particular.