5631_Session 1-Introduction_mutual Fund Concept

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Mutual Funds

PGPBFS‐2010‐11

Session 1

Outline

• Financial System

•

Role of intermediaries in the financial system• Mutual funds as intermediaries

• Concept of mutual fund



Financial system

• Transfer savings from ‘savers’ in the economyto orrowers n t e economy e c ent y .

– Savers‐‐‐‐!!!

– Borrowers‐‐‐‐!!!

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How is economy benefited

from this transfer ?

• People who save are frequently not the same people who have profitableinvestment opportunities available to them, the entrepreneurs

• Suppose A has Rs, 50,000 as excess savings this year, but no borrowing orlending is possible so this 50,000 does not earn any further income for A.

• B has a small business scheme needing an investment of Rs.50,000( say an

up gradation of his grocery shop) which will fetch him additional 10,000Rs per year, but he has no money to start the business.

•

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,he gets 5000 extra and B gets 10,000 – 5000 (interest) = 5000 extraincome, so both of them are better off.



Fund transfer from savers to borrowers ‐‐‐Direct

and indirect route

•

Direct Finance Route : – borrowers borrow funds directl from the lenders in the

financial markets, by selling them securities ( also calledfinancial instruments). These are assets to those who buythem and liabilities to those who sell( issue) them.

• The Indirect Finance Route : – This involves a financial intermediary between lender‐

savers and borrower –spender and helps transfer fundsfrom one to the other.

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– The intermediary borrows funds from the savers and thenusing this fund makes loans to the borrower spenders.

Role of financial Intermediaries

INDIRECT FINANCE

Financial

Intermediaries

(banks, mfs ,insurance

companies)

Financial

Markets

funds

funds

fundsfunds

Lender Savers1. House holds

Borrowers Spenders1. House holds

2. Business Firms

funds

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. usin ss irms

3. Govt.

4. Foreigners

. .

4. Foreigners

DIRECT FINANCE

Primary securities like stocks , bonds etc.



Transfer of funds through intermediary..

•

Example : – A bank mi ht ac uire funds b issuin a liabilit in the form

of savings deposits( an asset for the public).

– It might then use the funds to acquire an asset by making aloan to reliance Industries by buying a bond issued by RILin the financial markets.

– –

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savers) to RIL( borrower spender) with the help of afinancial intermediary.

– Process called financial intermediation

Financial Intermediation.. Global picture

• Financial intermediaries are a much more important source of financingfor corporations than securities markets are

• This is true for most countries globally.. US, Great Britain, Japan, Italy,Germany, France etc. ( true even for US which has the most developedfinancial markets in the world).

•

Germany and Japan have made least use of Financial markets in that thefinancing from financial intermediaries have been ten times greater thanfor securities markets.

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• In India ….also historically financial intermediaries have played a moreimportant role than the financial markets .



Need for intermediaries

• Why are financial intermediaries and indirectnance so mportant or nanc a mar ets

– Reduction of Transaction costs and economies of

scale

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– Reduction of Adverse selection problem arising

from Asymmetric information

Transaction cost

• People who save are frequently not the same people who have profitableinvestment opportunities available to them, the entrepreneurs

• Suppose A has Rs, 50,000 as excess savings this year, but no borrowing orlending is possible so this 50,000 does not earn any further income for A.

• B has a small business scheme ( say an up gradation of his grocery shop)

which will fetch him additional 10,000 Rs per year

• if A can lend his money to B and charge an interest rate of 10% per year, – =

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,income, so both of them are better off



Transaction costs… contd…

• in the absence of a financial intermediary , to protect his investment Amay require a lawyer to write up a loan contract … specifying terms and

‐. .

• When this is figured in the transaction cost for making the loan, he realizesthat he cannot earn enough from the deal ( he spends 15000 to earn5000/‐) and reluctantly A would ask B to look somewhere else .

• small savers like A and potential borrowers like B might be driven out of the financial markets and thus be unable to benefit from them

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• Can anyone come to rescue? …..Financial Intermediaries can.

Transaction costs.. Contd..

• Financial intermediaries can substantially reduce the transaction costs byusing the advantage of economies of scale.

• For example a bank will know how to find a good lawyer to produce anairtight loan contract, and this contract can be used over and over again inits loan transactions, thus lowering the legal cost per transaction.

•Instead of a loan contract ( which may not be that well written) costing15000/‐ a bank can hire a top class lawyer for 50,000/‐ to draw up anairtight loan contract that may be used for 2000 loan transactions at a costof 25/‐ er contract.

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• At a cost of 25/‐ per contract it now becomes profitable for theintermediary to loan B the amount of 50,000/‐.



Asymmetric information : adverse selection

• Asymmetric information : One party in a transaction.

– For example in financial markets, a borrower who takes out

a loan knows better about the potential risks and returns

associated with the investment projects for which the funds

are earmarked than the lender does.

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• leads to problems in the financial markets --- adverse

selection problems.

Adverse selection.. Problem of lemons

• ‘Problem of lemons’– first noted by George Akerlof(1970)—“ ‘ ’ ,mechanism,”– Quarterly Journal of Economics, Vol. 84.

• Lemon’s problem is a market problem caused by information

asymmetry leading to failure of the market.

•

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,insurance companies issuing new policies etc.



Problem of lemons—contd..

• Example 1) Used car market :

• Suppose you want to purchase an old car ‐‐there are 10 cars on display‐5‐

.good and bad cars (the only information you are provided is say year of manufacture).

• Suppose the good cars can sell at a min. price of 100k and the bad cars ata min price of 40 k.

• But you will have to quote‐How do you quote?

•

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• quote an average price of say 70 k‐‐‐

• what will happen?


• All the good cars will go away and you will be left‐‐‐‐

"Lemons "‐‐‐‐

• now if you buy one with 70k you will lose out‐you do

that‐

get cheated and want to take your hands off the market in future.

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• may eventually lead to a complete breakdown of themarket.



Problem of lemons—contd..• Lemons Problem is also important for corporate finance.

• If investors cannot observe the value of the firms before they buy them then theywould be willin to a onl an avera e rice for the e uit of the firms.

• Given the price is average, selling equity on the market will be much moreattractive to owners of bad firms than to owners of good firms.

• So the true value of the firms that are actually offered on the market will be belowthe average price commanded.

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• This implies that the investors will be generally cheated and should be suspiciousthat if they are offered equity then it must mean that the firm’s value is more likely

to be below the average.

• Hence the investors will no longer be there in the market.


• What is the solution ? …..Going back to the old carexample—

• which one is bad.

• He gives his opinion using his expertise ,which one to buy maybe against some fee.

• Then you can confidently buy the cars. Both the buyers andthe sellers in the market are benefited.

• In case of financial markets ..this expert is the intermediary.

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– banks with their credit departments,

– mutual fund with an analyst,

– Credit rating agencies( good at distinguishing between good and badinvestment opportunities),

– investment banks etc.



Other roles played by the intermediary

1. Production of information/signal :• Example:

• good bank has given money to a company

implies company must be in good position

,o/w they would not have touched it.

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Other Roles played by the intermediary‐ contd..

2. Size Intermediation :

• Example : I have 100,00 Rs and I want to invest in Reliance industriesBut Reliance won’t take it from me due to the reason that they are

'ea ng n crores o s. an ey on wan o ea w suc sma sand pieces. Intermediaries like mutual funds pool many such bits andpieces and may invest the entire sum ( indirect finance route) whichcould be acceptable to RIL.

3. Temporal Intermediation :

• Matching of time

• perhaps when I want the money the company may not be in a positionto a but if I channelize throu h an intermediar and thousands of

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others do likewise they may be able to match the outflow and inflow(assuming incremental deposit > incremental withdrawal )



Role played by the intermediary‐ contd..

4.Monitoring Difficulty :

• Even if a company like Reliance is ready to take my small amount of money it is notossible for me to monitor their activities which can be easil done b an

intermediary ( say the credit department of a bank)

• A large intermediary is also likely to have much more bargaining power than asmall investor in enforcing certain covenants for the company.

5. Risk Intermediation:

• With my small money I will not be able to enjoy the benefits of diversification andreduce the risk of my portfolio. But with an intermediary in place (mutual funds forexample ) I can probably buy the units of the fund which with its huge pool of money from many investors like me can ensure considerable diversification‐‐‐‐thus

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I enjoy the benefits of diversification without having to invest a lot of money.

Types of Intermediaries

1. Depository Institutions or banks

. on epos ory ns u ons

– Development Financial Institutions ( DFIs)

– Investment intermediaries ( Mutual funds, Pensionfunds etc.)

– Insurance companies

– Other NBFCs like

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• leasing and hire purchase companies,

• factoring and forfaiting agents,

• credit rating companies etc.



• Mutual funds

What is a mutual fund ?

• A mutual fund is a common pool of fund or

investors, and invested on their behalf inseveral securities in the market.

• All the returns from such investments, both interms o v en s an cap ta apprec at on ,net of various expenses , accrue to theinvestors.



Advantage of investing

through a mutual fund

1)Provide continuous professional portfolio

• The money pooled in the mutual funds is managed

by professionals who decide investment strategy on

behalf of the unit holders.

• Because of relatively large pool of investable funds,

qualified , full time investment managers.


through a mutual fund…contd..• 2)Diversification : It can be shown ( with the help of portfolio

theory) that if one invests in a large number of uncorrelated“ ” ,

specific risk can be diversified away. The only risk that cannot bediversified away is the systematic or market risk which affects allassets in the economy.

•To give a naïve example to explain what diversification is all about : – Suppose you heard that Phenomenal Pharmaceuticals has developed

a drug that stops cancer cells in their tracks.

– ou run to t e p one mme ate y , ca your ro er , an nvest a yoursavings in shares of Phenomenal stock.

– Five years later , suppose the food and drug administration denies thecompany approval for the drug and the company is ruined , takingyour entire savings along with it.




through a mutual fund…contd..

• Diversification… contd..

• Your money would have been much safer in a mutual fund. A mutual fund mightbu some shares of a romisin but risk com an like Phenomenal without exposing investors like you to financial ruin. A fund owns stocks or bonds fromdozens of companies, diversifying against the risk of bad news from any singlecompany or sector. So when Phenomenal gets ruined, the fund may barley feel aripple.

• Diversifying like that on your own might be difficult.– and expensive– unless youhave several hundred thousand bucks and a great deal of time to invest. You’dneed to invest in atleast 12 to 15 different companies in various industries toensure that your portfolio could withstand a downturn in one or more of the

.

• Mutual funds ,on the other hand because of large investable funds can afford to

invest in 25 to 100 securities or more. Proper diversification increases theprobability ,that the fund receives the highest possible return at the lowestpossible risk, given the objectives of the fund. By purchasing units of mutualfunds , an investor gets a proportional claim to the diversification benefits .

Advantage of investingthrough a mutual fund.. Contd..

• 3) Variety and convenience: Mutual funds can have variety of products with wide range of objectives and services to suit the

‐ ‐ .

• 4) Reduction in transaction cost :

– Average cost of managing a rupee ( in terms of brokerage costs, D‐

mat account maintenance expenses etc.) will be much lower for a

mutual fund than for an investor managing a diversified portfolio onhis own.

– This is because of the fact that given its size an AMC would be in a

purchases of its investment.

– Regulators ( SEBI in India) set limits to expenses that can be chargedto the investors. Apart from regulatory ceilings, competition plays itsown role in determining the cost of mutual fund investing.




through a mutual fund.. Contd..• 5) Regulatory Protection :

– Mutual funds are subject to strict regulation . – As part of this regulation mutual funds provide full and complete disclosures

about the funds in a written offer document, which tells the investors aboutthe scheme’s investment objectives, its investment methods, and informationabout how to purchase and redeem units

– SEBI also requires the funds to provide the fee structure of the fund andperiodic reports about the fund’s portfolio holdings and performance .

• 6) Tax Advantage : – In general investors pay tax on a year on year basis. So if they were to earn

and then reinvest any income, what they would reinvest is the amount that isava a e a ter pay ng tax.

– Mutual fund schemes on the other hand do not pay any tax on their income.

– So the same earning in a mutual fund scheme could facilitate higherreinvestment thus allowing investors to multiply their money within ascheme without paying tax in the interim.

5631_Session 1-Introduction_mutual Fund Concept

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