Mutual Funds

PGPBFS201011 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 economy to borrowers i th economy ffi i tl t b in the efficiently.
Savers!!! Borrowers!!!

How is economy benefited from this transfer ?

People who save are frequently not the same people who have profitable investment opportunities available to them, the entrepreneurs Suppose A has Rs, 50,000 as excess savings this year, but no borrowing or lending 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 10,000 Rs per year, but he has no money to start the business. if A can lend his money to B and charge an interest rate of 10% per year year, he gets 5000 extra and B gets 10,000 5000 (interest) = 5000 extra income, so both of them are better off.

Fund transfer from savers to borrowers Direct and indirect route

Direct Finance Route :
borrowers borrow funds directly from the lenders in the y financial markets, by selling them securities ( also called financial instruments). These are assets to those who buy them 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 funds from one to the other. The intermediary borrows funds from the savers and then using this fund makes loans to the borrower spenders.

Role of financial Intermediaries

INDIRECT FINANCE Financial Intermediaries (banks, mfs ,insurance companies)

funds

funds

funds

Borrowers Spenders

Lender Savers
1. House holds 2. 2 Business Firms 3. Govt. 4. Foreigners

funds

Financial Markets

funds

1. House holds 2. Business Firms 3. Govt 3 Govt. 4. Foreigners

Primary securities like stocks , bonds etc.

DIRECT FINANCE

Transfer of funds through intermediary..

Example :
A bank might acquire funds by issuing a liability in the form g q y g y of savings deposits( an asset for the public). It might then use the funds to acquire an asset by making a loan to reliance Industries by buying a bond issued by RIL in the financial markets. Results in transfer of funds from the public( lender savers) to RIL( borrower spender) with the help of a financial intermediary. Process called financial intermediation

Financial Intermediation.. Global picture

Financial intermediaries are a much more important source of financing for 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 developed financial markets in the world). Germany and Japan have made least use of Financial markets in that the financing from financial intermediaries have been ten times greater than for securities markets. In India .also historically financial intermediaries have played a more important role than the financial markets .

Need for intermediaries

Why are financial intermediaries and indirect finance so i fi important f fi t t for financial markets ? i l k t
Reduction of Transaction costs and economies of scale Reduction of Adverse selection problem arising from Asymmetric information

Transaction cost
People who save are frequently not the same people who have profitable investment opportunities available to them, the entrepreneurs Suppose A has Rs, 50,000 as excess savings this year, but no borrowing or lending 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, he gets 5000 extra and B gets 10,000 5000 (interest) = 5000 extra 10 000 income, so both of them are better off

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Transaction costs contd

in the absence of a financial intermediary , to protect his investment A may require a lawyer to write up a loan contract specifying terms and conditions @ Rs.15000/ . Rs 15000/ When this is figured in the transaction cost for making the loan, he realizes that he cannot earn enough from the deal ( he spends 15000 to earn 5000/) 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 Can anyone come to rescue? ..Financial Intermediaries can.

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Transaction costs.. Contd..

Financial intermediaries can substantially reduce the transaction costs by using the advantage of economies of scale. For example a bank will know how to find a good lawyer to produce an airtight loan contract, and this contract can be used over and over again in its loan transactions, thus lowering the legal cost per transaction. Instead of a loan contract ( which may not be that well written) costing 15000/ a bank can hire a top class lawyer for 50,000/ to draw up an airtight loan contract that may be used for 2000 loan transactions at a cost / p of 25/ per contract. At a cost of 25/ per contract it now becomes profitable for the intermediary to loan B the amount of 50,000/.

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Asymmetric information : adverse selection

Asymmetric information : One party in a transaction knows more than the other party party.
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.

leads to problems in the financial markets --- adverse selection problems.

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Adverse selection.. Problem of lemons

Problem of lemons first noted by George Akerlof(1970) The market for lemons: quality, uncertainty and the market The lemons : quality mechanism, Quarterly Journal of Economics, Vol. 84. Lemons problem is a market problem caused by information asymmetry leading to failure of the market. Popular example can be found with the used car market market, insurance companies issuing new policies etc.

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Problem of lemonscontd..
Example 1) Used car market : Suppose you want to purchase an old car there are 10 cars on display5 bad and 5 good You are not an expert and cannot distinguish between good. 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 at a min price of 40 k. But you will have to quoteHow do you quote? Now if you want to be overcautious what is your most natural quote? quote an average price of say 70 k what will happen?

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Problem of lemonscontd..
All the good cars will go away and you will be left with only the bad cars in the marketthese are the market these "Lemons " now if you buy one with 70k you will lose outyou do that get cheated and want to take your hands off the market in future. may eventually lead to a complete breakdown of the market.
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Problem of lemonscontd..
Lemons Problem is also important for corporate finance. If investors cannot observe the value of the firms before they buy them then they would be willing to pay only an average price for the equity of the firms. g p y y g p q y Given the price is average, selling equity on the market will be much more attractive 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 below the average price commanded.

This implies that the investors will be generally cheated and should be suspicious that if they are offered equity then it must mean that the firms value is more likely to be below the average.

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

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Problem of lemonscontd..
What is the solution ? ..Going back to the old car example Get an expert who somehow knows which old car is good and which one is bad. He gives his opinion using his expertise ,which one to buy may be against some fee. Then you can confidently buy the cars. Both the buyers and the sellers in the market are benefited. In case of financial markets ..this expert is the intermediary.
Example: banks with their credit departments, mutual fund with an analyst, Credit rating agencies( good at distinguishing between good and bad investment opportunities), investment banks etc.
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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 industries But Reliance wont take it from me due to the reason that they are dealing in crores of Rs. and they don't want to deal with such small bits Rs don t and pieces. Intermediaries like mutual funds pool many such bits and pieces and may invest the entire sum ( indirect finance route) which could be acceptable to RIL. 3. Temporal Intermediation : Matching of time perhaps when I want the money the company may not be in a position to pay but if I channelize through an intermediary and thousands of others do likewise they may be able to match the outflow and inflow( assuming incremental deposit > incremental withdrawal )

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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 not possible for me to monitor their activities which can be easily done by an intermediary ( say the credit department of a bank) A large intermediary is also likely to have much more bargaining power than a small 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 and reduce the risk of my portfolio. But with an intermediary in place (mutual funds for example ) I can probably buy the units of the fund which with its huge pool of money from many investors like me can ensure considerable diversificationthus I enjoy the b j h benefits of di fi f diversification without h i to i ifi i ih having invest a l of money. lot f

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Types of Intermediaries
1. Depository Institutions or banks 2. 2 Non depository Institutions

Development Financial Institutions ( DFIs) Investment intermediaries ( Mutual funds, Pension funds etc.) Insurance companies Other NBFCs like
leasing and hire purchase companies, factoring and forfaiting agents, credit rating companies etc.

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 Mutual funds

What is a mutual fund ?

A mutual fund is a common pool of fund or capital mobilized from a large number of investors, and invested on their behalf in several securities in the market. All the returns from such investments, both in terms of di id d and capital appreciation , t f dividends d it l i ti net of various expenses , accrue to the investors.

Advantage of investing through a mutual fund

1)Provide continuous professional portfolio management services : 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, mutual funds have the resources to hire very qualified , full time investment managers.

Advantage of investing through a mutual fundcontd..

2)Diversification : It can be shown ( with the help of portfolio theory) that if one invests in a large number of uncorrelated securities or in well diversified portfolio , the unique or security well portfolio specific risk can be diversified away. The only risk that cannot be diversified away is the systematic or market risk which affects all assets in the economy. To give a nave 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. Y run t th phone i You to the h immediately , call your b k , an i di t l ll broker invest all your t ll savings in shares of Phenomenal stock. Five years later , suppose the food and drug administration denies the company approval for the drug and the company is ruined , taking your entire savings along with it.

Advantage of investing through a mutual fundcontd..

Diversification contd.. Your money would have been much safer in a mutual fund. A mutual fund might buy some shares of a promising ,but risky company like Phenomenal without exposing investors like you to financial ruin. A fund owns stocks or bonds from dozens of companies, diversifying against the risk of bad news from any single company or sector. So when Phenomenal gets ruined, the fund may barley feel a ripple. Diversifying like that on your own might be difficult. and expensive unless you have several hundred thousand bucks and a great deal of time to invest. Youd need to invest in atleast 12 to 15 different companies in various industries to ensure that your portfolio could withstand a downturn in one or more of the investment. investment 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 the probability ,that the fund receives the highest possible return at the lowest possible risk, given the objectives of the fund. By purchasing units of mutual funds , an investor gets a proportional claim to the diversification benefits.

Advantage of investing through 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 specific riskreturnliquidity requirement of the investor risk return liquidity investor. 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 on his own. This is because of the fact that given its size an AMC would be in a position to negotiate better brokerage terms for the sales and purchases of its investment. Regulators ( SEBI in India) set limits to expenses that can be charged to the investors. Apart from regulatory ceilings, competition plays its own role in determining the cost of mutual fund investing.

Advantage of 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 about the schemes investment objectives, its investment methods, and information about how to purchase and redeem units SEBI also requires the funds to provide the fee structure of the fund and periodic reports about the funds 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 is available after paying tax. il bl f i 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 higher reinvestment thus allowing investors to multiply their money within a scheme without paying tax in the interim.