Comparison with other products

The mutual fund sector operates under stricter regulations as compared to most other investment avenues.  Apart from the tax efficiency and legal comfort, the comparison of mutual funds with other products as follows:

Company fixed deposits versus Mutual funds : Fixed deposits are unsecured borrowings by the company accepting the deposit.  Credit rating of the fixed deposit program is an indication of the inherent default risk in the investment.

The moneys of investors in a mutual fund scheme are invested by the AMC in specific investments under that scheme.  These investments are held and managed in-trust for the benefit of scheme’s investors.  On the other hand, there is no such direct correlation between a company’s fixed deposit mobilization, and the avenues where these resources are deployed. 

A corollary of such linkage between mobilization and investment is that the gains and losses from the mutual fund scheme entirely flow through to the investors.   Therefore, there can be no certainty of yield, unless a named guarantor assures a return or, to a lesser extent, if the investment is in a serial gilt scheme.  On the other hand, the return under a fixed deposit is certain, subject only to the default risk of the borrower.

Both fixed deposits and mutual funds offer liquidity, but subject to some differences:

1. The provider of liquidity in the case of fixed deposits is the borrowing company.  In mutual funds, the liquidity provider is the scheme itself (for open-end schemes) or the market (in the case of closed-end schemes).
2. The basic value at which fixed deposits are in Investor is not subject to market risk.  However, the value at which units of a scheme are redeemed entirely depends on the market.  If securities have gained in value during the period, then the investor can even earn a return that is higher than what Investor anticipated when Investor invested. Conversely, Investor could also end up with a loss.
3. Early encashment of fixed deposits is always subject to a penalty charged by the company that accepted the fixed deposit.  Mutual fund schemes also have the option of charging a penalty on “early” redemption of units (by way of an ‘exit load’)  If the NAV has appreciated adequately, then despite the exit load, the investor could earn a capital gain on Investor’s investment.

Bank fixed deposits versus Mutual funds : Bank fixed deposits are similar to company fixed deposits.  The major difference is that banks are more stringently regulated than are companies.  They even operate under stricter requirements regarding Statutory Liquidity Ratio (SLR) and Cash Reserve Ratio (CRR).

While the above are causes for comfort, bank deposits too are subject to default risk.  However, given the political and economic impact of bank defaults, the government as well as Reserve Bank of India (RBI) try to ensure that banks do not fail. 

Further, bank deposits upto Rs 100,000 are protected by the Deposit Insurance and Credit Guarantee Corporation (DICGC), so long as the bank has paid the required insurance premium of 5 paise per annum for every Rs 100 of deposits.  The monetary ceiling of Rs 100,000 is for all the deposits in all the branches of a bank, held by the depositor in the same capacity and right.

Bonds and debentures versus Mutual funds : As in the case of fixed deposits, credit rating of the bond / debenture is an indication of the inherent default risk in the investment.  However, unlike fixed deposits, bonds and debentures are transferable securities. 

The investments of a mutual fund scheme are held by a custodian for the benefit of investors in the scheme.  Thus, the securities that relate to a scheme are ring-fenced for the benefit of its investors.

Equity versus Mutual funds : Investment in both equity and mutual funds are subject to market risk.  An investor holding an equity security that is not traded in the market place has a problem in realizing value from it.  But investment in an open-end mutual fund eliminates this direct risk of not being able to sell the investment in the market.  An indirect risk remains, because the scheme has to realize its investments to pay investors.  The AMC is however in a better position to handle the situation.  

Another benefit of equity mutual fund schemes is that they give investors the benefit of portfolio diversification through a small investment.  For instance, an investor can take an exposure to the index by investing a mere Rs 5,000 in an index fund.

Life insurance versus Mutual fund : Life insurance is a hedge against risk – and not really an investment option.  So, it would be wrong to compare life insurance against any other financial product. 

Occasionally on account of market inefficiencies or mis-pricing of products in India, life insurance products have offered a return that is higher than a comparable “safe” fixed return security – thus, investor are effectively paid for getting insured!  Such opportunities are not sustainable in the long run.