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“Risk comes from not knowing what you’re doing,” warned Warren Buffet, the iconic American businessman, investor, and philanthropist, to investors. Beginning as a small stock investor in Wall Street, he is now the second richest person in the US.

But then he was Warren Buffet. What was possible for him is not so for others. And instead of taking risk in ignorance he recommended to an average investor that “it’s better to hang out with people better than you. Pick out associates whose behaviour is better than yours and you’ll drift in that direction”. He also suggested that diversification is a protection against ignorance.

Put together, Buffet’s recommendations would indicate mutual fund as the alternative investment avenue for an average person. Here, the fund will be managed by better informed financial experts who are better equipped with the functioning of the market and will put the fund in diversified securities to minimise the risk quotient. Two most important aspects of Buffet’s recommendation- better associates and diversified portfolio- would be taken care of by investing in mutual funds.

What are mutual funds?

A mutual fund is a professionally-managed investment scheme usually run by an asset management company that brings together a group of people and invests their money in stocks, bonds and other money market instruments. The income / gains generated from this collective investment is distributed among the investors after deducting applicable expenses and fees, by calculating a scheme’s net asset value.

Most investors do not have the required knowledge, time or resources to build their portfolio of stocks or bonds. The asset management companies are equipped with technically expert professionals to assess stocks and the market and thus, investing in mutual funds enables an investor to own a professionally-managed diverse portfolio without having knowledge of the stocks or bonds.

Growth of mutual funds in India

The mutual fund industry in India began its journey way back in 1963 with the formation of Unit Trust of India at the initiative of the government and the Reserve Bank of India. The second phase began in 1987 with the entry of non-UTI public sector mutual funds set up by public sector banks and Life Insurance Corporation and General Insurance Corporation. SBI Mutual Fund was the first non-UTI mutual fund set up in 1987.

With the entry of private sector in 1993, a new era started in the Indian mutual fund industry allowing the Indian investors a wider choice of fund families. Also, 1993 was the year when the first Mutual Fund Regulations came into being, under which all mutual funds, except UTI, were to be registered and governed. The erstwhile Kothari Pioneer (now merged with Franklin Templeton) was the first private sector mutual fund registered in 1993.

The 1993 SEBI (Mutual Fund) Regulations were submitted by more comprehensive and revised Mutual Fund regulations in 1996. The industry now functions under the SEBI (Mutual Fund) regulations. The number of mutual fund houses went on increasing with many foreign mutual funds setting up funds in India.

The mutual fund industry had a compound annual growth rate (CAGR) of 18% over the past 10 years. Despite the global economic slowdown of 2010–13, there has been a remarkable increase in MF investments in India. However, factors such as favourable demographics, rising income levels and ongoing government initiatives continue to make it one of the most attractive sectors in the financial services industry.

The growth in the size of the industry has largely been possible due to the twin effects of the regulatory measures taken by Sebi in re-energising the industry in September 2012 and support from mutual fund distributors in expanding the retail base.

The regulatory measures apart, the industry has been constantly expanding the range and scope of various instruments it has been offering to customers. The introduction of hybrid fund is one such scheme that tries to make a balance between equity and debt.

Choosing between equity and debt is often difficult and the hybrid funds allow investors to invest in a combination of equity and debt. It’s a category of mutual fund that is characterized by portfolio made up of a mix of stocks and bonds, which can vary proportionately over time or remain fixed. That is, it reduces the risk through investment in bond but at the same time keeps the chances of higher return by investing partly in equity.

Based on their objectives and strategy, hybrid funds set different proportion of equity and debt in different schemes. The equity hybrid funds also called as balanced funds contain a higher ratio of equity to debt. The returns here are generally lower than a purely equity-focused fund but then the risk is also lower.

Alternatively, the debt hybrid fund contains more debt than equity. The risk level is higher than the pure debt fund, but lower than a balanced fund because of a smaller equity component. Debt funds known as monthly income plans also allow conservative investors to earn a regular dividend.

The result has been phenomenal; in just five years the total asset under management (AUM) of the mutual fund industry has grown more than three times from `5.87 trillion as on March 31, 2012 to `18.96 trillion as on June 30, 2017.

The total number of accounts (or folios as per mutual fund parlance) was counted at a record `5.82 crore as on June 30, 2017. The number of folios under Equity, ELSS and Balanced schemes, wherein the maximum investment is from retail segment, stood at `4.70 crore during the same period.

Technological upshot

The spectacular growth of the mutual fund industry was possible among other reasons, because of regular innovations in technology. Technology has now become an integral part of the industry and is used in every aspect – from fund management to transaction processing and from customer servicing to distribution. With the increasing use of smartphones and their regular technological upgradation, there lies a huge opportunity for asset management houses to leverage them for a successful business-to-customer (B2C) model and pass on the benefit to end customer.

Robo-advisers, artificial intelligence, blockchain, cloud computing, big data analytics are expected to replace the traditional model in the coming days. And the industry is expected soon to depend more and more on robotic applications to understand client requirements, their spending behaviour as well as future goals and will accordingly make calculated suggestions with regard to the right investment portfolio.

This will make the entire sales as well as client on boarding process more efficient and help increase the market reach of the industry. Both the government and the regulator (SEBI and AMFI) are supporting the adoption of technology by launching several initiatives to promote its use in the industry.

The flipside of mutual funds

But surely not everything about mutual fund is hunky-dory. Neither can investors slip on their investment hoping to realise hefty returns. Investors need to be alert in choosing the scheme. Like most investments here too some disadvantages are inherent.

Mutual funds do not offer fixed guaranteed returns in that you should always be prepared for any eventuality including depreciation in the value of your mutual fund. In other words, mutual funds entail a wide range of price fluctuations. Professional management of a fund by a team of experts does not absolutely insulate from bad performance of the fund.

The value of a mutual fund may fluctuate depending on the changing market conditions. Furthermore, there are fees and expenses involved towards professional management of a mutual fund which is not the case for buying stocks or securities directly in the market. There is an entry load which has to be borne by an investor when buying a mutual fund. Furthermore, some companies charge an exit cost as well when an investor chooses to exit from a mutual fund.

Another consideration the investors need to make is the locked in clause of fund. There are two different mutual fund structures – one allows investors to go in and out at any time. The other one is locked for a specified period and charges investors if to get out of the scheme before the maturity date.

With lower interest rates in bank deposits and demonetization, the AUM of the mutual fund industry is expected to grow at a higher rate in the coming years. Investors are increasingly concerned about keeping their surplus funds in savings bank accounts and the use of digitisation has made the mutual fund industry more appealing.

The return on bank deposits has become negligible after accounting for inflation and tax as compared to a mutual fund is which the dividend/returns received is completely tax exempt (on equity, after one year).