Investing Basics: Funds, Shares, Bonds, and Asset Allocation

What pooling money changes

A mutual fund pools money from many investors and employs a manager to invest it according to a stated objective. Each investor holds units representing a proportional share of the pool. The value of a unit, the net asset value, is the total value of the fund's holdings less its liabilities, divided by the number of units. It is calculated at the end of each dealing day, and subscriptions and redemptions during the day are transacted at that computed value rather than at a price set by trading.

Pooling changes three things. It gives a small investor exposure to a spread of securities that would be impractical to assemble individually. It transfers security selection to a manager operating under a defined mandate. And it introduces a continuing cost, expressed as an expense ratio, which is deducted from the fund's assets rather than billed separately. Because the deduction is invisible in that sense, it is easy to overlook, and it applies every year regardless of whether the fund performs well.

What to compare across funds is therefore not only past returns, which reflect a particular period, but the stated mandate, the expense ratio, the turnover of the portfolio, the size of the fund relative to the liquidity of what it holds, and any exit load applied on early redemption. The scheme information document sets all of this out, and it governs what the manager may do even if the recent portfolio looks narrower than the mandate allows.

Exchange-traded funds and the mechanics of the price

An exchange-traded fund is also a pooled vehicle, but its units trade on a stock exchange throughout the session like a share. That single structural difference produces several practical ones. You transact at a market price that can differ from the underlying net asset value, you can deal at any time the market is open, and you pay brokerage and face a bid-ask spread rather than dealing directly with the fund at a computed value.

The gap between market price and net asset value is kept narrow by a creation and redemption mechanism. Large authorised participants can exchange a defined basket of the underlying securities for new units, or the reverse, which gives them a profitable trade whenever the price drifts materially from the underlying value. That mechanism works well when the underlying securities are themselves liquid and trade during the same hours. When the underlying market is thin or closed, the discipline weakens and the discount or premium can widen.

What an index fund is actually tracking

An index fund does not attempt to select securities. It aims to replicate the composition and therefore the return of a specified index, either by holding every constituent in the same proportion or by holding a representative sample. Because the rules of the index dictate the holdings, the manager's discretion is limited to implementation, and the cost of running such a fund is typically lower than that of a fund whose manager researches individual securities.

The consequence worth internalising is that the fund inherits every characteristic of the index it follows, including the concentration. An index weighted by market capitalisation gives the largest constituents the largest weights, so a small number of very large companies can determine much of the movement, and a sector that has grown will occupy a larger share than it did previously. This is a property of the construction rules, not a fault, but it means describing such a fund as broadly diversified requires knowing how concentrated the index has become.

Owning shares and receiving dividends

A share is a residual claim on a company: shareholders rank behind lenders, suppliers, and employees, and receive what remains. A dividend is a distribution of some part of the company's profits to shareholders, declared by the board and, in the case of a final dividend, approved by shareholders in general meeting. Companies are not obliged to pay dividends, and a company retaining its profits to reinvest is following a different capital allocation policy, not necessarily a worse one.

The mechanics run on a calendar. The company announces a dividend and sets a record date, and an ex-dividend date is fixed such that buyers from that date onward are not entitled to the declared payment. On the ex-dividend date the share price would, other things equal, be expected to open lower by roughly the amount of the dividend, because the company is about to part with that cash. Dividends are not free income added on top of an unchanged asset.

Dividend yield, the annual dividend divided by the share price, is often used as a screening measure and is easily misread. The denominator falls when the price falls, so a yield can rise sharply because the market has grown pessimistic about the business. And the numerator reflects past declarations, which the board may not repeat. What to examine instead is whether the distribution is comfortably covered by earnings and, more importantly, by free cash flow over several years.

Lending to companies through bonds

A corporate bond is a loan from investors to a company, on stated terms. The face value is repaid at maturity, and the coupon is the periodic interest, usually expressed as a percentage of the face value. As a lender, a bondholder ranks ahead of shareholders in a liquidation and has a contractual entitlement to payment, which is a meaningfully different legal position from that of a shareholder even in the same company.

That contractual entitlement is only as good as the borrower's capacity to pay, which is why credit risk is the central consideration. Credit ratings offer an opinion on that capacity, expressed on a scale, and they are opinions that can be revised rather than guarantees. The bond's own documentation matters too: whether it is secured against specific assets, where it ranks against other borrowings, and what covenants restrict the company's behaviour while the debt is outstanding.

Bonds also carry risks unrelated to default. If prevailing interest rates rise after issue, an existing bond paying a fixed coupon becomes less attractive and its market price falls, with longer-dated bonds moving more for a given change in rates. A callable bond can be repaid early by the issuer, typically when rates have fallen and refinancing is cheaper, which removes the favourable stream precisely when it was worth most.

Yields, prices, and what a curve is saying

Yield and price move in opposite directions, and understanding why removes most of the confusion around bond commentary. Take an illustrative bond with a face value of one thousand rupees paying fifty rupees a year. At a price of one thousand rupees the return is five per cent. If the market price falls to eight hundred rupees, the same fifty rupees represents six and a quarter per cent to a new buyer. Nothing about the bond changed; the price adjusted so that its fixed payments offer a return in line with what comparable alternatives now offer.

Yield to maturity extends this by accounting for the timing of every remaining payment and the repayment of face value, and expressing the whole as an annualised return assuming the bond is held to maturity and payments are made. It is a single number standing in for a schedule, and it embeds assumptions, so it should be read as a comparison tool rather than a promise.

Aggregated across maturities, yields form a curve. Its shape carries information about collective expectations for interest rates and inflation, and shifts in the spread between yields on government borrowing and yields on corporate borrowing of similar maturity indicate changing views on credit risk. These are expectations rather than forecasts with a record of accuracy, and they are frequently wrong; the useful discipline is to read them as a summary of what the market currently believes, not as a prediction.

Deciding the mix before choosing the holdings

Asset allocation is the division of a portfolio across broad categories with different risk and return characteristics, such as equities, debt instruments, cash, and in some cases property or commodities. It is a decision about the shape of the whole rather than the merits of any single holding, and it tends to determine the character of the outcome more than security selection does, because assets within a category often move together while categories may not.

There is no allocation that is correct in general, and this is one of the places where the honest answer is that it depends. The factors that actually bear on it are the length of time before the money is needed, the stability and predictability of income, existing obligations including debt, the size of accessible reserves, tax treatment, and the degree of fluctuation a person can tolerate without being forced to sell. A mix appropriate for money needed in eighteen months is not the mix appropriate for money not needed for two decades.

The purpose of holding assets that behave differently is that their movements are imperfectly correlated, so the combined portfolio fluctuates less than the weighted average of its parts would suggest. This benefit is real but not reliable in every episode: correlations between categories have a tendency to rise during severe market stress, which is exactly when the diversification was expected to help most.

Rebalancing: what drift does to a portfolio

Left alone, a portfolio changes shape. Suppose an illustrative portfolio is set at sixty per cent equities and forty per cent debt. If equities rise substantially over a few years while debt is roughly flat, the equity share might drift to seventy-five per cent. Nothing was decided; the allocation moved because one component grew faster, and the portfolio now carries more risk than was originally intended, at the point in the cycle when equities have already risen.

Rebalancing restores the intended proportions by selling part of what has grown and adding to what has lagged. Two common disciplines are used: calendar-based, where the portfolio is reviewed at fixed intervals, and threshold-based, where action is taken only when a component deviates from its target by more than a set margin. Combining the two, by checking on a schedule but acting only when a threshold is breached, avoids both neglect and unnecessary trading.

The costs are worth stating plainly, because rebalancing is not free. Selling may trigger tax on gains and will incur transaction costs, and trimming a rising asset means holding less of it if it continues to rise. What rebalancing offers in exchange is not higher returns but control: it keeps the portfolio's risk close to the level that was actually chosen, rather than the level that recent performance happened to produce.

What an index measures and what it omits

A stock market index is a rules-based summary of a defined set of shares. Its level has no absolute meaning; it is a number relative to a base value on a base date, and comparisons between the levels of two different indices are meaningless. What is informative is the change over time and the composition being tracked, both of which are set by published methodology rather than by judgement at the moment of calculation.

The weighting rule determines the character of the index. Under market capitalisation weighting, larger companies exert proportionally more influence, and free-float variants count only shares actually available for trading. Under equal weighting, every constituent counts the same, which gives smaller members far more influence than their size would suggest. The same set of companies measured under these two rules will produce visibly different results over any extended period.

The most frequent misreading is treating a headline index as a measure of the economy. Indices contain listed companies of a particular size, and typically exclude unlisted businesses, the informal economy, and the public sector's non-listed activity, while including revenue earned abroad. An index can rise in a weak year for household incomes without any contradiction, because the two are measuring different things.

Liquidity is a condition, not a property

Liquidity describes how readily an asset can be converted to cash near its prevailing price. It has two dimensions that are easy to conflate: how quickly a transaction can be completed, and how much the price moves against you in completing it. An asset that can be sold immediately at a substantial discount is not liquid in any useful sense.

The observable indicators are the bid-ask spread, the depth of orders at prices near the current quote, and traded volume relative to the size you intend to transact. Volume is the least reliable of the three when taken alone, because a security can show respectable average volume while offering very little depth on the particular day you need to deal.

The critical point is that liquidity is a market condition rather than a fixed attribute of the instrument. It is generally most abundant when least needed and can contract sharply during periods of stress, when many participants want to transact in the same direction. This is why the liquidity of what a pooled fund holds matters to anyone in that fund: if the fund faces heavy redemptions while its underlying holdings have become difficult to sell, the strain is transmitted to every remaining unitholder.