This post covers various aspects such as:
But, what are mutual funds?
Mutual funds pools money from many investors and invest the money in securities such as stocks, bonds, commodities, etc. based on pre-agreed mandate. They offer diversification of assets as per individual’s objective, professional management and liquidity, at the same time allowing investors to avail benefits from the lower trading cost. A mutual fund is professionally managed and always keep aside some part of the money as cash to fulfil redemptions. Every investor gets to participate by holding units or shares that are proportional to the amount invested. The gains recorded by a mutual fund are distributed correspondingly among investors after deducting certain expenses.Why should one invest in Mutual Funds?
To enjoy better returns
The best performing mutual funds have offered returns of anywhere between 15% to 20% consistently over the last 2 decades. An individual who would have invested Rs 10,000 every month would be able to create a corpus of Rs 27,86,573 assuming a CAGR of 15% But if we extrapolate this case to 20 years, the individual ends up with a corpus of almost Rs 1.5 crores.
Very few asset classes are able to match up to such returns. And what is the icing on the cake?
Liquidity!
You can redeem your mutual fund units anytime you wish. The redemption time varies between 1-2 working days for debt-oriented funds and 4-5 days for equity-oriented funds.
Accurate selling price
During the redemption, mutual fund units will be sold according to the NAV as on that day. Which means you get exactly what your investment is worth.
Inflation beating returns
What costs Rs 2 lakhs today, would cost Rs 4 lakhs after nine years considering an inflation rate of 8%. Most asset classes are not able to beat inflation effectively. Mutual Funds offer inflation beating returns consistently over a period of time.
Goal based investing
People have several goals in life. They wish to buy latest gadgets, travel to exotic destinations, purchase an automobile with all the bells and whistles, buy a house, educate their children in the best universities and hopefully – retire early!
These goals can be primarily divided into short term, medium term and long term.
Choosing the right type of fund is critical to ensure that your financial goals are achieved.
Short Term Goal
One can invest in debt-oriented funds to prepare for achieving short term goals. These funds are less volatile and offer steady returns as they primarily are invested in government securities, bonds and other debt instruments. If one’s investment horizon is less than 2 years, debt oriented mutual funds are recommended.
Medium Term Goal
Medium term goals may require an investment duration of 3 to 6 years. Balanced funds, which invest in a comfortable mix of equity and debt instruments, are most suitable to help an investor achieve medium term goals.
Long Term Goal
Long term goals may require an investment duration of more than 7 years. One can consider equity-oriented funds as these invest heavily in equities. The time frame is also such that the fund can take advantage of market volatility to offer attractive returns.
Different types of Mutual Funds
How does one decide which type of mutual fund to invest in?
One can choose a mutual fund scheme based on one’s investment duration, objective and risk appetite.
Based on maturity or investment duration!
Depending on its maturity period, a mutual fund scheme can be classified into open-ended scheme or close-ended scheme.
Open-ended Fund/ Scheme
As the name suggest, an open-ended fund or scheme is one that is available for subscription and sale on a continuous basis. These schemes do not have a fixed maturity period. Investors can conveniently buy and sell units at Net Asset Value (NAV) which are declared on a daily basis. The key feature of open-end schemes is liquidity.
Close-ended Fund/ Scheme
A close-ended fund or scheme has a maturity period that is clearly specified. When the scheme is launched, the fund is open for subscription only during a prescribed period. Thereafter investors can buy or sell the units of the scheme on the stock exchanges as they would do in case of any other listed security. To enable investors to exit, some close-ended funds offer an option of selling back the units to the mutual fund through periodic repurchase at NAV related prices.
Based on objective > Receiving Creating a corpus or Regular Income – Growth or Dividend
One’s investment objective may also determine the type of fund which one would have to shortlist:
Growth Funds
Growth funds usually put a huge portion in shares and growth sectors, suitable for investors who have a surplus of idle money to be distributed in riskier plans (albeit with possibly high returns) and can wait over a period of time.
This will also require the investment horizon to be longer as volatile markets may cause adverse movement in value of these funds and hence there may not be immediate or steady returns.
Dividend Funds
For investors who seek to earn a regular income, dividend funds are best suited. However, there is a difference in the dividends that are offered by stocks and by mutual funds. In the case of stocks, dividends are earnings generated by a company (usually profits) that are distributed amongst shareholders. This is besides the appreciation in share price of a stock. Whereas in the case of a dividend mutual fund, a small chunk of the units or shares of the mutual fund are sold at a price which is higher than the purchase price to earn dividends. The dividend pay-outs can be monthly, quarterly or yearly. Depending on the fund, the dividend can also be re-invested.
Based on Risk Appetite
Risk appetite is also a function of investment goals. A retired citizen who is investing for regular monthly income would have a different risk appetite from someone who is investing with horizon of a decade for buying a house.
Index funds mirror an index.
These funds will purchase stocks in the same proportion in which they comprise an index. For instance, if a particular stock forms 2% of an index which is being followed by a mutual fund, the mutual fund will invest 2% of its investible corpus in that particular stock. The performance of an index fund will more or less mimic that of the index which it follows except for a difference that would creep up, known as tracking error. Expenses incurred by an index fund are lower as compared to other types of mutual funds.
Balanced funds are also known as hybrid funds. These are primarily of two types: Equity Oriented Funds and Debt Oriented Funds.
Equity-oriented funds
Equity-oriented funds invest a mix of equity (at least 65 per cent of the corpus) and debt. These funds offer attractive returns over a longer period of time but returns can be highly volatile in the short term. These funds are suitable for investors who can deal with the risk and have a longer investment horizon.
Debt-oriented funds
are low risk funds that primarily invest in highly rated corporate bonds and stable government bonds. They offer steady returns and are suitable for conservative investors.
Equity Linked Savings Schemes
Equity Linked Savings Schemes make it possible for investors to claim upto Rs 1.5 lakhs as tax deduction under Section 80C of the Income Tax Act while creating a corpus! However, an investor cannot withdraw money before 3 years as this scheme has a mandatory lock in period.
Largecap Funds
Largecap funds invest mostly in big companies. Funds identify these companies by their market capitalisation. These companies are well established and have immense credibility. They are most likely to be among the top names in their respective sector. Although there is no fixed nomenclature, a company whose market cap is more than Rs 10,000 crores is considered to be a large cap company in India. Conservative and risk averse investors can start investing in large cap funds. These funds carry less risk and offer modest returns.
Midcap funds
Midcap funds invest mostly in medium-sized companies. Their rise and fall, both could occur at a scorching space. But these companies may successfully grow over a period of time and provide handsome returns to investors. Investors with the ability to take considerable risks should bet on these funds.
Smallcap funds
Smallcap funds invest in small companies. Investing in these companies over short term could be perilous unless backed by substantial research and credible experience. However, they can also offer phenomenal return over a longer duration of time. They are appropriate only for investors with a significantly high-risk appetite.
Sector funds
Sector funds invest only in businesses which are operating in a particular sector. For example, a Pharma themed fund will only invest in Pharmaceutical companies. As investments are directed towards a specific sector or theme, sector funds are considered extremely risky. Timing the entry into and exit from these sectoral funds is imperative as some of these sectors are cyclical. They are meant for investors with deep knowledge about a specific sector. It is advisable for investors to only take marginal positions in these funds.
Should I be investing a little every-month? Or should I invest at one go?
SIP, which is an acronym for Systematic Investment Plan, is the most popular method of investing regularly in mutual funds as it enables an investor to take advantage of the market’s volatility. It is also easier on the pocket as an investor can begin investing with an amount that is as low as Rs 500 every month. Enabling a systematic investment plan will ensure that an investor is also able to adhere to a discipline of investing consistently during the ups and downs of stock market.
How to select a Mutual Fund
SIP, which is an acronym for Systematic Investment Plan, is the most popular method of investing regularly in mutual funds as it enables an investor to take advantage of the market’s volatility. It is also easier on the pocket as an investor can begin investing with an amount that is as low as Rs 500 every month. Enabling a systematic investment plan will ensure that an investor is also able to adhere to a discipline of investing consistently during the ups and downs of stock market.
Consider the Portfolio Manager
Now a days it is not very difficult to dig out information about your fund’s portfolio manager. You should also look at the performance of other funds which he is managing. If you find yourself holding a mutual fund with a manager that has discouraging, little or no track record you should consider exiting the investment.
Rankings
Certain investors carefully scrutinize the star ratings given by various research agencies. These star ratings can be one of the factors to look at, but more than the recent or long-term performance of any scheme its ranking among peers should be looked at. One should select the scheme which has remained in top quartile most of the time.
Past performance
Investors should avoid investing by evaluating only the latest performance of a mutual fund. One should look for consistency in performance over longer tenures like 3, 5 and 10 years, if that is available, rather than the short-term returns. One must choose schemes that have consistently beaten benchmark indices (index to which a fund's returns are compared) and compare reasonably with their peer set over the above time frames.
How to begin investing
Mutual fund schemes offer regular and direct plans. A regular plan involves investing through a distributor/broker/agent. However, a direct investor must understand if the scheme is appropriate, considering its track record, the investor’s goal and risk profile.
There are various online platforms for investing
- Transaction portal on the mutual fund website.
- Transaction portals belonging to registrar and transfer agents of mutual funds.
- Transaction portals of the distributor or agent
When to sell / redeem
When goals are achieved
It is ideal to sell one’s MF holdings on the eve of achieving one’s financial goals. Or probably a couple of years before that. It is advisable to shift one’s invested corpus from an equity fund to a low risk debt fund when one is a couple of years away from reaching the goal. This is to ensure that a sudden phase of volatility in the stock market does not upset one’s financial plan. For example, you might have invested in an equity-oriented mutual fund whose returns have fallen as the market has tumbled.
If Mutual fund is not performing well
When we talk of underperformance we are referring to consistent underperformance. Even the best of funds tends to have a few bad quarters. That is why it is always better to focus on three to five year returns on mutual funds. But then there are some genuine cases of underperformance. For example, your funds may be exposed to the wrong sectors at the wrong time. Alternatively, your debt fund may have taken too much risk on low quality debt without the associated benefit of outperforming the benchmark. If your equity mutual fund is yielding lower than an index fund, then you are actually earning negative yields on your market risk. That does not make sense. There are occasions when the fund returns have been too volatile which again defeats the purpose of MF investing. These are cases you must look to exit and reinvest in alternate funds.
Past performance
Investors should avoid investing by evaluating only the latest performance of a mutual fund. One should look for consistency in performance over longer tenures like 3, 5 and 10 years, if that is available, rather than the short-term returns. One must choose schemes that have consistently beaten benchmark indices (index to which a fund's returns are compared) and compare reasonably with their peer set over the above time frames.
Documentation
Like any other financial transaction, mutual fund investment it is not devoid of documentation. The investor will need to complete the following activities.
- Application form: You may need to fill in an application form to open a mutual fund account and another form if you are going for an electronic transfer from your bank account.
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KYC Compliance: PAN has to be verified under the Know Your Customer (KYC) norms to be able to invest in mutual funds.
If one is already KYC-compliant, one needs to submit the KYC acknowledgement letter or copy of the KYC-compliance page.
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Proof of identity: Some of the following documents are acceptable as proof of identity
- PAN with photograph
- Aadhaar
- Passport
- Voter’s ID card
- Driving licence
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Proof of address: Some of the following documents can be submitted as proof of identity
- Aadhaar
- Driving licence
- Passport
- Voter’s ID card
- Ration card
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Proof of identity: Some of the following documents are acceptable as proof of identity
- Cheque for SIP or lump sum amount. However, if one opens a mutual fund account online, cheques would be required.
These days almost all fund houses and many distributors offer online facilities to invest in mutual funds. All you need to do is fill the relevant information and submit it. e-KYC enables completion of KYC process online for which one will need to enter your Aadhar number and PAN.
Conclusion
It is to be borne in mind that Mutual fund investments are subject to market risks and one should read scheme related documents carefully before investing. Also, past performance is not indicative of future returns. One should consider one’s specific investment requirements before choosing a fund or designing a portfolio that suits one’s needs.
Mutual funds have democratized the opportunity to invest in various asset classes and create wealth by banking on the expertise of a qualified professional. One should aspire to invest at least 20% of one’s monthly income through a systematic investment plan in mutual funds. One can also increase one’s SIP amount by 10% every year as one’s income would also keep increasing. The journey of a thousand miles begins with a single step as does the journey of achieving financial independence begin with a single SIP.
