Mutual Funds 101

Mutual Funds – does it ring a bell?

Recall hearing the disclaimer at the end of the TV commercial which basically sounds like gibberish?

Well, let me take you through what this seemingly confusing product is and why it is so important to actually read the fine print before investing your hard-earned money.

What is a Mutual Fund?

A Mutual Fund is a trust that collects money from a number of investors who share a common investment objective. It invests the money in equities, bonds, money market instruments and/or other securities. Each investor owns units, which represent a portion of the holdings of the fund. The income/gains generated from this collective investment is distributed proportionately amongst the investors, in the ratio of the sum invested by them, after deducting certain expenses which are incurred in managing the fund.

A mutual fund is not an alternative investment option to stocks, bonds, etc. It rather pools the money of several investors and invests this in the same.

Here are some terms to be aware of before we delve deeper into Mutual Funds:

Fund Manager: Fund Manager is the expert who takes decisions on how to invest the pool of money. He takes a call on which stocks to buy and/or which asset classes to invest in. Based on research and analysis, he takes the decisions about buying and selling.

Asset Management Company (AMC): It is the company that manages the funds.

Asset Under Management:  It is the total sum of money that is collected from all the investors.

Expense Ratio: It is the amount of money charged by the AMC on account of the annual maintenance charges incurred to manage the fund. The expenses could be administrative, advertising, operating, etc. It includes the fees of the Fund Manager along with other team members of the AMC.

Entry Load: The fee charged to enter or buy a Mutual Fund.

Exit Load: The fee charged at the time of withdrawing from the fund.

Investment in Mutual Funds offers the following benefits:

  • Professional Money Management – Since the fund manager is an expert in this field, he takes actions based on extensive research to match the objectives of the fund. Fund managers monitor market and economic trends and analyse securities in order to make informed investment decisions.

Typically, a stock mutual fund’s objective would be either capital appreciation, or income from equities, or both. For example, a stock fund might have both growth and income as objectives, or its primary objective might be capital appreciation, with income as a secondary objective.

  • Diversification – As an individual, if one wishes to purchase a share/stock of a company where the value of a share is Rs 25000, one may not be able to buy it if that’s the maximum limit of funds available to invest. Since it is difficult to invest individually, a mutual fund collects money from multiple investors making individually small pots of money collectively large. Your Rs. 25,000 can be split across multiple Mutual Funds (MFs) and you can still be a co-holder of the share of the company, which you couldn’t earlier, by contributing a significantly lesser amount.

The AMC will collect different amounts of money from multiple investors. With that pool they will buy a share of your desired company along with shares of multiple other companies or in different asset classes based on the goal.

This way you will be exposed to less risk and yet have the opportunity to invest in a particular company.

Investing in MFs reduces the risk as money is spread across different instruments and doesn’t rely solely on one particular product.

  • Liquidity – Most mutual funds offer the flexibility of exiting as and when you desire. Hence, if you need this money for something else immediately, you can liquidate the MF and get it back. Some MFs may apply an exit load (for e.g. if you withdraw within 7 days) or may have a lock-in period before which you cannot withdraw the money. Investors can sell their mutual fund units on any business day and receive the current market value on their investments within a short period of time (normally three- to five-days).
  • Transparency  – All MFs are regulated by the Securities & Exchange Board of India (SEBI). SEBI mandates the declaration of the exact details of the composition of any Mutual Fund. Each AMC has to declare where it has invested an investor’s money.
  • Expertise in the market not required – Small investors usually have neither the necessary expertise nor the time to undertake any study that can facilitate informed decisions. The extensive market research that is required to invest directly in the stock market/shares isn’t required for an investment in MFs.
  • Affordability – The minimum initial investment for a mutual fund is fairly low for most funds (as low as Rs500 for some schemes).
  • Low Transaction Costs –   Mutual fund transactions are generally conducted in large volumes. These large volumes attract lower brokerage commissions and other costs when compared to the smaller volumes of transactions that individual investors enter into. The brokers quote a lower rate of commission due to two reasons. The first is competition for the institutional investor’s business. The second reason is that the overhead cost of executing a trade does not differ much for large and small orders. Hence, for a large order these costs spread over a large volume enabling the broker to quote a lower commission rate.
  • Convenience Most private sector funds provide you the convenience of periodic purchase plans, automatic withdrawal plans and automatic reinvestment of interest and dividends. You can invest in a Mutual Fund either as a one-time lump sum investment or as periodical investments in the form of Systematic Investment Plans (SIPs).

AMCs also provide you with detailed reports and statements that make record-keeping simple.

  • Flexibility and VarietyYou can pick from conservative funds, blue-chip stock funds, sectoral funds, funds that aim to provide income with modest growth or those that take big risks in search of returns. You can even buy balanced funds, those that combine stocks and bonds in the same fund. Features of a MF scheme such as regular investment plan, regular withdrawal plan and dividend reinvestment plan allows investors to systematically invest or withdraw funds according to their needs and convenience.

Returns from a MF comes in three forms:

  1. Income is earned from dividends on stocks and interest on bonds held in the fund’s portfolio. A fund pays out nearly all of the income it receives over the year to fund owners in the form of a distribution. Funds often give investors a choice either to receive a check for distributions or to reinvest the earnings and buy more shares.
  2. If the fund sells securities that have increased in price, the fund has a capital gain. Most funds also pass on these gains to investors in the form of a distribution.
  3. If fund holdings increase in price but are not sold by the fund manager, the fund’s shares increase in price. You can then sell your mutual fund shares for a profit in the market.

The returns expected from a Mutual Fund range from 10% – 22%, much higher than a Fixed Deposit.

There are 4 types of Mutual Funds based on how they invest the money:

  • Equity Fund – Equity Funds are those that invest a minimum of 65% of its assets in Equities or the Stock Market. The Fund Manager invests money in shares of different companies. They offer high returns and are subject to market fluctuation risks. This type of fund is suitable for someone in their 30-35s (millennials) as they have a longer horizon to reduce the impact of fluctuations.
  • Debt Fund – This type of fund invests in debt instruments like Bonds, Commercial Papers, Treasury Bills, Certificates of Deposit (CDs) etc. Funds where less than 65% of the investment is made in equities qualify as Debt Funds. They offer a fixed return in the form of interest income.  They are thus less risky and suitable for old and risk averse investors.  This ensures a passive safe income with higher return than a fixed deposit.
  • Hybrid Fund – A hybrid fund invests in a mix of Debt & Equity with about 65-80 % in Equity to achieve diversification and avoid concentration risks. Sometimes, they also invest in Gold or Real Estate. This offers a balanced portfolio thus creating an opportunity for higher returns than a Debt Fund and yet minimising the risk. Hybrid funds aim to achieve wealth appreciation in the long run and generate income in the short run via a balanced portfolio. Portfolio risk can be further reduced by combining assets that have low correlation.
  • Money Market Funds – Money Market is an exchange where the trade of cash and cash-equivalent instruments like Treasury Bills, Certificate of Deposit, Commercial Papers, etc.  takes place. Money Market Funds are debt funds that lend to companies for a period of up to 1 year. These Funds are designed in a manner that allows the fund manager to generate high returns while keeping risk under control through adjustment of lending duration. They are ideal for investors with low risk tolerance and an investment horizon of up to one year. Typically, investors with idle cash lying in their savings account can earn better returns by investing in these funds. It is important to note that these funds are recommended to investors having short-term cash surplus which they won’t need urgently.

How to invest in a Mutual Fund:

  • Mandatory KYC to be completed
  • No DEMAT Account required
  • Multiple apps and platforms available to invest
  • Invest a lump sum amount or a recurring fixed investment through a Systematic Investment Plan (SIP).

An SIP is a method of investing in mutual funds which allows investors to invest a fixed sum in a mutual fund scheme at predetermined intervals (daily, weekly, monthly, bi-annually or annually). SIP investments eliminate the potential financial risk associated with a lump sum investment. It also enables an investor to increase/decrease the investment in line with their current financial situation.

There are as many as 44 AMFI (Association of Mutual Funds in India) registered fund houses in India which together offer more than 2,500 Mutual Fund schemes. The wide array of funds available often makes it a little difficult for investors to choose the scheme that best suits them.

Things that an Investor should consider while selecting a Fund:

As a thumb rule, go for a fund that has a strong vintage and a track record of having navigated at least three complete market cycles/movements. An investor should evaluate how the fund management team reacted during tumultuous market phases, such as during the global financial crisis of 2008 or the Covid-19 recession of 2020.

a. Risk factor – Any instrument that invests in equity markets will have some risk. One must exercise caution and portfolio rebalancing regularly. An investor must identify their risk appetite and choose a fund based on their risk profile. Mutual funds offer a variety of investment options that can cater to investors having varied risk-taking capacities.

b. Return – Mutual Funds don’t offer guaranteed returns (except those that invest in Debt Instruments that have a fixed return in the form of interest). The performance of underlying securities affects the Net Asset Value (NAV) of these funds. So, it may fluctuate due to market movements.

c. Cost – Mutual funds charge a fee for managing your portfolio, which is known as the expense ratio. Before investing in a MF, ensure that it has a low expense ratio vs. other competing funds, as this translates into higher take-home returns for the investor.

d. Investment Horizon–  A Mutual Fund Investment is not a Get-Rich-Quick scheme. Define your investment horizon based on your goals. Find the funds that offer high returns for each horizon and invest accordingly.

e. Financial Goals – Define your financial goals. Have a clear idea of what and when you need the money for and invest accordingly.

You can meet intermediate financial goals like buying a car or funding higher education with hybrid funds. Retirees too invest in balanced hybrid funds and go for a dividend option to supplement their post-retirement income. An Equity fund may be used for sponsoring your child’s education or marriage.

f. Tax on Gains – Long-term capital gains (LTCG) over Rs.1 lakh on equity component are taxed at the rate of 10%. Short-term capital gains (STCG) on equity component are taxed at the rate of 15%. You must add these gains to your income while filing your return. LTCG from debt component is taxable at 20% after indexation and 10% without the benefit of indexation.

As a basic thumb rule for someone who is a fresher in Mutual Funds, invest a share equal to your age in Fixed Income Securities. The Balance 100 – Your Age can be invested in Equities.

E.g.:  Age – 30 years, 100-30 = 70% investment in Equities and 30% in Fixed Income Securities like Debt etc.

The key to making good returns is to exercise Disciple, Patience & Resilience. Don’t interrupt your plan and stay invested for a long time. Good things take time. The magic of compound interest plays its role and helps earn higher returns when invested for a longer duration.

Mutual Funds are one of the most viable investment options available to the common man as it offers an opportunity to invest in a diversified and professionally managed basket of securities at a relatively low cost.

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