Investment in mutual funds

Step 1: What is a Mutual Fund?

A vehicle for investing in stocks and bonds

A mutual fund is not an alternative investment option to stocks and bonds, rather it pools the money of several investors and invests this in stocks, bonds, money market instruments and other types of securities.

Buying a mutual fund is like buying a small slice of a big pizza. The owner of a mutual fund unit gets a proportional share of the fund’s gains, losses, income and expenses.

Each mutual fund has a specific stated objective

The fund’s objective is laid out in the fund's prospectus, which is the legal document that contains information about the fund, its history, its officers and its performance.

Some popular objectives of a mutual fund are -

Managed by an Asset Management Company (AMC)

The company that puts together a mutual fund is called an AMC. An AMC may have several mutual fund schemes with similar or varied investment objectives.

The AMC hires a professional money manager, who buys and sells securities in line with the fund's stated objective.

All AMCs Regulated by SEBI, Funds governed by Board of Directors

The Securities and Exchange Board of India (SEBI) mutual fund regulations require that the fund’s objectives are clearly spelt out in the prospectus.

In addition, every mutual fund has a board of directors that is supposed to represent the shareholders' interests, rather than the AMC’s

Step 2 :Basics of Mutual Fund

Net Asset Value or NAV

NAV is the total asset value (net of expenses) per unit of the fund and is calculated by the AMC at the end of every business day.

How is NAV calculated?

The value of all the securities in the portfolio in calculated daily. From this, all expenses are deducted and the resultant value divided by the number of units in the fund is the fund’s NAV.

Expense Ratio

AMCs charge an annual fee, or expense ratio that covers administrative expenses, salaries, advertising expenses, brokerage fee, etc. A 1.5% expense ratio means the AMC charges Rs1.50 for every Rs100 in assets under management.

A fund's expense ratio is typically to the size of the funds under management and not to the returns earned. Normally, the costs of running a fund grow slower than the growth in the fund size - so, the more assets in the fund, the lower should be its expense ratio.

Load

Some AMCs have sales charges, or loads, on their funds (entry load and/or exit load) to compensate for distribution costs. Funds that can be purchased without a sales charge are called no-load funds.

Open- and Close-Ended Funds

1) Open-Ended Funds

At any time during the scheme period, investors can enter and exit the fund scheme (by buying/ selling fund units) at its NAV (net of any load charge). Increasingly, AMCs are issuing mostly open-ended funds.

2) Close-Ended Funds

Redemption can take place only after the period of the scheme is over. However, close-ended funds are listed on the stock exchanges and investors can buy/ sell units in the secondary market (there is no load).

Important documents

Two key documents that highlight the fund's strategy and performance are 1) the prospectus (legal document) and the shareholder reports (normally quarterly).

Professional Money Management

Fund managers are responsible for implementing a consistent investment strategy that reflects the goals of the fund. Fund managers monitor market and economic trends and analyze securities in order to make informed investment decisions.

Diversification

Diversification is one of the best ways to reduce risk (to understand why, read The need to Diversify). Mutual funds offer investors an opportunity to diversify across assets depending on their investment needs.

Liquidity

Investors can sell their mutual fund units on any business day and receive the current market value on their investments within a short time period (normally three- to five-days).

Affordability

The minimum initial investment for a mutual fund is fairly low for most funds (as low as Rs500 for some schemes).

Convenience

Most private sector funds provide you the convenience of periodic purchase plans, automatic withdrawal plans and the automatic reinvestment of interest and dividends.

Mutual funds also provide you with detailed reports and statements that make record-keeping simple. You can easily monitor the performance of your mutual funds simply by reviewing the business pages of most newspapers or by using our Mutual Funds section.

Flexibility and variety

You can pick from conservative, blue-chip stock funds, sectoral funds, funds that aim to provide income with modest growth or those that take big risks in the search for returns. You can even buy balanced funds, or those that combine stocks and bonds in the same fund.

Tax benefits on Investment in Mutual Funds

1) 100% Income Tax exemption on all Mutual Fund dividends

2) Equity Funds - Short term capital gains is taxed at 15%. Long term capital gains is not applicable.
Debt Funds - Short term capital gains is taxed as per the slab rates applicable to you. Long term capital gains tax to be lower of - 10% on the capital gains without factoring indexation benefit and 20% on the capital gains after factoring indexation benefit.

3) Open-end funds with equity exposure of more than 65% (Revised from 50% to 65% in Budget 2006) are exempt from the payment of dividend tax for a period of 3 years from 1999-2000.

Note: Equity Funds are those where the investible funds are invested in equity shares in domestic companies to the extent of more than 65% of the total proceeds of such funds.

Step 1: Why Choose Mutual Funds?

Mutual funds are investment vehicles, and you can use them to invest in asset classes such as equities or fixed income. Experts recommend that you use the mutual fund investment route rather than invest yourself, unless you have the required temperament, aptitude and technical knowledge.

We are not all investment professionals

We go to a doctor when we need medical advice or a lawyer for legal guidance. Similarly, mutual funds are investment vehicles managed by professional fund managers. And unless you have a high Investment IQ, we recommend you use this option for investing. Mutual funds are like professional money managers, however a key factor in their favour is that they are more regulated and hence offer investors the ability to analyse and evaluate their track record.

Investing is becoming more complex

There was a time when things were quite simple - the market went up with the arrival of the first monsoon showers and every year around Diwali. Since India started integrating with the world (with the start of the liberalisation process), complex factors such as an increase in short-term US interest rates, the collapse of the Brazilian currency or default on its debt by the Russian government, have started having an impact on the Indian stock market.

Although it is possible for an individual investor to understand Indian companies (and investing) in such an environment, the process can become fairly time consuming. Mutual funds (whose fund managers are paid to understand these issues and whose asset management company invests in research) provide an option of investing without getting lost in the complexities.

Mutual funds provide risk diversification

Diversification of a portfolio is amongst the primary tenets of portfolio structuring. And a necessary one to reduce the level of risk assumed by the portfolio holder. Most of us are not necessarily well qualified to apply the theories of portfolio structuring to our holdings and hence would be better off leaving that to a professional. Mutual funds represent one such option.

Step 2: Selecting a mutual fund

What's strategy got to do with selecting a mutual fund? Shouldn't you just go and invest in the best performing fund? The answer is no. Mutual fund investing requires as much strategic input as any other investment option. But the advantage is that the strategy here is a natural extension of your asset allocation plan. Experts recommend the following process:

Identify funds whose investment objectives match your asset allocation needs

Just as you would buy a computer that fits your needs and budget, you should choose a mutual fund that meets your risk tolerance (need) and your risk capacity (budget) levels (i.e. has similar investment objectives as your own). Typical investment objectives of mutual funds include fixed income or equity, general equity or sector-focused, high risk or low risk, blue-chips or turnarounds, long-term or short-term liquidity focus.

Evaluate past performance, look for consistency

Although past performance is no guarantee for the future, it is a useful way of assessing how well or badly a fund has performed in comparison to its stated objectives and peer group. A good way to do this would be to identify the five best performing funds (within your selected investment objectives) over various periods, say 3 months, 6 months, one year, two years and three years. Shortlist funds that appear in the top 5 in each of these time horizons as they would have thus demonstrated their ability to be not only good but also, consistent performers. 

Diversify

Don't just zero in on one mutual fund (to avoid the risk of being overly dependent on any one fund). Pick two, preferably three mutual funds that would match your investment objective in each asset allocation category and spread your investment. We recommend a 60:40 split if you have shortlisted 2 funds and a 50:30:20 split if you have shortlisted 3 funds for investment.

Consider Fund Costs

The cost of investing through a mutual fund is not insignificant and deserves due consideration, especially when it comes to fixed income funds. Management fees, annual expenses of the fund and sales loads can take away a significant portion of your returns. As a general rule, 1% towards management fees and 0.6% towards other annual expenses should be acceptable. Carefully examine load the fee a fund charges for getting in and out of the fund.

Having made an investment in a mutual fund, you should monitor it to see whether its management and performance is in line with stated objectives and also whether its performance exceeds or lags your expectations. Unlike individual stocks and bonds, mutual fund reviews are required less frequently, once in a quarter should be sufficient.

A review of the fund’s performance should be carried out with the objective of holding or selling your investment in the mutual fund. You might need to sell your investment in a mutual fund if any of the events below apply –

You change your investment plan.

For example, as you grow older you might adopt a more conservative investment approach, pruning some of your riskier (equity-oriented) funds.

A fund changes its strategy.

A fund that alters its investment objective or approach might no longer fit your strategy.

The fund's poor results persist.

If a fund regularly trails other funds that invest in similar securities, consider replacing it. The poor performance is more often than not a reflection on the relative expertise of the asset management company.

Mutual Fund Investing Checklist

Using the checklist below should help you to extract the most from your mutual fund investment process. Assuming that you will be investing largely through mutual funds to meet your targeted asset allocation plan.

1. Draw up your asset allocation

Take a printout of your suggested asset allocation plan so that you can use that to plan your investments across mutual funds.

2. Identify funds that fall into your Buy List

3. Obtain and read the offer documents

You could do this by either asking your broker or the asset management companies.

4. Match your objectives

Read through the offer documents and check to see whether the mutual funds identified meet your investment needs in terms of equity share and bond weightings, downside risk protection, tax benefits offered, dividend payout policy, sector focus and other parameters of relevance to you. 

5. Check out past performance

Make sure you do this. There is no other indicator that you can use as effectively to select funds for investment. 

6. Don't forget the index funds

Index funds offer you probably the ideal hedge against varying performance across sectors and across fund managers over longer-periods of time.

7. Think hard about investing in sector funds

Investing in specific sector funds is recommended for aggressive investors. However, if you are not in close touch with the developments in the sector or do not review your portfolio regularly, we would not recommend investing in sector funds.

8. Look for `load' costs

Management fees, annual expenses of the fund and sales loads can take away a significant portion of your returns. As a general rule, 1% towards management fees and 0.6% towards annual expenses should be acceptable. Try and avoid funds that have a sales load, unless of course they have a consistent track record of being a top-performer.

9. Does the fund change fund managers often?

Since you will be giving past track record a consideration, you are inadvertently relying on the continuity of the fund manager. Stay away from mutual funds whose fund managers change often.

10. Look for size and credentials

As far as possible avoid investing in funds with an asset base of less than Rs25 crores. Which means that we are recommending you invest in funds only after they have established a track record. And unless it is a really exciting new (theme) fund that fits into your asset allocation plan, try and avoid new funds.

11. Customer Service

Check out the customer service delivery mechanism of the mutual fund you choose. Can you get in touch with them easily? How long do they take to disburse payments? How often do they send you portfolio updates? And investor newsletters? These questions are important to address because shortcomings on any of these factors could affect your overall returns.

12. Diversify, but not too much

Do not hold just one fund in each asset category. Its good to diversify your risk between different funds, but do not overdo it. 

13. Style, not returns matter first in the long-term

Don't let a top performing fund veer you away from a disciplined approach. Stick to your chosen asset allocation plan.

14. Monitor regularly and review

Try to review your mutual fund holdings atleast once a quarter. If you follow the same principles to review as you did to identify the mutual funds you invested in, you will be able to take `sell decisions' very easily.

15. Invest regularly, choose the MIP

Try to make mutual fund investing an integral part of your savings and wealth-building plan. The monthly investment plan option offered by some mutual funds is a strongly recommended approach for you to execute this process . However, don’t let the availability of this option override your fund selection criteria.