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What are Mutual Funds and How to Invest in Them?

What Is A Mutual Fund?

To many people, Mutual Funds can seem complicated or intimidating. We are going to try and simplify it for you at its very basic level. Essentially, the money pooled in by a large number of people (or investors) is what makes up a Mutual Fund. This fund is managed by a professional fund manager.

It is a trust that collects money from a number of investors who share a common investment objective. Then, 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 after deducting certain expenses, by calculating a scheme’s “Net Asset Value or NAV. Simply put, a Mutual Fund is one of the most viable investment options for the common man as it offers an opportunity to invest in a diversified, professionally managed basket of securities at a relatively low cost.

A mutual fund collects money from investors and invests the money on their behalf. It charges a small fee for managing the money. Mutual funds are an ideal investment vehicle for regular investors who do not know much about investing. Investors can choose a mutual fund scheme based on their financial goal and start investing to achieve the goal.

How to invest in mutual funds?

You can either invest directly with a mutual fund or hire the services of a mutual fund advisor. If you are investing directly, you will invest in the direct plan of a mutual fund scheme. If you are investing through an advisor or intermediary, you will invest in the regular plan of the scheme.

If you want to invest directly, you will have to visit the website of the mutual fund or its authorized branches with relevant documents. The advantage of investing in a direct plan is that you save on the commission and the money invested would add sizeable returns over a long period. The biggest drawback of this method is that you will have to complete the formalities, do the research, monitor your investment… all by yourself.

Types of Mutual Funds –

The Securities and Exchange Board of India has categorized mutual fund in under four broad

categories:

  • Equity Mutual Funds
  • Debt Mutual Funds
  • Hybrid Mutual Funds
  • Solution-oriented Mutual Funds

Equity mutual fund scheme: These schemes invest directly in stocks. These schemes can give superior returns but can be risky in the short-term as their fortunes depend on how the stock market performs. Investors should look for a longer investment horizon of at least five to 10 years to invest in these schemes. There are 10 different types of equity schemes.

Debt mutual fund schemes: These schemes invest in debt securities. Investors should opt for debt schemes to achieve their short-term goals that are below five years. These schemes are safer than equity schemes and provide modest returns. There are 16 sub-categories under the debt mutual fund category.

Hybrid mutual fund schemes: These schemes invest in a mix of equity and debt, and an investor must pick a scheme based on his risk appetite. Based on their allocation and investing style, hybrid schemes are categorized into six types.

Solution-oriented schemes: These schemes are devised for particular solutions or goals like retirement and child’s education. These schemes have a mandatory lock-in period of five years.

Mutual fund charges: The total expenses incurred by your mutual fund scheme are collectively called expense ratio. The expense ratio measures the per unit cost of managing a fund. The expense ratio is generally in between 1.5-2.5 per cent of the average weekly net assets of the schemes.

Mutual Fund objectives

To invest in a Mutual Fund, you need to understand the types of Mutual Funds that are available to you. These include:

Equity: These are funds that invest exclusively in the stocks of domestic companies listed on stock exchanges. These are categorised as high-risk funds.

Money market: These are mainly meant for investors looking for easy liquidity and returns in the short-term. These funds invest in money market instruments such as Treasury bills (T-Bills), Commercial Papers (CPs), Repurchase Agreements (Repo) and government securities. These are categorized as low-risk funds.

Debt: These are funds that are considered as an alternative to Fixed Deposits. These funds invest in fixed-income securities. Debt funds are typically low-risk funds.

Hybrid or balanced: These funds invest in both fixed-income securities (debt) and stocks (equities), thereby offering a balanced portfolio to investors.

Costs associated with investing in Mutual Funds

The fund value is calculated as per the Net Asset Value (NAV), which is the value of the fund’s portfolio net of expenses. This is calculated after every business day by the AMC.

AMCs will charge you an administration fee, which covers their salaries, brokerage, advertising and other administrative expenses. This is usually measured using an expense ratio. The lower the expense ratio, the lower the cost of investing in that Mutual Fund.

AMCs may also charge loads, which are basically sales charges incurred by the company in the form of distribution costs.

If you are unfamiliar with associated charges, you might get into a position where the profits from your investment are reduced considerably due to overhead expenses. So, it’s a good habit to read the fine print for details on expenses and fees related to a Mutual Fund.

How to invest in Mutual Funds

So, you know what Mutual Funds are and their associated costs. It’s time to know more about how to invest in them.

Asset allocation

The first thing here is to understand what kind of portfolio you need. Your funds will need to be divided into different asset classes to achieve the returns that you want. This is known as asset allocation. The ideal asset allocation route would help you to invest in a number of funds that are based on your risk profile. Your risk profile will also help determine the extent to which you should invest in each asset segment such as equity and debt.

Your asset allocation should have a healthy mix of high-risk and low-risk components. The usual rule is that the percentage of funds you allocate to low-risk debt instruments should be equal to your age. For instance, if you are a 30-year-old, then 30% of your fund allocation should go toward debt instruments. This will cushion you against any downturns due to investments in high-risk assets. This might be true when you are young but as you grow older, you must reduce your high-risk investments. A golden rule here is that the younger you are, the more you can invest in equities and other high-risk Mutual Funds. Up to a certain age, your risk profile can be moderately high as you have certain flexibilities to invest in high-risk, high-return funds without getting too worried about potential losses.

Shortlisting fund types

Shortlisting and zeroing in on the right funds represents the most important part of investing in Mutual Funds. Once you are done with the asset allocation that best reflects your needs, the next step is to look for and compare different Mutual Funds on the basis of their past performance and investment philosophy. For this, you should refer to the shareholder reports and prospectuses provided by AMCs. The prospectus will detail the information related to the Mutual Fund from a legal perspective while the shareholder report can help you understand the past performance and consistency of returns.

Before investing in a fund, you should first be certain about what your ultimate financial goals are. Are you investing to substitute your current income or planning for retirement or are you looking to save for child’s marriage?

Next, you need to determine what the horizon for these goals will be. The more money you need, the more risk you might need to take if you don’t have much time. You can afford to take lower risks if your goal is a long-term one. However, understand that when you invest in high-risk funds for the long term, the risks will become considerably lower as your goal nears. You should choose your Mutual Funds accordingly.

Some Mutual Funds are open-ended while others are close-ended. In case of the latter, you won’t be able to liquidate the funds until the fund has matured. Therefore, you need to be careful about the time frame you’re investing for. In general, the shorter the period of investment, the lower the risks that you should take, while a higher time frame will help you overcome downturns in case of high-risk instruments.

Finally, ensure that your risk profile is right. This may seem daunting but once you have charted out your future requirements and the time frame, you can find out what kind of risk profile you are comfortable with. Are you comfortable with the dynamics of the stock market and can you accept both ups and downs? Or are you looking for safe and assured bets that will meet your needs and still keep you safe? These depend on your personal outlook. If you aren’t comfortable with an asset class even though it’s aligned directly with your goals, you should drop that option.

Comparing funds

Once you have factored in the points given above, you should be able to shortlist funds based on them. Here are some tips for picking the right funds:

  • When looking for a Mutual Fund, understand its past history. Look at how it has done during market upturns as well as crashes.
  • Look for the best funds in the asset class (equity, debt or hybrid). Ensure that they will help you meet your financial goals in the time frame that your need. They should also be according to your risk profile.
  • Check the performance of the fund for different time frames such as 3 months, 6 months, 1 year and so on. While you could check for last 3 years performance in case of debt funds, you can go up to 6 years for equity funds.
  • The funds that you shortlist using these criteria will be consistent performers and are most likely managed by exceptional fund managers.
  • Check for the profile of the fund managers and the AMC management. This can be found in the prospectus of the respective Mutual Funds.

If you follow the above process, it will help you make an informed decision and choose the right Mutual Fund for you. Though exhaustive, you need to do all this to ensure that you are taking the right decision, more so if you are a new investor with little knowledge on investing in Mutual Funds and the markets as such.

Importance of diversification

Every investment you make has some element of risk, regardless of the risk profile associated with the Mutual Fund. With diversification, you can minimise the potential losses, while earning profits, when you invest in a number of Mutual Funds. The best way to diversify your investments is by dividing your portfolio to include assets that are not fully correlated. You should have a healthy mix of equity, debt, money market, sector specific and other types of funds to have a balanced portfolio. Even within an asset class such as equity, you should ensure that the funds don’t invest in similar securities. This will help ensure that your portfolio is truly diversified.

Following up

So, you have selected the funds you will invest in and have asked for forms and documents to fill in and submit. Your job’s done, right? No, following up on your investments is equally important. Any savvy investor will tell you the importance of keeping track of the funds you’ve invested in, even if the funds are managed by top notch advisors and managers. And if you have invested in open-ended funds, you can exit funds that have remained consistent underperformers. The following means will help you track the performance of your investments:

Online: The website for your AMC or an aggregator website will give you daily updates on the performance of funds. These can be tracked through daily NAVs, performance stats, newsletters, fact sheets etc. The AMFI website also contains historical and daily data on the NAVs of funds.

Newsletters: Newsletters are typically released on a quarterly basis by the concerned AMC. This will have information on your fund’s portfolio as well as a direct report from the respective fund manager explaining the performance of the fund and other such details.

Newspapers: Financial newspapers also publish NAVs as well as sale prices of various schemes apart from reports and fact sheets from AMCs.

All this data can seem overwhelming, but unless you have invested in too many funds, you can manage following up on your investments pretty easily. All the information can be accessed online and you can always fall back on a mobile app that gives you updates about your Mutual Funds. This will only take a few minutes of your time every day and can help you manage investments in a better manner.

Why Mutual Funds?

When you can invest in stocks or government securities on your own, you may feel that you don’t need professional help to manage such investments. You could be wrong. Investing in the markets is not simply choosing stocks and forgetting about them. The process becomes fairly complex when more than a couple of stocks and fixed-income securities are involved and almost impossible for any run-of-the-mill investor. With professionally managed Mutual Funds, you can be assured that your investments are managed by people with many years of experience with market analysis. They will have enough knowledge to take calls on buying and selling those stocks and other investments. You might not actually have that kind of knowledge or time to handle individual stock or fixed-income investments. Fund managers can easily identify laggards and prevent the portfolio from becoming stagnant due to underperformers. With Mutual Funds, you get:

The right amount of diversification

Mutual Funds allow you to diversify your investment across assets and asset classes, something that is very difficult to do on your own.

Flexibility

You are given options to pick any type of fund as per your risk profile, and bundle all of them into a single portfolio. Data about the performance of the funds is easily available for you to take those buy and sell calls.

Professional managers

The fund managers of Mutual Funds are usually highly experienced in their respective fields and will have years of experience handling different types of assets. And what’s more, you will be provided with the profile of your fund manager so that you know who’s actually handling your hard-earned money.

Accessibility

There’s nothing more convenient than a central database providing you with all the required information and even highlighting what’s best for you. This is possible through Mutual Funds.

Liquidity

Your Fixed Deposit may be offering decent returns with little option for liquidity, or the stock market may give you decent returns with easy liquidity and a high probability of losses. A Mutual Fund is a fine balance between the two offering you good returns while providing you with decent liquidity.

Tax benefits

There are tax benefits associated with Mutual Funds. You need to invest in Equity Linked Savings Schemes (ELSS) of Mutual Funds for the same.

Investing in Mutual Funds can be very exciting and highly profitable as long as you choose the right funds. If you don’t know how to choose the right funds, BankBazaar is there to help you.

Updated: June 3, 2018 — 11:27 am

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