Mutual Fund Basics

A mutual fund does not give you fixed returns or guarantee your principal, and you cannot pick your choice of stock. So why do investors choose mutual funds? These are the commonly cited benefits:

1. Professional management – a fund manager
2. Diversification – across sectors of the economy
3. Return potential
4. Costs – entry and exit loads
5. Liquidity – redemption and partial withdrawal
6. Transparency – the fact sheet
7. Flexibility – switching from one scheme to another
8. Choice of schemes – various funds
9. Tax benefits – under section 80C (ELSS)

Professionally managed

In a mutual fund, securities are picked on your behalf by a professional fund manager, who researches the market, builds a portfolio based on the objective of the fund and keeps a continuous track of the investments. This suits people who do not have the knowledge or the time, or both, to manage investments themselves.

Investment options

You can invest as per your convenience and your investable surplus: a lump sum, or a Systematic Investment Plan (SIP) to invest over a period of time. You can also choose a dividend or growth option based on your money requirement.

Systematic Investment Plan (SIP)

In an SIP, you choose the scheme, investment amount, investment date and tenure. The amount is debited from your account automatically and invested on the chosen date every month for the entire tenure. It brings discipline to investing and averages the cost of investment, since it is invested regularly through market ups and downs: when markets are down the same amount buys more units, and when markets are up it buys fewer units.

Power of compounding

Returns generated by a mutual fund are compounded over time. Mutual funds give access to a variety of market-linked instruments, and the returns are not guaranteed.

Diversification

Diversification can be summed up in the phrase “Don't put all of your eggs in one basket.” The idea is to create a portfolio that includes multiple investments in order to reduce risk.

“Safe” means different things to different investors. For one it is guaranteed returns, for another it is protection of the principal, while some expect their money to grow irrespective of market conditions. Investing safely starts with understanding your own risk profile, time horizon, financial needs and the purpose of the investment.

“Mutual fund investments are subject to market risks, read all scheme related documents carefully” holds true not only for mutual funds but for any product you invest in. It is important to understand a product’s risk, where it invests and who manages it. When it comes to safety, investors are mostly concerned about two things: capital protection and fraud.

Capital protection

Mutual funds do not guarantee returns. Risk is reduced through professional management and diversification: a mutual fund invests in a portfolio of securities rather than a single stock or bond. You can review the performance of your fund from time to time and switch your investments when needed.

Choosing investments that suit you also matters. For example, a conservative investor should avoid small and mid-cap funds, where volatility is high, and can focus on hybrid or debt funds. The main risks to understand are market risk, liquidity risk, credit risk and interest rate risk.

Fraud

Many investors are afraid to invest through distributors. Even if a distributor or agent closes down, you can always approach the asset management company (AMC) of the mutual fund and redeem your units. To safeguard investors’ interests, mutual funds are regulated by SEBI, and AMCs need approvals and have to follow due diligence before taking investors’ money.

How can I assess the risk of a mutual fund?

Every mutual fund scheme carries a riskometer, which shows the scheme's level of risk with colour codes, like a car speedometer, so that investors can understand it and match it with their own risk profile.

Unit Trust of India was the first mutual fund set up in India, in 1963. In the late 1980s, the Government allowed public sector banks and institutions to set up mutual funds. In 1992, the Securities and Exchange Board of India (SEBI) Act was passed. The objectives of SEBI are to protect the interest of investors in securities, and to promote the development of and regulate the securities market.

SEBI formulates policies for, regulates and supervises mutual funds to protect the interest of investors. SEBI notified regulations for mutual funds in 1993, after which mutual funds sponsored by private sector entities were allowed to enter the capital market. The regulations were fully revised in 1996 and have been amended from time to time. All mutual funds, whether promoted by public sector, private sector or foreign entities, are governed by the same set of regulations and are subject to monitoring and inspection by SEBI.

A mutual fund is a portfolio which invests in securities like stocks, bonds, cash and government securities. The type and objective of the fund decide what it invests in, and the fund manager must follow this mandate while selecting the portfolio. Under SEBI’s categorisation of mutual fund schemes, AMCs follow one scheme per category, with an exception for index funds and ETFs.

Equity fund categories

• Market cap funds: large cap, mid cap, large and mid cap, multi cap and small cap funds
• Sector funds
• Thematic funds: dividend yield, contra, global, MNC
• Value funds
• Equity savings funds
• Equity linked savings schemes (ELSS)
• ETFs: gold, index
• Focused funds
• Index funds

Debt funds and hybrid funds have their own categories, and SEBI has also introduced solution-oriented schemes, with retirement and children’s funds as sub-categories. Categorisation makes it more convenient for investors to choose mutual funds based on their requirements.

How retail investors invest

Lump sum: a one-time purchase in a mutual fund, without any commitment of future investment.

SIP: instalments are invested on specified dates. Investors can choose an auto-debit or a manual payment option for instalments; with auto-debit, the amount is deducted from the bank account and invested even if you forget the SIP date.

After you invest

Once the money is invested, it is sent to the asset management company (AMC), which shares the information with the registrar and transfer agent (RTA). RTAs register and maintain detailed records of investors' transactions for the mutual fund houses. The RTA checks the folio history of the investor linked with their PAN, to see whether this is a new or an existing investor.

An existing investor can invest under a new folio, where units are allotted under a new account, or under the same folio. Investment under the same folio is possible when the investor has already invested with the AMC and wants to buy more units of the same fund, or another fund of the same AMC.

Physical and demat units

Units can be allotted in physical (statement of account) form or in demat form. Units in physical form are bought from and, on redemption, sold back to the AMC. In demat form, the units are dematerialised.

Choosing a mutual fund is like choosing a friend for life: it is going to help you achieve your future goals and be with you in good times and bad. The right fund should match your risk profile and investment time horizon. Some points to consider:

• Avoid the rating trap
• Look at the AUM of the fund
• Identify your goals and understand your risk profile
• Quality of securities
• Consistency of performance
• Expense ratio

Avoid the rating trap

You can look at the star rating of a fund given by mutual fund analysts and websites, but it should not be the sole parameter for picking a fund. A star rating compares a fund within its category; a high rating does not mean that the fund is the best performer of the entire category.

Look at the AUM of the fund

Beyond a certain level, a fund's AUM can start affecting its performance negatively. Fund managers may also hold large amounts in cash when there are fewer opportunities to deploy the capital.

Identify your goals and understand your risk profile

Understand your own requirements first: how much time you have until you need the money, and how much you need to achieve the goal. List all your goals and design an investment plan accordingly, and always keep some money aside for emergencies and contingencies.

Investors sometimes invest in funds that performed well recently without realising that such funds may have higher exposure to small and mid caps, which are very volatile and may not suit their risk profile. Your risk profile is different from your willingness to take risk: a person with large loans may be willing to take higher risk to clear the loans early, but should ideally take moderate or lower risk because of the financial commitments.

Quality of securities

Debt funds are not free of risk. While selecting a debt fund, look at the allocation towards AAA or AA rated bonds; higher exposure to low-rated bonds increases the default risk of the fund.

Consistency of performance

Do not judge a fund only on its 1-year returns; look at 3 to 5-year returns to see how consistent the performance is. Occasional high returns may be due to favourable market conditions or a specific sector performing well, and may not be repeated.

Expense ratio

Whether direct or regular plan, the cost of managing the fund is adjusted in your returns, so always look at the expense ratio of a fund.

Important ratios

• Alpha
• Beta
• Standard deviation
• Sharpe ratio
• Sortino ratio
• Capture ratio

Many of us wait until March to plan our tax savings and end up in the wrong products just to get it over with. This especially happens to investors who have just started working. Tax saving mutual funds are one of the options to review before deciding.

ELSS (Equity Linked Savings Scheme) is a category of mutual fund which helps in saving taxes. It offers capital appreciation as well as tax deduction under section 80C of the Income Tax Act. ELSS is an open-ended equity scheme, which means that more than 65% of the money is invested in equity. ELSS funds offer growth and dividend options.

Features of ELSS funds

• Lock-in period: other tax saving products such as PPF, NPS or tax-saving FDs have a lock-in of more than 5 years; ELSS has a minimum lock-in of 3 years.
• Tax saving: deduction of up to Rs. 1.5 lakh from total income under section 80C.
• Dividend and growth: in the growth option, the money is reinvested and keeps growing until you redeem it; in the dividend payout option, dividends are paid out.

Advantages of ELSS funds

• A 3-year lock-in.
• The portfolio is available transparently to all investors.
• Once the invested money completes the 3-year lock-in period, you can withdraw all of it.
• You can invest through SIP or lump sum.
• Your money is managed by a fund manager, so ELSS can be an option even if you are new to investing and want to save tax.
• There is no maximum limit for investment in ELSS, though the tax deduction is limited under section 80C.

Disadvantages of ELSS funds

• ELSS is an equity-linked investment, so it is not suitable for conservative investors.
• The money received after the lock-in period is taxable as long-term capital gains.
• Returns are not guaranteed; no investment in mutual funds guarantees returns.

ELSS has a 3-year lock-in, is easy to redeem, is managed by a professional, and you can invest through an SIP. It is advisable to start saving for taxes as early as possible, so that you have enough time to choose the right fund. You can claim a deduction of up to Rs. 1,50,000 under section 80C, and you should always link your investment to a goal.

Step 1: Determine your tax slab and taxable income

Have a clear idea of your taxable income and tax slab. This makes clear under which sections you can save taxes and which products are useful to you.

Step 2: Pick an ELSS fund

• Past performance and age of the fund: past performance cannot guarantee future returns, but it indicates how the fund manager generated returns through the ups and downs of market cycles.
• Consistency: a fund cannot be judged on its 1-year or 6-month returns.
• XIRR of the fund: XIRR calculates the internal rate of return for scheduled cash flows, such as periodic investments.

Step 3: Invest in ELSS online

• Create an account
• Fill in the required details in your personal profile and the FATCA form
• Fill in your bank details
• Upload a cancelled cheque
• Choose the fund you selected in step 2 and invest

Step 4: SIP or lump sum

An SIP means you are not burdened with investing the whole amount at once, and it gives you the benefit of rupee cost averaging. Many investors invest a lump sum towards the end of the financial year, when the deadline for the tax benefit draws near. We feel this is not the right strategy: ELSS funds are equity-oriented schemes, and by effectively timing the market on a similar date every year, investors take the risk of negative returns.

Step 5: Redemption of ELSS

ELSS has a lock-in period of 3 years. Once the lock-in period is over, you can withdraw the complete amount or part of it. The returns are taxed as long-term capital gains.

A systematic investment plan (SIP) is a way to invest in mutual funds, where a specified amount is deducted from your bank account at regular intervals and invested in the fund you have selected. SIPs can be weekly or monthly, and a few funds allow quarterly SIPs.

An SIP helps you build discipline in investing and reduces the burden of a bulk investment. It suits people who want to invest a small amount every month out of their disposable income. You can start a mutual fund SIP with as little as Rs. 500.

Benefits of SIP

• Power of compounding
• Rupee cost averaging
• Systematic and disciplined investment
• Flexibility

Power of compounding

Even a small amount invested for a long time can grow. You may not see the effect in a short time; you have to keep investing and be patient.

Rupee cost averaging

It is nearly impossible to time the market. In an SIP you invest on the same date every period, whether the market is at its peak or its lowest, so at the end of the term your cost of acquiring units is neither the lowest nor the highest, but the average.

Systematic and disciplined

If you had to invest manually, you could miss a few instalments. With an SIP, you fill in the mandate form once and the money is deducted from your account automatically.

Flexible

You can choose the amount you are comfortable investing, the date of investment and the fund category you want to invest in.

Tax saving

You can invest in ELSS (Equity Linked Savings Schemes) through an SIP and claim a deduction of up to Rs. 1,50,000 under section 80C of the Income Tax Act.