Investing in Mutual Funds
Updated: Jan 19
There are hundreds of schemes across different categories of mutual funds. It is hard for an investor to identify which scheme is better. It is not about the highest returns; it is about a scheme or combination of schemes that will help in achieving an investor's financial objective. In this write-up, we will explore a lot of information from knowing the basics to creating investment portfolios using mutual funds.
What are mutual funds?
A mutual fund is a pool of funds from many investors that is used by a fund manager to meet a certain investment objective.
Are mutual funds safe?
The next question investor often has is whether mutual funds are safe. During the 90s when the Harshad Mehta scam happened followed by US 64 disaster, a whole generation lost faith in the equity market.
A lot of cleaning has been done in the last three decades. The equity market regulator, SEBI has progressively made mutual fund investments safe for the investor.
SEBI understands that Indian investors are not financially savvy. All the regulations related to mutual funds can be categorised as biased towards retail investors. Regulations cannot protect the movement of the market; an investor must guard himself or herself against any market movement. You cannot blame the regulator for a general decline in markets and the erosion of investment portfolios. You have to do your homework, anyways.
Types of mutual funds
In India, mutual funds are available in three categories i.e., debt, equity, and gold. Soon we may be looking at the fourth category, real estate in the form of real estate investment trusts (REITs).
Debt funds are for income; in simple terms, you can see them as a substitute for your fixed deposit.
Equity funds are used for long-term investing.
Gold provides a good hedge against inflation.
There are many debt instruments in India including provident fund, PPF fixed deposit, NSE and others. The benefit of investing in a debt mutual fund is firstly liquidity. A lot of government-sponsored debt instruments including provident funds are not liquid. Another benefit of debt mutual funds is the diversification benefit. Investing in one debt mutual fund gives you access to a broad range of bonds across different sectors, including government bonds.
The third benefit is tax efficiency. In case your investment stays in the fund for three years or beyond, you can claim an Indexation benefit. An indexation benefit is associated with inflation in the economy. In simple terms, if the inflation is 5%, then you pay 20% tax only on the returns over 5%. So, in case your return is 7%, you pay tax only on the additional 2% i.e., 20% on 7% - 5% = 2% X 20% = 0.40%. The effective after-tax return will be 7% - 0.4% which is 6.6%.
There are many types of debt mutual funds. Broadly they are classified across four categories.
The first category is a liquid fund. A liquid fund invests in corporate deposits and government treasuries. Across all categories, the liquid fund is the least volatile.
The other categories include ultra-short-term debt funds and short-term debt funds. These funds invest in corporate debt and government debt maturing in 1 to 3 years. When RBI makes changes, liquid funds will be the least impacted.
The next category is medium and long-term debt funds. As the name suggests these funds invest in medium-duration and long-term duration i.e., more than five years of maturity. When RBI makes changes to the interest rate, these funds are severely impacted.
The last one is the arbitrage fund. Although arbitrage funds are equity funds they behave like liquid funds. Since these are equity category funds, taxation of equity is applied i.e., in the short-term 15% and in the long-term 10%. This category would be the most tax efficient for people in high tax brackets.
Now we assess the average category-level returns across that over the last five years. Please note that these five years also include the impact of Covid from 2020- 22.
When you look at medium and long-term debt funds, the return is 6 1/2% and 7% respectively. If an investor were to just look at these returns, they would naturally get inclined towards medium and long-term debt. For most investors, medium and long-term debt categories should be explored only when the interest rates are extremely high.
There is an inverse relationship between interest rates and the duration of a mutual fund. A medium and long-term debt fund will fluctuate a lot when there is interest rate movement. A lot of retired people who want to create cash flows based on their retirement needs may evaluate medium and long-term debt funds.
Let’s discuss the equity category now.
There are broadly four categories of equity mutual funds. The other categories such as thematic, small and mid, large, and mid etc. are just slice and dice of these categories.
The first category is large cap funds. Large cap funds invest in the top hundred companies by market capitalisation in India. There is a lot of debate that index funds are better in this category than actively managed funds. An index fund as the name suggests is passively managed and there is no fund manager whereas an actively managed fund has a fund manager and thus a higher fee is applicable.
The next category is midcap funds. These funds invest in the top hundred to 250 companies by market capitalisation. In this category, a fund manager has a crucial role. This is the reason performance within the Midcap category can be very wide. Wrong selection in this category can be very costly to the investor.
The next category is small cap funds. These funds invest in the top 250 to 500 companies by market capitalisation. In this category also a fund manager’s role is critical. Relying on index funds can backfire.
The next category is multi-cap category. These funds invest across categories irrespective of the market capitalisation which is a combination of large cap, mid-cap and small cap.
Let’s look at the performance over the last five years.
Please note that these are category-level returns, at a fund level, the returns could be very different, especially for mid and small-cap categories.
Indian mutual fund industry offers debt, equity, and gold mutual funds. What should be the combination across all these for the investor? Should the debt be high, or Equity be high? what about gold?
You need to know whether you are an aggressive, moderate, or conservative investor.
Do not assume that if you are earning well, you are aggressive, and do not assume that if you are not earning well, you are conservative.
You must reflect on your risk profile from two perspectives. One has your level of income and asset base and on the other side your comfort with volatility.
An aggressive investor is a long-term investor and very comfortable with volatility. Similarly, a moderate investor is a long-term investor but is not too comfortable with volatility. A conservative investor is an investor with an extremely low level of comfort with portfolio volatility.
Regular versus Direct Mutual Fund
There can be two categories of the same mutual fund. One mutual fund which covers the load i.e., a higher expense ratio. These funds are called regular funds, and these are distributed by distributors, including your bank, ICICI securities, etc. And a no-load fund is also called a direct fund. In these funds, an investor invests directly or through an advisor.
The choice to invest in a regular scheme or a direct scheme depends upon the investor. In the case of a regular scheme, a certain brokerage is paid to the distributor for facilitating the investment, and in the case of a direct fund, there is no brokerage charge. An investor must pay a fee to the adviser.
Irrespective of your engagement model, you should follow a certain way to invest in mutual funds. The first task you need to perform is to identify your investment objective also called financial goals. This will help you understand the time horizon that you have to invest in.
Retirement could be a long-term goal say 15-20 years from now, whereas buying a car could be a short-term goal. Once you have identified your goals and time horizon, you will have clarity in terms of which mutual fund to select.
Based on your risk profile and your investment objective, a combination of equity, debt and gold can be selected. A conservative investor can have a minimum investment of 25% into equity and 75% in combination with debt and gold. This changes to 75% in equity and 25% in debt and gold for an aggressive investor.
This is a broad guideline and not an answer; even if you are an aggressive investor, but you have a short-term goal, say you’re retiring in the next five years, you should not invest 75% in equity. Similarly, if you are a conservative investor, and you have a long time to achieve your objective, you should not shy away from not investing in equity.
‘Mutual funds Sahi Hai’ is only for those people who partner with the right fund managers. A careful assessment to select the right fund managers is key to ‘mutual fund Sahi Hai’.