We keep hearing the buzz about how bank deposits aren’t good enough anymore and we should invest in mutual funds and SIP’s to be able to fight the ever rising inflation and save a substantial amount in the long term. But do we often literally gamble with our hard earned money when we just blindly invest them in mutual funds recommended by random acquaintances (sometimes, biased due to their monetary interests), thinking them to be a safer option over equity while blatantly ignoring a sentence that is almost always so explicitly associated with them – “Mutual Fund investments are subject to market risks.”
Having a rough idea about mutual funds is not enough if you don’t want to simply rely on chance to make major investment decisions. For making value investments in mutual funds it is necessary to have clarity on the basic concepts of mutual funds and get answers to your fundamental questions on the suitability of different investment options based on your goals (what to buy), where to buy from and how to track and evaluate the performance of your fund. These are some areas that will be discussed in this article and will assist new investors to make informed decisions and eventually create wealth for themselves through value investments.
What are Mutual Funds and why are they so lucrative?
I am sure you have come across the text book definition of mutual funds many times and I am not going to go into that again. Conventionally, only people who regularly followed the share markets invested in equity and the masses who did not have the time, knowledge or experience stayed away from the risky markets and in turn also stayed away from the rewards that equity offered in terms of capital appreciation. Mutual Funds help bridge this gap. Mutual Funds are investment schemes offered by AMCs (Asset Management Company) where a corpus of money raised through sale of units to the public is professionally managed and invested into a diversified array of equities and debt instruments by a Fund Manager. Thus, mutual funds enable small investors to get the services of experts who are backed by research teams.
We have often heard of this age old investment advice “Do not put all your eggs in one basket”. This seems truer than ever now when we see presumably well performing stocks suddenly crash down to lifetime lows due to scams discovered or other unforeseeable factors and small investors who are mostly invested in that single stock are stuck knee-deep in huge losses. Investing in a fund that has a diversified portfolio protects investors from getting impacted by a sharp fall in the price of a particular share.
Mutual Funds give us the benefit of Rupee Cost Averaging. It simply means that since mutual funds keep buying and selling stocks of their portfolios at regular intervals, they can take advantage of market dips and buy much more quantity at lower prices and less and less as the prices go up so the average price of their stock holdings becomes low.
Mutual Funds also give us the benefit of economies of scale (due to collective bulk investments) in terms of lower brokerage, custodial and other fees that translate into lower costs for investors.
What to buy?
This question can be answered in two parts. Firstly, the different types of schemes available and secondly, which schemes suit you the most based on your goals.
Mutual Fund schemes can be classified into the following broad categories based on investment objective:
Growth Funds – There primary purpose is to give capital appreciation to the investor over a period of time. These funds mostly invest in equities and both risks and returns are often high. Many growth schemes invest in equities sector wise, (like pharmaceuticals, IT, Power etc) or industry wise or scale wise (like large cap, midcap etc). (Selecting which growth fund to invest in is discussed in details later in this article).
Income Funds – The primary objective of this type of fund is to give regular income to the investors. These type of funds primarily invest in debt instruments like bonds and corporate debentures (Bond Funds) or Government Securities and Treasury bills (Gilt Funds). They are less risky than equity based funds and have both, a lower upside and a lower downside.
Balanced Funds – These funds invest both in equity and debt instruments in a balanced manner thus giving investors the benefits of both capital appreciation and regular income.
Money Market Funds – The primary objective of this type of fund is capital preservation. These funds invest into safer short term highly liquid instruments such as Commercial Paper, Certificates of Deposits and Inter-bank call money.
Special Funds – These funds are specific to certain type of schemes or instruments they invest in
Tax Saving Funds: These schemes (like ELSS – Equity Linked Savings Scheme) provide tax incentives and rebates under specific provisions of the Indian Income Tax laws for investors who can park their otherwise taxable income here and save tax.
Fund of Funds: Funds which invest in other funds and ETFs (Exchange Traded Funds) like Gold ETFs.
Index Funds: A fund that has a portfolio similar to that of an index like Sensex or Nifty and thus gives similar returns like those indices. All funds are subjected to both systematic/market risks and unsystematic risks with the exception of index funds which are only subjected to market risks. Thus, keeping a part of investments in index funds might bring stability to the portfolio.
Offshore Funds: A fund that primarily invests in foreign markets and gives domestic investors the opportunity to invest in other booming markets.
On the basis of redemption they can be classified into open-ended funds (funds that can be freely bought or sold at any time) and close-ended funds (funds that are redeemed after a fixed period). Most of the above discussed types are generally offered in form of open ended schemes.
Which scheme suits you the most?
Firstly, you should have a clear idea about the purpose for which you are saving the money (say, retirement, buying a house, children’s education or marriage) and accordingly the period of time (in years) for which you can hold your funds before you need to sell them off and utilize the money.
Many a times we have more than one goal with different time horizons. For example a person might need say, 30 lacs after 4 years for buying a house and 1 crore after 15 years for retirement. In such cases, if we don’t distinguish between the two goals having different period of holding and take a very risky scheme for both goals thinking it’s a long term investment, we might not be able to meet our targets for the 4 year (medium term) goal or even end up making a loss on that. Note that the goal amount that you need in future should be inflation adjusted. (This article does not imply that you should achieve all your goals investing only into mutual funds. Other articles in this blog discuss about overall financial planning and alternative investment instruments).
Once we enlist all our goals and their respective time horizon, we should evaluate our risk appetite for each of them. In general, as the time period for which we can hold the fund increases, so does our risk appetite. This is because if our time horizon is less and if due to economic slowdown or some other temporary reason there is a bear run but our need for the money is immediate, we might have to sell our holdings at a loss. However, a longer capacity to hold might have turned them into profits in future. Compounding also helps in accentuating gains from long term holdings.
The graph below shows what kind of fund schemes you should invest in based on your risk appetite and period of holding for individual goals.
How to decide on which growth fund (equity based) to buy?
While investing in equity based funds it is very important to be cautious and know about the portfolio of the fund. Though it seems that the broader indices (Sensex and Nifty50) have gradually increased in the last few years however, many stocks (even some ‘blue-chips’) have not increased as much and some of them are even quoted lower than they were in 2008. Thus, you should do some basic amount of analysis of the stocks in the portfolio of the fund and check certain factors which are discussed below.
[To do this analysis given below for individual fund schemes you will require data about the portfolio composition and past performance which can most reliably be obtained from the fund overview section or downloadable factsheets from the website of the mutual fund company.
Based on your approach – There are two approaches, either of which you could use to select your fund scheme:
Top down approach – In this approach, we look at the macro issues and the economy in general and predict which industry or sector is expected to perform well and accordingly select the scheme. For example, if rupee weakens against US dollar then IT companies do well or if there is a big tax exemption declared in the union budget for a particular sector or industry, that sector scheme may be accordingly chosen.
Bottom up approach – In this approach, the fundamentals and performance of individual companies are analyzed and then we can invest in funds that buy the particular stocks we expect will do well.
Past Performance and Management – We should see the track record of past dividends and the returns in terms of capital appreciation given by the fund. We should also see the credentials of the Fund Manager.
Expense ratio and Load Charges – This ratio represents the percentage of total assets of the fund that is used to pay expenses like management, advisory and administrative fees. SEBI has set an upper ceiling for the expense ratio that AMC’s can charge. This regulation helps expense ratios to stay within reasonable limits. Lower expense ratio means lower costs for investors. Some funds have a load charge that they might charge on Entry or Exit or Both. Load charges are based on initial marketing expenses of the funds and are not included in the expense ratio but directly charged to the investor as a percentage of the NAV (Net Asset Value – discussed later in the article).
Portfolio Turnover – This percentage indicates the frequency with which the fund manager buys and sells stocks in the portfolio of the fund. A very high rate may indicates higher transaction costs and will translate into higher costs for investors. A very low rate may indicate that the fund management might not be as active in monitoring the portfolio.
What are SWP’s and SIP’s?
SWP (Systematic Withdrawal Plan) is a plan by which an investor can invest at one go and withdraw in parts at regular intervals. These periodic withdrawals can be either taken in cash or reinvested into another or same mutual fund scheme by the investor thus giving the investor the benefit of both regular cash inflows and growth of the money still invested.
SIP (Systematic Investment Plan) is a plan by which an investor invests a fixed amount every month in a mutual fund. This helps them save a large amount of money eventually. SIP’s are gaining a lot of popularity among investors in planning for retirement and other long term goals. (To know more about investing strategies with SIP’s read the detailed article about SIP’s in the value investing section of this blog).
Where to buy from?
There are many avenues through which you can buy mutual funds like agents and banks. But buying direct plan mutual fund schemes (instead of regular plans which have a higher expense ratio and thus lower NAV’s) directly from AMC’s will get you the lowest cost as there will be no intermediaries between you and the AMC. Many AMC’s give options to buy online. Alternatively you may also invest in mutual funds through the local offices of the various AMC’s in many cities.
Once you have filled the form, made the payment and completed the other formalities your purchase is done at the NAV as on that day. Most AMC’s send the details of the number of units purchased and the purchase NAV by mail.
Alternatively you can also invest through MF utility enabling you to invest in different schemes of different Mutual Fund houses using one common account. Below is a link to the website.
http://www.mfuindia.com/Investors?src=MFU
How to track your mutual fund investments?
The easiest and the most reliable way to track the NAV of a fund regularly is through the website of AMFI (Association of Mutual Funds in India) the link to which is given below.
http://www.amfiindia.com/net-asset-value
Given above is a screenshot from the AMFI website. When we select our fund house name (AMC) then latest NAV’s of all the schemes of that AMC are displayed. You can then calculate the current market value (MV) of your investment by:
Current MV = Units held × Current NAV
You will see that there are three columns that display NAV per unit. On the date of purchase you get your holdings at the rate of normal NAV. If you have chosen the dividend reinvestment option then the new units you get on the reinvestment of dividend into the fund is at the rate of the repurchase price NAV. When we sell our holdings, we get it at the sale price NAV. The three NAV’s may or may not be different according to the different Entry and Exit Loads charged by various funds.
How is this NAV actually calculated?
Instead of directly going into the formula, I would first like to explain the working of a mutual fund from inception to give a thorough idea with the help of a hypothetical example. Suppose a fund scheme is launched with 10,000 units of Rs 10 each, that makes a capital of Rs 1 lac subscribed by the public. Now say, the Fund Manager invests its capital in the following hypothetical stocks as follows-
A Ltd 1,000 shares × Rs 35 per share = Rs 35,000
B Ltd 500 shares × Rs 60 per share = Rs 30,000
C Ltd 2,000 shares × Rs 15 per share = Rs 30,000
Cash and cash equivalents =Rs 5,000
Total = Rs 1,00,000
Say, after sometime the market price of A Ltd rises upto Rs 50 per share, B Ltd to Rs 70 per share and C Ltd drops to Rs 12 per share. Cash and cash equivalents remain the same and the company incurs Rs 2,000 as accrued expenses (this includes their management fees) then the NAV of the fund on that day would be calculated as follows-
NAV = MV of Stocks/holdings + Cash equivalent – Net accrued expense
Number of units of the fund outstanding
= (1,000×50) + (500 × 70) + (2,000 × 12) + 5,000 – 2,000
10,000
= Rs 11.20 per unit
How to evaluate the performance of your mutual fund?
You need to evaluate the performance of your fund to know if it is really reaping fruits and giving you rewards for your risks. A few effective methods to do so are given below:
Calculating CAGR (Compounded Annual Growth Rate) : Investments do not grow at the same pace in all periods. Suppose you invested in a mutual fund for five years, then it is not necessary that the investment fetched you equally good returns in all those years. CAGR gives you the average yearly compounded return for each of those five years, helping you understand how your investment has performed on an annual basis. It is computed using the following formula –
(Final Value of Investment ÷ Initial Value of Investment)1/period of investment – 1
Comparing to Indices : Most funds generally perform well when the entire market is on the uptrend, but the real test lies when the markets are down. If the fund is really managed well it should do a little better in comparison with the broader indices even though there will be some downtrend due to the overall market situation. The index to which a particular fund is compared to depending on the fund composition is known as the benchmark index. Data regarding fund returns with respect to benchmark returns can be found in the factsheet of the fund and can be downloaded from the relevant AMC’s website.
Sharpe’s Ratio : It measures the reward to risk ratio of a mutual fund’s portfolio and can be used to evaluate the comparative performance of the different mutual fund schemes. The reward is calculated as the percentage of extra return that a portfolio gives over the risk free rate of return. Standard deviation is used as a measure of total risk (comprises of both systematic or market risk and unsystematic risk) in this formula. It measures the volatility of a portfolio by computing the degree to which all returns for a particular investment deviate from the expected or mean return. The formula of Sharpe’s ratio is
% Return on Portfolio – % Risk free rate of return
Standard Deviation of Portfolio
The higher the ratio, the more the investor is compensated for the risk they undertook. This ratio is often already computed and given in the factsheets of the individual funds.
Are there any disadvantages to investing in mutual funds?
Mutual funds have some inherent disadvantages:
No Customization : Mutual Funds do not give us the liberty to choose from individual stocks and instruments and when we invest in a fund but don’t like a particular stock in its portfolio then we have no option but to invest in the entire portfolio.
Higher Costs : Mutual fund companies not only charge us the brokerage or other costs related to purchase and sales of stocks/financial instruments but also for their administrative, management and advisory fees. Thus costs to the investors are much more than they would be if the investor were to invest directly in those stocks/financial instruments. This is acceptable if professional touch also translates into higher earnings, however it’s not always the story of every mutual fund scheme.
Too much diversification : Sometimes too much diversification may lead to you losing opportunities in the market where particular stocks are expected to do extremely well due to their strong fundamentals.
No guarantee of returns : Since mutual fund investments are subject to market risks there are equal possibility of losses as there are of gains and even the SEBI has prohibited mutual fund companies from assuring guaranteed returns through mutual fund schemes.
So what should you do?
Even though mutual funds have some limitations they are still the preferred tool of investment for many. If you are a new investor and have no experience in the markets there is a good chance you might not make profits at first and mutual funds can really be the way to go. In my personal opinion closely tracking the portfolios of the popular mutual funds can also be a learning experience for people who are starting to learn the ABC’s of the markets as it gives us the insights on how professional and highly experienced individuals backed by a proactive research team choose stocks and financial instruments for their portfolio.
Note 1: We do not endorse any particular company, association or fund and any mention of their names in this article is only for investor education purpose.
Note 2: This article only discusses growth funds in details. Other articles in this blog discuss about debt funds and money market funds.
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