Beginners guide to Mutual Funds

Mutual funds have become popular asset classes for individuals to invest. However, new (and sometimes even existing investors) end up having several questions about mutual funds. This post is an attempt to answer several possible questions which investors would have.

Understanding mutual funds as a Beginner

Mutual funds pools money from many investors and invest the money in securities such as stocks, bonds, commodities, etc. based on pre-agreed mandate. They offer diversification of assets as per individual’s objective, professional management and liquidity, at the same time allowing investors to avail benefits from the lower trading cost. A mutual fund is professionally managed and always keep aside some part of the money as cash to fulfil redemptions. Every investor gets to participate by holding units or shares that are proportional to the amount invested. The gains recorded by a mutual fund are distributed correspondingly among investors after deducting certain expenses.

Why Mutual Funds?

To enjoy better returns

The best performing mutual funds have offered returns of anywhere between 15% to 20% consistently over the last 2 decades. An individual who would have invested Rs 10,000 every month would be able to create a corpus of Rs 27,86,573 assuming a CAGR of 15% But if we extrapolate this case to 20 years, the individual ends up with a corpus of almost Rs 1.5 crores.

Very few asset classes are able to match up to such returns. And what is the icing on the cake?

Liquidity!

You can redeem your mutual fund units anytime you wish. The redemption time varies between 1-2 working days for debt-oriented funds and 4-5 days for equity-oriented funds.

Accurate selling price

During the redemption, mutual fund units will be sold according to the NAV as on that day. Which means you get exactly what your investment is worth.

Inflation beating returns

What costs Rs 2 lakhs today, would cost Rs 4 lakhs after nine years considering an inflation rate of 8%. Most asset classes are not able to beat inflation effectively. Mutual Funds offer inflation beating returns consistently over a period of time.

Goal based investing

People have several goals in life. They wish to buy latest gadgets, travel to exotic destinations, purchase an automobile with all the bells and whistles, buy a house, educate their children in the best universities and hopefully – retire early!
These goals can be primarily divided into short term, medium term and long term.
Choosing the right type of fund is critical to ensure that your financial goals are achieved.

Short Term Goal

One can invest in debt-oriented funds to prepare for achieving short term goals. These funds are less volatile and offer steady returns as they primarily are invested in government securities, bonds and other debt instruments. If one’s investment horizon is less than 2 years, debt oriented mutual funds are recommended.

Medium Term Goal

Medium term goals may require an investment duration of 3 to 6 years. Balanced funds, which invest in a comfortable mix of equity and debt instruments, are most suitable to help an investor achieve medium term goals.

Long Term Goal

Long term goals may require an investment duration of more than 7 years. One can consider equity-oriented funds as these invest heavily in equities. The time frame is also such that the fund can take advantage of market volatility to offer attractive returns.

Should I be investing a little every-month? Or should I invest at one go?

SIP, which is an acronym for Systematic Investment Plan, is the most popular method of investing regularly in mutual funds as it enables an investor to take advantage of the market’s volatility. It is also easier on the pocket as an investor can begin investing with an amount that is as low as Rs 500 every month. Enabling a systematic investment plan will ensure that an investor is also able to adhere to a discipline of investing consistently during the ups and downs of stock market.

Guide to choose a Mutual Fund

SIP, which is an acronym for Systematic Investment Plan, is the most popular method of investing regularly in mutual funds as it enables an investor to take advantage of the market’s volatility. It is also easier on the pocket as an investor can begin investing with an amount that is as low as Rs 500 every month. Enabling a systematic investment plan will ensure that an investor is also able to adhere to a discipline of investing consistently during the ups and downs of stock market.

Consider the Portfolio Manager

Now a days it is not very difficult to dig out information about your fund’s portfolio manager. You should also look at the performance of other funds which he is managing. If you find yourself holding a mutual fund with a manager that has discouraging, little or no track record you should consider exiting the investment.

Rankings

Certain investors carefully scrutinize the star ratings given by various research agencies. These star ratings can be one of the factors to look at, but more than the recent or long-term performance of any scheme its ranking among peers should be looked at. One should select the scheme which has remained in top quartile most of the time.

Past performance

Investors should avoid investing by evaluating only the latest performance of a mutual fund. One should look for consistency in performance over longer tenures like 3, 5 and 10 years, if that is available, rather than the short-term returns. One must choose schemes that have consistently beaten benchmark indices (index to which a fund's returns are compared) and compare reasonably with their peer set over the above time frames.

Guide to begin

Mutual fund schemes offer regular and direct plans. A regular plan involves investing through a distributor/broker/agent. However, a direct investor must understand if the scheme is appropriate, considering its track record, the investor’s goal and risk profile.

There are various online platforms for investing
  • Transaction portal on the mutual fund website.
  • Transaction portals belonging to registrar and transfer agents of mutual funds.
  • Transaction portals of the distributor or agent

When to sell / redeem

When goals are achieved

It is ideal to sell one’s MF holdings on the eve of achieving one’s financial goals. Or probably a couple of years before that. It is advisable to shift one’s invested corpus from an equity fund to a low risk debt fund when one is a couple of years away from reaching the goal. This is to ensure that a sudden phase of volatility in the stock market does not upset one’s financial plan. For example, you might have invested in an equity-oriented mutual fund whose returns have fallen as the market has tumbled.

If Mutual fund is not performing well

When we talk of underperformance we are referring to consistent underperformance. Even the best of funds tends to have a few bad quarters. That is why it is always better to focus on three to five year returns on mutual funds. But then there are some genuine cases of underperformance. For example, your funds may be exposed to the wrong sectors at the wrong time. Alternatively, your debt fund may have taken too much risk on low quality debt without the associated benefit of outperforming the benchmark. If your equity mutual fund is yielding lower than an index fund, then you are actually earning negative yields on your market risk. That does not make sense. There are occasions when the fund returns have been too volatile which again defeats the purpose of MF investing. These are cases you must look to exit and reinvest in alternate funds.

Past performance

Investors should avoid investing by evaluating only the latest performance of a mutual fund. One should look for consistency in performance over longer tenures like 3, 5 and 10 years, if that is available, rather than the short-term returns. One must choose schemes that have consistently beaten benchmark indices (index to which a fund's returns are compared) and compare reasonably with their peer set over the above time frames.

Documentation

Like any other financial transaction, mutual fund investment it is not devoid of documentation. The investor will need to complete the following activities.

  • Application form: You may need to fill in an application form to open a mutual fund account and another form if you are going for an electronic transfer from your bank account.
  • KYC Compliance: PAN has to be verified under the Know Your Customer (KYC) norms to be able to invest in mutual funds. If one is already KYC-compliant, one needs to submit the KYC acknowledgement letter or copy of the KYC-compliance page.
    1. Proof of identity: Some of the following documents are acceptable as proof of identity
      • PAN with photograph
      • Aadhaar
      • Passport
      • Voter’s ID card
      • Driving licence
    2. Proof of address: Some of the following documents can be submitted as proof of identity
      • Aadhaar
      • Driving licence
      • Passport
      • Voter’s ID card
      • Ration card
    3. Cheque for SIP or lump sum amount. However, if one opens a mutual fund account online, cheques would be required.

These days almost all fund houses and many distributors offer online facilities to invest in mutual funds. All you need to do is fill the relevant information and submit it. e-KYC enables completion of KYC process online for which one will need to enter your Aadhar number and PAN.

Conclusion

It is to be borne in mind that Mutual fund investments are subject to market risks and one should read scheme related documents carefully before investing. Also, past performance is not indicative of future returns. One should consider one’s specific investment requirements before choosing a fund or designing a portfolio that suits one’s needs.

Mutual funds have democratized the opportunity to invest in various asset classes and create wealth by banking on the expertise of a qualified professional. One should aspire to invest at least 20% of one’s monthly income through a systematic investment plan in mutual funds. One can also increase one’s SIP amount by 10% every year as one’s income would also keep increasing. The journey of a thousand miles begins with a single step as does the journey of achieving financial independence begin with a single SIP.