What is a Mutual Fund?
A Mutual Fund is a vehicle for investing in stocks and bonds. It is not an alternative investment option to stocks and bonds, rather it pools the money of several investors and invests this in stocks, bonds, money market instruments and other types of securities. Buying a mutual fund is like buying a small slice of a big pizza. The owner of a mutual fund unit gets a proportional share of the fund’s gains, losses, income and expenses.
Do mutual funds offer a periodic investment plan?
Most private sector funds provide you the convenience of periodic purchase plans (through a Systematic Investment Plan), automatic withdrawal plans and the automatic reinvestment of dividends. You would basically need to give post-dated cheques or a bank mandate (monthly or quarterly, periodic date of the cheque or bank mandate is fixed by the Asset Management Company). Most funds allow a monthly investment of as little as Rs500 with a provision of giving 4-6 post-dated cheques and follow up later with more. Regular monthly investments are a good way to build a long-term portfolio and add discipline to your investment process.
Do any mutual funds invest in both stocks and bonds?
Yes, balanced funds invest in a combination of stocks and bonds, a typical mix is 60:40 in favour of stocks. Returns from balanced funds are normally lower than pure equity mutual funds when markets are rising, however if the market declines, the losses are also normally lower. Balanced funds are best suited for investors who do not plan their asset allocation and yet want to invest in equities. Buying separate equity and income funds for your portfolio also achieves the same results as buying a balanced fund. The advantage with the former option is that you can choose your own split (between stocks and bonds i.e fixed income) rather than let the fund manager decide the same.
What are the different types of Mutual Funds?
Mutual Funds are classified by structure in to:
• Open - Ended Schemes
• Close-Ended Schemes
• Interval Schemes
and by objective in to
• Equity (Growth) Schemes
• Income Schemes
• Money Market Schemes
• Tax Saving Schemes
• Balanced Schemes
• Offshore funds
• Special Schemes like index schemes etc
What are the time tested investment strategies that work?
Start investing as early as possible - the power of compounding is the single most important reason for you to start investing right now as even a relatively small amount invested early will grow over the course of your working life into a substantial nest egg. Remember, every day that your money is invested, is a day that your money is working for you.
Buy stocks or equity mutual funds and hold long-term – historically, world over, and even in India, stocks have outperformed every other asset class over the long run.
Invest regularly – use the Rupee Cost Averaging approach – this will help you to adopt a disciplined approach to investing and works equally well for both buying and selling decisions. Importantly, it increases your potential gains when acting against the market trend, reduces risk when you are playing the market trend and relieves you from the pressures of forecasting tops and bottoms. Rupee Cost Averaging can effectively convert a regular savings plan into a regular investing approach.
And, Diversify your investment - by diversifying across assets, you can reduce your risk without necessarily having to reduce your returns. To get the maximum benefit of reducing your risk through diversification spread your portfolio across different assets whose returns are not 100% correlated.
How significant are fund costs while choosing a scheme?
The cost of investing through a mutual fund is not insignificant and deserves due consideration, especially when it comes to fixed income funds. Management fees, annual expenses of the fund and sales loads can take away a significant portion of your returns. As a general rule, 1% towards management fees and 0.6% towards other annual expenses should be acceptable. Carefully examine the fee a fund charges for getting in and out of the fund. Again, you can query on entry and exit loads.
Ideally how many different schemes should one invest in?
Don't just zero in on one mutual fund (to avoid the risk of being overly dependent on any one fund). Pick two, preferably three mutual funds that would match your investment objective in each asset allocation category and spread your investment. We recommend a 60:40 split if you have shortlisted 2 funds and a 40:30:30 split if you have short-listed 3 funds for investment.
How do you select a mutual fund scheme?
What's strategy got to do with selecting a mutual fund? Shouldn't you just go and invest in the best performing fund? The answer is no. Mutual fund investing requires as much strategic input as any other investment option. But the advantage is that the strategy here is a natural extension of your asset allocation plan. Madhuvan recommends the following process:
Identify funds whose investment objectives match your asset allocation needs
Just as you would buy a computer that fits your needs and budget, you should choose a mutual fund that meets your risk tolerance (need) and your risk capacity (budget) levels (i.e. has similar investment objectives as your own). Typical investment objectives of mutual funds include fixed income or equity, general equity or sector-focused, high risk or low risk, blue-chips or turnarounds, long-term or short-term liquidity focus.
Evaluate past performance, look for consistency
Although past performance is no guarantee of future performance, it is a useful way of assessing how well or badly a fund has performed in comparison to its stated objectives and peer group. A good way to do this would be to identify the five best performing funds (within your selected investment objectives) over various periods, say 3 months, 6 months, one year, two years and three years. Shortlist funds that appear in the top 5 in each of these time horizons as they would have thus demonstrated their ability to be not only good but also, consistent performers.
Are investments in mutual funds liquid?
Yes. Investors of open-ended schemes can redeem their units on any business day and receive the current market value on their investments within a short time period (normally three- to five-days). Investors of close-ended schemes can redeem their units only on maturity but can sell it in the secondary market like stocks.
Why should you invest through Mutual Funds?
Firstly, we are not all investment professionals. We go to a doctor when we need medical advice or a lawyer for legal guidance, similarly mutual funds are investment vehicles managed by professional fund managers. And unless you rate highly on the Investment IQ Quiz, we recommend you use this option for investing. Mutual funds are like professional money managers, however a key factor in their favour is that they are more regulated and hence offer investors the ability to analyse and evaluate their track record.
Secondly, investing is becoming more complex. There was a time when things were quite simple - the market went up with the arrival of the first monsoon showers and every year around Diwali. Since India started integrating with the world (with the start of the liberalisation process), complex factors such as an increase in short-term US interest rates, the collapse of the Brazilian currency or default on its debt by the Russian government, have started having an impact on the Indian stock market. Although it is possible for an individual investor to understand Indian companies (and investing) in such an environment, the process can become fairly time consuming. Mutual funds (whose fund managers are paid to understand these issues and whose asset management company invests in research) provide an option of investing without getting lost in the complexities.
Lastly, and most importantly, mutual funds provide risk diversification: Diversification of a portfolio is amongst the primary tenets of portfolio structuring (see The Need to Diversify). And a necessary one to reduce the level of risk assumed by the portfolio holder. Most of us are not necessarily well qualified to apply the theories of portfolio structuring to our holdings and hence would be better off leaving that to a professional. Mutual funds represent one such option.
What is the role of a Fund Manager?
Fund managers are responsible for implementing a consistent investment strategy that reflects the goals and objectives of the fund. Normally, fund managers monitor market and economic trends and analyse securities in order to make informed investment decisions.
How are mutual funds regulated?
All Asset Management Companies (AMCs) are regulated by SEBI and/or the RBI (in case the AMC is promoted by a bank). In addition, every mutual fund has a board of directors that represents the unit holders’ interests in the mutual fund.
What is an Asset Management Company (AMC)?
The company that manages a mutual fund is called an AMC. For all practical purposes, it is an organized form of a “money portfolio manager”. An AMC may have several mutual fund schemes with similar or varied investment objectives. The AMC hires a professional money manager, who buys and sells securities in line with the fund's stated objective.
Are investments in mutual fund units risk-free or safe?
This depends on the underlying instrument that a mutual fund invests in, based on its investment objectives. Mutual funds that invest in stock market-related instruments cannot be termed “risk-free or safe” as investment in shares are inherently risky by nature, whereas funds that invest in fixed-income instruments are relatively safe and those that invest only in government securities are the safest.
How is NAV calculated?
The value of all the securities in mutual fund’s portfolio is calculated daily. From this, all expenses are deducted and the resultant value divided by the number of units in the fund is the fund’s NAV or its Net Asset Value.
What is Net Asset Value (NAV)?
NAV is the total asset value (net of expenses) per unit of the fund and is calculated by the Asset Management Company (AMC) at the end of every business day. Net asset value on a particular date reflects the realisable value that the investor will get for each unit that he his holding if the scheme is liquidated on that date.
What is an entry load and an exit load?
Some Asset Management Companies (AMCs) have sales charges, or loads, on their funds (entry load and/or exit load) to compensate for distribution costs. Funds that can be purchased without a sales charge are called no-load funds. Entry load is charged at the time an investor purchases the units of a scheme. The entry load percentage is added to the prevailing NAV at the time of allotment of units. Exit load is charged at the time of redeeming (or transferring an investment between schemes). The exit load percentage is deducted from the NAV at the time of redemption (or transfer between schemes). This amount goes to the Asset Management Company and not into the pool of funds of the scheme.
What are Offshore Funds?
Offshore funds specialise in investing in foreign companies or corporations. These funds have non-residential investors and are regulated by the provisions of the foreign countries where these are registered. These funds are regulated by RBI directives.
What are Index Funds?
Index schemes attempt to replicate the performance of a particular index such as the BSE Sensex or the NSE 50. The portfolio of these schemes will consist of only those stocks that constitute the index. The percentage of each stock to the total holding will be identical to the stocks index weightage. And hence, the returns from such schemes would be more or less equivalent to those of the Index.
What are Tax-Saving Schemes?
You can also call them as Equity Linked Savings Schemes (as they are widely known – ELSS). Under the Income-Tax Act, investing in these schemes in a particular financial year to the extent of Rs. 1,00,000 provide an individual or HUF with a deduction of the same amount – thereby saving tax. These particular investment have a lock-in of three years from the date of investment because of their facility of providing tax savings.
What are Money Market Schemes?
Money Market Schemes aim to provide easy liquidity, preservation of capital and moderate income. These schemes generally invest in safer, short-term instruments, such as treasury bills, certificates of deposit, commercial paper and inter-bank call money.
What are Balanced Schemes?
Balanced Schemes aim to provide both growth and income by periodically distributing a part of the income and capital gains they earn. These schemes invest in both shares and fixed income securities, in the proportion indicated in their offer documents (normally 60:40).
What are Income Schemes?
Income Schemes are also known as debt schemes. The aim of these schemes is to provide regular and steady income to investors. These schemes generally invest in fixed income securities such as bonds and corporate debentures. Capital appreciation in such schemes may be limited.
What are Growth Schemes?
Growth Schemes are also known as equity schemes. The aim of these schemes is to provide capital appreciation over medium to long term. These schemes normally invest a major part of their fund in equities and are willing to bear short-term decline in value for possible future appreciation.
What are Interval Schemes?
Interval Schemes are those that combine the features of open-ended and close-ended schemes. The units may be traded on the stock exchange or may be open for sale or redemption during pre-determined intervals at NAV related prices.
What are close-ended mutual fund schemes?
Close-ended mutual fund Schemes have a stipulated maturity period wherein the investor can invest directly in the scheme at the time of the initial issue and thereafter units of the scheme can be bought or sold on the stock exchanges where the scheme is listed. The market price at the stock exchange could vary from the scheme’s NAV on account of demand and supply situation, unit holders’ expectations and other market factors. Usually a characteristic of close-ended schemes is that they are generally traded at a discount to NAV; but closer to maturity, the discount narrows.
What are open-ended mutual fund schemes?
Open–ended schemes usually do not have a fixed maturity period and are available for subscription and redemption on an ongoing basis. The units can be bought and sold any time during the life of the scheme at NAV related prices.
What is the difference between an open-ended and close-ended scheme?
Open-ended schemes can issue and redeem units any time during the life of the scheme while close-ended schemes cannot issue new units except in case of bonus or rights issue. Hence, the number of units of an open-ended scheme can fluctuate on a daily basis while that is not the case for close-ended schemes. Another way of explaining this difference is that new investors can join the scheme by directly applying to the mutual fund at applicable net asset value related prices in case of open-ended schemes while that is not the case in case of close-ended schemes, where new investors can buy the units from secondary market only.
What is venture capital? What are venture capital funds?
Venture Capital is the fund/initial capital provided to businesses typically at a start-up stage and many times for new/ untested ideas. Venture capital normally comes in where the conventional sources of finance do not fit in. Venture capital funds are mutual funds that manage venture capital money i.e. these funds aggregate money from several investors who want to provide venture capital and deploy this money in venture capital opportunities.
Typically venture capital funds have a higher risk/ higher return profile as compared to normal equity funds and whether you should invest in these would depend on your specific risk profile and investment time-frame.
How do I invest with a limited amount?
Regular investing is a very good way to build up an investment portfolio and this can be done with any amount of money. First, plan out how your investments should be spread out i.e. how much should be invested in equity shares and how much in fixed-income (bonds/ debentures) instruments. This should be based on your risk profile i.e. what your risk taking capacity is (how much risk can you take financially) and what your attitude towards risk is.
Unless you rate high on aptitude, temperament and knowledge related to investing in shares, equity mutual funds offer a better alternative to investing directly in shares. Income mutual funds also offer a good alternative to fixed-income investment. For regular investment, most mutual fund schemes have a Systematic Investment Plan - this can be either monthly or quarterly installments. Typically, the minimum installment amount is around Rs500 and while choosing this plan, you will need to give around three- to four-post dated cheques at the time of investment – these days bank mandate is also an option.
How many funds or stocks should you diversify your portfolio over?
To get the maximum benefit of reducing your risk through diversification spread your portfolio across different assets whose returns are not 100% correlated. Different assets should ideally span across different asset classes such as fixed income, equity, real estate, gold as well as different investment options within these asset classes e.g. within equity shares, your exposure should be to companies in different sectors; or within fixed income investments, partly government risk and partly corporate risk.
As a thumb rule, diversify your investments across 15-20 different portfolio holdings if you are directly investing in stocks or bonds. If you are investing through mutual funds, then three MF schemes for stocks and three schemes for bonds should provide you adequate diversification.
How does "entry load" eat into your investment returns?
A 2.25% entry load sounds small. But it still bites a chunk off your returns over a long period of time. For instance, Rs 1 lakh invested directly in the no-load option of an equity fund that grows at a rate of 15% over a period of 20 years yields around Rs 16.36 lakh against Rs 15.99 lakh that a load fund would return—a difference of Rs 36,820. This is because even a small sum of 2.25% gets compounded over the years.
The pinch remains the same even in a systematic investment plan (SIP). As SIPs entail investments on a regular basis, say every month, you end up paying entry loads on all your investment instalments. Assume you had invested Rs 5,000 in Reliance Vision Fund (RVF) on January 1, 2003 through a monthly SIP. If you had withdrawn your entire investment after five years, on December 31, 2007, you would have got back Rs 11.52 lakh in the no-load option and Rs 11.25 lakh in a load option, a difference of a cool Rs 25,914.