BackFund basics
Before investing in mutual funds there are few important aspects of this product that you should know.
Premium
What is a mutual fund?
It is a pool of money collected from a large number of investors by a professional entity with an aim to invest in different avenues for a variety of investment purposes. These avenues could be equity, debt, gold, commodities, real estate and so on. At present in India, mutual funds are not allowed to invest in real estate directly, though they can invest in equity shares or bonds of real estate companies. Equity, debt and gold are the most popular asset classes that Indian mutual funds invest in. The purpose of investment will vary according to the asset class chosen. Equity is usually a vehicle for long-term wealth creation. Debt is used for capital protection and shorter term money management goals. Gold is used as an inflation hedge and for liquidity. Investors can look at where the fund manager aims to invest and then match personal financial needs to choose a fund.
Why is mutual fund needed?
Managing money is a specialized task and a mutual fund can be viewed as a public transport to take people, who do not want to drive their own cars (that is, take their own investment calls), to their investment destinations. People who drive their own cars (invest on their own) end up going faster if they are good at choosing their investments. Or can end up badly hurt with a crashed car, losing money due to poor investment choices. While mutual funds give an option to invest in several asset classes such as equity, debt and gold, retail investors find equity investing one of the biggest attractions of owning a mutual fund, as it is safer due to the diversification offered by a mutual fund. Of course, investors can diversify using stocks themselves, but will have to actively manage their stock portfolio that requires knowledge and time. Mutual funds are for those who don’t have time to make money decisions every day but will do so, say, twice a year to examine their mutual fund choices and changed personal financial needs.
Equity mutual funds are useful for lay investors since stock selection is not easy for an average investor and can be fairly full of risk. Reading balance sheets is a specialized task and knowing when to buy and sell needs active monitoring of markets and events. Most people are busy with their jobs and families and have no time to spend on managing an active portfolio. Additionally, small investors run the risk of over-concentrating their portfolios in a few stocks and seeing their money erode due to the risk of a tight portfolio. Funds hire professional money managers to make investment calls and monitor the portfolio on a daily basis.
The mutual fund route reduces volatility by diversifying the portfolio. The risk of having all your money in just one or two stocks is much bigger than buying a basket of stocks that are diversified across market and across sectors.
PLUS AND MINUS
Plus points
Small amounts can be invested. To start with, you can invest just ₹ 5,000 to buy a mutual fund scheme that invests across 50 companies. However, a systematic investment plan can be started with as low as ₹ 500. But try and buy stocks yourself and you will find that ₹ 5,000 does not go very far. You will be forced into just one or two companies and very few stocks. For instance, with ₹ 5,000 you could buy just about, say, two equity shares of State Bank of India, India’s largest public sector bank. But with a mutual fund, you can own tiny bits of many large companies.
All, or some, money can be taken back quickly. Mutual funds are easy to redeem. Funds will buy back any quantity of units at the given price as denoted in the net asset value (NAV), or the price of each unit of a mutual fund. You can redeem your liquid fund within 24 hours and debt funds upto three days. There are some mutual funds that come with a lock in, such as equity-linked savings schemes, but they impose a lock in for a purpose; they currently give tax deduction benefits at the time of investing. Few others come with lock-in, but they give redemption windows at regular intervals.
Minus points
Investors have to pay the fund manager irrespective of profit or loss. As the fund manager’s sole job is to manage your money, they charge you every year, in addition to certain costs they incur, such as brokerage costs to buy and sell scrips, marketing, administration and selling costs that they charge, to a permissible extent. Nothing wrong in paying them, but the catch is that even if your fund manager underperforms the market or even if markets do badly in some years, like in 2008, and you lose money, you have to pay the annual charge called the expense ratio.
Investors have no control in stock selection. When you give money to your fund manager, it is his decision which stocks to buy or sell and when. It’s a double-edged sword. His calls may go right. His call may also go wrong. It’s not in your control. If his calls go wrong, you obviously lose money. There are no guarantees, as there aren’t any when you invest directly in the markets.
What is an expense ratio
Every time you invest in a mutual fund, the mutual fund incurs some expenses. They are on account of marketing and advertising, brokerages paid to brokers to buy and sell scrips, administrative charges and so on. The capital markets regulator, Securities and Exchange Board of India (Sebi), limits the charges that your mutual fund can impose on you to about 3.00% for equity funds and about 2.75% for debt funds. These figures were raised in 2012, which were 2.50% for equity funds and 2.25% for debt funds then, after Sebi allowed mutual funds to charge more for penetrating towns beyond the usually classified top 15 cities of India. Any expenses incurred by the fund over and above these limits are to be borne by the fund house.
Did you know: mutual funds cannot assure returns
The capital markets regulator, Sebi, has banned mutual funds from assuring any income—dividend or principal—to investors. Here’s why: Prices of equity and debt scrips go up and down depending on their demand and supply. Your mutual fund scheme’s net asset value also moves accordingly since the money is invested in individual stocks and debt products. Even liquid funds are prone to market swings.
Good quality equity shares and high-rated debt scrips limit the chances of your fund’s value going down to zero. However, they too fall in bad markets. In the 2008 market crash, the Nifty index (50 most liquid scrips on the National Stock Exchange) lost 52%. Large-cap funds also lost 53.12% on average. Quality scrips limit your losses, but they don’t eliminate losses completely. Even in 2011, the Nifty fell by 25% and equity mutual funds fell by about 24% on average.
Capital protection-oriented funds aim to protect, and not guarantee, your money. These are compulsorily closed-end and typically invest in a mix of equity and debt scrips in a way that you get your principal—with some gains from the market—at the end of the term. Usually, these funds have a tenor of three-five years. These funds, though, come with a lock-in and mandate that you stay invested throughout the tenor to get the benefits of capital protection. These schemes are listed on stock exchanges where you can sell your units and exit, but the trading volumes of such funds are very low. It is best to stay invested over the tenor of the product.
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