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Home / Money / Calculators /  To find the right MF, get down to the basics

What are the typical instruments that you think of, when you want to invest? A bank fixed deposit, to begin with? Perhaps it has been ingrained in us since our childhood that a bank deposit is the safest instrument around. Then, maybe a Public Provident Fund account and, if you are salaried, then your Employee’s Provident Fund that gets deducted from your monthly salary. The former because it helps you save taxes (under section 80C of the income tax Act) and the latter because you have, well, little choice.

But there is another instrument you should consider because it helps you grow wealth over a long period of time, a mutual fund (MF). We’ve come a long way since the country’s first MF was launched—although technically it wasn’t called one—in 1964. With close to 3,000 MF schemes spread across 45 fund houses and combined assets under management of 14 trillion, choosing the right fund is like finding your way through a maze. But keep aside the numbers for a moment, and let us focus on some first principles. Team Mint Money tells you what you need to know before you dig into the numbers. What is a mutual fund and why it works and when it doesn’t work?

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 purposes. These avenues could be equity, debt, gold, commodities, real estate and so on. Presently in India, MFs are not allowed to invest in real estate directly, though they can invest in equity shares or bonds of real estate companies. Equity markets, debt markets and gold are the most popular asset classes that Indian MFs invest in. The purpose of investment will vary according the asset class chosen. Equity is usually a vehicle for long-term wealth creation; debt for some regular income and an attempt to protect your capital; and gold as an inflation hedge. Investors can look at where the fund manager invests and then match that with personal financial needs to choose a fund.

When do MFs work...

This instrument works when you choose the right fund. Unlike bank fixed deposits—where, whichever deposit you choose, you get a fixed rate of return—MFs don’t assure returns. The degree of risk varies from scheme to scheme. So, be mindful of which one you select. The good news is that risk is not a bad word; it means volatility and volatility can be managed.

For a chosen scheme to work, you also need to you stay invested for an appropriate tenure. The trick to making risk work in your favour is to select a fund that best suits your needs and then stay invested for the right tenure.

Equity funds are meant for those who can stay invested for at least five to seven years (and more if you don’t need the money then). Debt funds are meant for those who need the money after three months or up to three years.

...and when do they not

MFs are not the right choice if you want guaranteed returns. MFs never guarantee returns; regulations prohibit them from doing so. Since they invest in equity and fixed-income markets, your money is subject to the volatility that these markets bring. But since you end up taking risks, the chances that you earn returns higher than a typical assured-return instrument are also high. If you are certain that you need assured returns, avoid MFs.

Past returns are a limited indication. By law, MFs are mandated to display past returns. But just because a scheme gave good returns in the past, doesn’t mean it would continue to do so. Past performance doesn’t guarantee future returns. Instead, pick funds that consistently beat their benchmark indices and come from good pedigreed fund houses.

Types of mutual funds

Broadly, there are four types of MF schemes.

Equity: These funds invest in equity markets. They could either invest in large and well-established companies (known as large-cap funds) or medium- and small-sized companies (mid- and small-cap funds). Some include a healthy proportion of both segments, and are called multi-cap funds. There are thematic and sector funds as well, which invest in a few sectors or just a single sector, and are meant for those who have timely and informed views about the fortunes of select sectors.

Among the four categories of funds, equity funds are the riskiest. In other words, you need to give them time to work for you. Use equity funds if your financial goal is at least five to seven years away.

Debt: These funds invest in fixed-income instruments such as bonds, government securities and short-term instruments such as certificates of deposit and commercial paper. Although they do not assure returns, they are less volatile than equity funds and are, therefore, used to earn regular income.

Debt funds come with varying risk levels. While liquid funds are least risky (since they cater to investments of up to three months), bond funds rank high on the risk ladder since their underlying instruments mature after 3-5 years. It’s essential to map your investment goal with the type of debt fund you invest in. Debt funds make money by managing credit risk and interest rate risk. A credit risk is managed by investing in low-rated companies with the view that if credit ratings improve, their scrip prices would also go up. Interest rate risk is managed by managing the maturity of the underlying securities, depending on where the fund manager believes interest rates would go.

Hybrid funds: These funds invest in equity and debt markets at the same time. Here, too, risk profiles differ depending on how much they invest in equity markets. Balanced funds typically invest 50-70% in equity markets. Monthly income plans (MIPs) invest between nil and 20% in equity markets and the rest gets invested in fixed-income markets. Therefore, while balanced funds are meant for long-term goals, MIPs are more conservative and are used for goals that need to be reached within 5 years with measured risks.

Gold funds: These funds invest in gold. They are passively managed funds and they track the price of gold. Instead of buying physical gold and then having to store it—which will require adequate safety and space—investing in gold funds is a good alternative to buying physical gold.

If you have a demat account, you can invest in a gold exchange-traded fund (ETF), which is a passively managed fund that gets listed on the stock exchanges. Or, if you don’t have a demat account, you can invest in a gold MF scheme, like any other scheme, which then invests your entire sum in a gold ETF.

How to choose a mutual fund

To earn good returns from your investment, in this case through an MF, looking at returns is just one aspect. There are some finer elements too, which you need to consider.

Ascertain your tenure: Ask yourself for how long would you need to stay invested, at the minimum? This depends on how distant is your financial goal. Say, you want to buy a house after 5 years, or you want to send your kids to a good college after 10 years. Or, you want to retire after 20 years and need to build yourself a retirement kitty. Ascertaining the tenure is important because you need to choose an appropriate fund that matches it. That’s because different MFs cater to different tenures. For example, liquid funds are meant for short-term (parking) needs. Equity funds are meant for long-term goals, but you need to wait out for at least 5 to 7 years, sometimes even longer.

To get the most out of your debt funds, match your investment horizon with that of the debt fund. For instance, liquid funds will disappoint if you stay invested in them for longer periods like one, two or more years. Similarly, if you invest in a long-term bond fund, but withdraw within a few months, you may end up losing money as they can be volatile.

Interest rates and bond prices move in opposite directions. A good measure to look at your fund’s sensitivity to interest rates is its modified duration. Most fund houses disclose this in their monthly fact sheets. Expressed in years, this number will tell you how much your debt fund would get affected if interest rates (your bond fund’s yield) were to move up or down by 1%.

Your risk tolerance and capacity: As per rules laid down by the capital market regulator, Securities and Exchange Board of India (Sebi), all registered investment advisers are supposed to assess the risk profile of all their clients. The reason why risk profile is important is that it captures your risk tolerance. You might say that you can take risks, when asked carte blanche, and take on riskier investments. However, in reality, you might be risk averse. The risk profile test asks you several questions and helps the adviser assess how much risk you are really willing to take.

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