Mutual funds that can replace your traditional investments6 min read . Updated: 19 Feb 2020, 10:24 PM IST
- Different mutual fund categories can serve various short- and long-term needs
- Before switching from traditional instruments to certain mutual fund categories, consider their suitability
With the Indian economy going through a churn and seeking to find its footing again, investors are facing a peculiar situation. On the one hand, fixed-income products such as fixed deposits (FDs) are losing favour as their returns plummet, on the other, identifying stocks and sectors to invest in seems more difficult than ever before.
As a result, investors are now more willing to consider products they have probably not invested in before. Various categories of mutual funds—which come with in-built advantages such as asset class choices and combinations, diversified portfolios and professional management—are good alternatives. They are especially useful for do-it-yourself investors. While equity mutual funds have become the default option for the equity allocation in most retail portfolios, the other categories of mutual funds do not get the same attention.
Here are some mutual fund categories you can use to replace traditional products for different needs.
For short-term balances: Investors hold money in their savings bank account either to meet immediate expenses or park their savings until they are able to invest them. With interest rates as low as 3-4%, holding large sums of money in savings accounts for long periods are an opportunity cost that can be easily avoided by using the liquid fund category. The primary need of the investor from this money is safety and easy accessibility.
Liquid funds are suitable for holding money that you don’t need in the next seven days; there is an exit load in that period. For money that is being held for periods of one to two months, liquid funds provide better returns at around 6.5% currently with a strict management of safety and liquidity that the Securities and Exchange Board of India’s guidelines ensure. “Liquid funds suit all categories of investors, even those who are new to mutual funds, since they are unlikely to have a negative experience with it whether it is the return, which is better than that of savings accounts, or the ease with which they are able to manage and access the money," said Gajendra Kothari, managing director, Etica Wealth Management, a wealth advisory firm.
Short-term debt funds
For debt allocations: The State Bank of India (SBI) is currently offering an interest rate of 6%, the lowest in a decade, on FDs for tenors ranging from three to 10 years. For shorter tenors of up to six months, SBI offers just 5%. Bank FDs have been the go-to products for investors for their debt allocations. With inflation, albeit temporarily, at over 7%, there is need for better products to at least protect their savings from inflation.
Well-managed short-duration funds that typically maintain a duration of two to three years can take the place of FDs; they have generated returns of over 9.5%. These funds compensate for the lower interest rate on debt instruments with gains in their value as interest rates come down. This makes debt fund returns volatile but you can offset the volatility by matching the period of investment with the duration of the fund. Other short-term debt funds such as ultra short-duration and low-duration funds too can efficiently stand in for short-term deposits with much better returns. “Short-duration funds, corporate bond funds and banking and PSU funds are good alternatives for an FD investor to consider, as they balance better returns with lower credit and interest rate risks," said Deepali Sen, a certified financial planner and founder partner of Srujan Financial Advisers LLP, a financial planning firm.
Another product that can replace FDs is the Bharat Bond Exchange-traded Fund with yields of 7.3% for the 10-year variant and 6.3% for the three-year one. The ETF yield is tied at the time of investment, if held to maturity, and with a portfolio of government-backed bonds, the credit risk is lower.
For individual bonds: Along with FDs, debentures issued by public and private sector companies are also preferred by retail investors for debt investment. During times of economic weakness, the risk of default is heightened in bonds.
Instead, a bond fund that invests in a variety of bonds will be a safer bet. The fund manager tracks the quality of the bonds and even if there is a default, the impact is smaller since the defaulting instrument forms a small portion of a large portfolio. Investors should ensure that they are comfortable with the credit quality of the bonds held in the fund’s portfolio. “For investors in the higher tax brackets, corporate bond funds and banking and PSU funds for over three-year horizons are good options, given the better post-tax returns that comes from indexation of long-term capital gains tax along with other benefits such as diversification and ease of withdrawal," said Kothari.
For a smoother ride: “Hybrid funds are a good way to introduce investors to equity investments," said Sen. “It is good to start with a fund with low equity exposure and then build it up as they get comfortable with the volatility.
Hybrid funds that invest in a combination of equity and debt and some that even add gold to the mix are a good alternative for fixed-income investors who are willing to explore equity for better returns. The benefits of asset class diversification brings the volatility down in this category. “It is important to explain the risk-return trade-off to the investor and the importance of staying for a minimum period," said Kothari.
For tax savings: Most of the products that provide tax deduction under Section 80C are fixed-income and their interest rates are seeing a downtrend as the economy struggles. Equity-linked savings schemes (ELSS) provide similar tax benefits, but should be considered only if there is a place for equity in the investor’s asset allocation.
These funds have a shorter lock-in period of three years compared to other traditional products under 80C and allow systematic investments. “The lock-in works in favour of a new investor because they are not able to take any action even if markets are unfavourable. Typically, they see good results, or at least better than what traditional fixed-income alternatives give, in three years and it helps them stay invested," said Kothari.
For direct equity investors: Some investors like to participate directly in the stock markets. However, recently, the markets were driven to higher levels by a narrow group of stocks within an index. So investors who did not hold these specific stocks did not benefit from the market gains. ETFs that track indices like the Nifty or the Sensex are a less risky way to invest in the market. ETFs invest in a diversified portfolio of stocks instead of holding just a few. ETF units can be bought and sold in the market during trading hours just like other stocks and their prices react to information on a real-time basis.
Before switching from traditional instruments to certain mutual fund categories, investors should consider their suitability. Having a financial adviser can ease the process. “The recommendation of categories and schemes for investors is the culmination of a process that looks at their circumstances and needs and what fits them. The communication of the solution will differ based on the investor’s level of comfort with MFs," said Shyam Sunder, managing director, PeakAlpha Investment Services, a financial planning firm. “If you can effectively communicate what they can expect from their investments and why they need these products, then you can give investors what is best suited for them rather than what is merely acceptable," he added.
It is important to understand and accept that mutual funds give market-linked returns, which are not fixed. Investors should take greater care before they match a category of funds to their needs.