This is going to be a long read, but it has everything you need to know about Mutual Funds. So please bear with me and read the whole thing before going ahead with your investment journey.
The article covers the following-
Benefits of Mutual Fund investing and why do you need them?
What are Direct and Regular Mutual Funds
NAV, Expense ratio, SIP
Active and Passive Funds
Categories- Large cap, Mid cap and Small cap funds, Sectorial funds, ELSS
Growth and dividend fund difference
Expectation of returns, 15*15*15 rule, Alpha and Beta
Concept of Compounding, CAGR
Asset Allocation, Loss aversion theory
Funds to avoid, NFO
A mutual fund, simply is a pool of money managed by a professional Fund Manager. The money can be invested in equities, bonds, money market instruments and/or other securities.
Mutual Funds offer diversification (opportunity to take exposure to handful of companies) by investing a small amount It offers convenience of finding a single fund, suitable to your needs, compared to 10-15 stocks and managing them yourself.
When you sell your holdings, it is the Mutual Fund company that buys it, offering you liquidity. Compared to this imagine being invested in a lesser known stock in hopes of high return and when you need money back, there are no buyers or buyers at a price lesser than your expectations.
Mutual funds offer an opportunity to a newbie to dip their toes in the stock market. But the toe dipping has to be an informed one, for this I would like to offer my two cents.
Firstly you will encounter two types of any mutual fund scheme, Direct and Regular.
Regular funds are offered through a distribution agent, who receives a commission from the Asset Management Company (AMC). Direct funds are offered directly by the AMC. The AMC also incurs some expenditure for managing the money. This becomes a part of Expense Ratio. In case of regular funds, the Expense ratio will be commission of the agent plus expenses of the AMC and in case of Direct funds only expenses are removed from the NAV. It is fairly obvious that one should choose to invest in Direct scheme.
Now let’s understand the concept of NAV.
When you invest let’s say rs 5000/- in a mutual fund, you receive 500 units, the NAV of the Unit becomes 10 rs per unit.
So, the NAV represents the total value of the assets (-minus liabilities) held by the AMC divided by the number of Units. You may think that a fund with lesser NAV is better as it will grow faster than a fund whose NAV is higher. In fact the NAV has no bearing on the returns given by the fund since it depends on the number of Units issues by the AMC. It may issue more units to make the NAV cheaper and more accessible to investors. So if two funds of a same category (please do not compare apples with oranges) of NAV 10 and 100 grow by 15 % in a year, the NAV will be 11.5 and 115 respectively. NAV and the returns are published daily after removing the expenses.
The term SIP is very popular while investing in Mutual Funds. SIP is nothing but investing a fixed amount every month on a specific date. It is just a mechanism to automate your savings habit. Other than this there is nothing systematic in SIP. You can invest in a Mutual Fund without any SIP also, simply by going to the AMC website, your demat account or any Mutual Fund investing app every month on a date of your choice and invest an amount of your choice. SIP does not guarantee performance and it does not reduce risk as well. Just like you pay your rent, EMI or utility bills every month as soon as you receive your salary, SIP will be one more such payment.
There are two ways a Fund Manager will invest your money. There are Active funds and then there are Passive Mutual Funds. Passive funds replicate the Index like Nifty 50 or Sensex, that is, they buy the same stocks which are present in the Index and in the same proportion. These index funds deliver the same returns which the index will deliver.
Whereas the Active funds like Large cap (these select stocks from top 100 listed companies in India), Mid cap (101st to 250th companies) and small cap (250th and beyond) try to beat the Index returns and generate an Alpha but the outperformance comes with more risk/volatility which is denoted by Beta of the fund. So when it comes to Large Cap Funds, in my opinion, you may choose to go with the Index Fund. IMHO, there is no requirement to take exposure to Mid and Small Cap funds, since they can be hugely volatile while the alpha they generate is marginal.
Then there are Growth Funds and Dividend funds. The meaning of dividend received from a share is a distribution of profits by a company to its shareholders. I find the Dividend term in Mutual funds to be a misnomer since these funds sell some portion of their holdings periodically and return that money to the investor. An important thing to note here is that the NAV also drops proportionately. So its your own money that the fund returns to you periodically.
In case of Growth funds, the profits are re-invested, thus you can reap the benefits of staying invested. Some people call it Compounding.
You will see four types of a fund of your choice
1 XYZ direct growth
2 XYZ direct dividend
3 XYZ Regular Growth
4 XYZ Regular Dividend
Hence it is you must only select 1 XYZ Direct Growth
Coming to addressing the elephant in the room, how much return can I expect and is it guaranteed? Historical returns of NIFTY are 12% over 20 years but history may or may not repeat itself, and past return of a fund should not be the only criteria for choosing a fund.
Then why should you invest in Mutual Funds?
We value loss much more than the equivalent gain. This loss aversion prevents us from taking decisions in life and in personal finance as well. Alternatively if you go for fixed income assets like Fixed Deposits, the returns after taxes and fees in a FD will be much less, it may not even beat inflation. Just keeping your money in savings account allows inflation to eat into your capital, Inflation at same time makes future cost of living expensive.
Higher risk has to be taken to generate higher returns. But remember risk is guaranteed but returns are not.
Let's now address the concept of Compounding return and whether it really exists?
The returns from stock exchange are not linear, in one year your fund may give you 50% return, in another year it will give -20% returns. Rs 100 invested in first year will become 150 and then Rs 120 at the end of second year. The Compound Annual Growth Rate (CAGR) will be 9.54% but you did not earn it every year.
A popular formula of 15*15*15 says that if you invest Rs 15,000/- every month, earn 15% return on it every year, after 15 years you will end up with 1 Crore rupees. This formula and the compounding word sweeps the volatility that you will experience for the whole 15 years under the carpet. You may reach your destination, but it will be a hell of a ride with too many ups and downs.
So, one way of reducing the risk is following Asset allocation. One simple rule of (100-your age) will tell your equity exposure. For example, if you are 30 years old then you can have 70% of your money in equity mutual fund and for the rest 30% you can go for PPF or EPF, debt mutual fund, even FDs as the primary goal here is capital protection. Key takeaway here is that one should not be 100% invested in equity and as you age, you have to go for portfolio rebalance and reduce equity exposure, if some year equity mutual funds have given good returns the you can sell some part of it and invest it in your debt portfolio. Rebalancing is a yearly activity.
Suppose you are planning to buy a new car or go for a world tour after 3-5 years, this is your short term goal, in this case no equity exposure is recommend,
If a goal is 10 years away then you can go for maximum of 50% in equity, but as the goal approaches you have to shift 100% to fixed income. This precaution necessary since a market correction or economic downturn will eat up into your equity gains that you have earned over last few years.
You must start at early age with your first salary/earning. It will allow you to make mistakes and give ample time to rectify them. Starting early allows you to start with smaller amount and increase as your earnings increase, as the exponential growth happens after 25-30 years.
Warren Buffett has been investing for around 75 years, he gathered most (99.7%) of his wealth after 52 years of age, he had started at the age of 10, so after 40 years of investing. Had he started at 30 and stopped at 60 with same returns of 22% that he is generating now, it would not have amounted much. Good investing is not about earning the highest returns. Spending time in the market is more important than trying to time the market.
But as the saying goes “Best time to plant a tree was 20 years ago, the second best time is now”. So don’t loose heart if you have not started yet. Start with finding out your goals, timelines and how much amount you will need for each goal.
Which funds can a beginner invest in?
Before answering this question I would tell you which funds you should not invest in-
1 New Fund Offering (NFO)- Riding on the IPO wave,(NFO is absolutely not an IPO) NFO have become very popular these days. The NAV of 10 rs seems very attractive but since they do not have any history and may have higher expense ratio, you should avoid them. Already existing Mutual Funds are sufficient for all your needs.
2 Closed funds- Except ELSS (Equity Linked Saving Scheme) funds which offer you Income Tax exemption of 1.5 lakhs, you should avoid any fund which has a lock in period as it reduces your liquidity. Also you should not invest in ELSS only in the month of February or March (it will destabilise your monthly budget and may force you to rely on credit cards) to complete the 1.5 lakh requirement because it may happen that when you invest this large amount the NAV might be very high, which will result in earning you just modest returns at the end of 3 years. Rather you should split 1.5 lakhs into 12-monthly instalments of 12,500/-.
3 Opting for a fund solely based on recent past performance- History may not repeat itself.
4 Sectorial funds- Avoid Mutual funds which invest all of their money in one sector. Like infra or IT or banking etc. They can be volatile and do not provide enough diversification.
It is utmost important to set goals (Long term- retirement, kid’s education, wedding, buying a home etc and Short term-vacation, new car, yearly school fees etc ) and tie your investment to that goal because it will provide you a direction, sense of purpose and reduce the daily noise driven impulsive decisions (TV Channels, Influencers telling you to go for Crypto, NFTs, Start ups, old wine, paintings and whatnot). It will make you less speculative, prevent you from chasing profits with disproportionate risks. Remember if something goes down 50% in value, it has to grow 100% just to break even.
It’s not necessary to go for Equity funds also. You have to find out your risk tolerance. In a bull market everyone thinks that they can handle any type of volatility in their portfolio but real test comes when market starts going down or sideways when there are no returns for 3-4 years. So you can start with a Nifty50 Index fund with a small amount, dip your toes, test the waters and then consider increasing the amount. One should not take a leap of faith just by thinking that mutual funds give inflation beating returns in long term. Once invested, don’t exit frequently since there will be tax implication, exit loads etc.
Don’t treat mutual funds like shares and gather 10-15 schemes, grass may appear greener on the other side but accumulating 10-15 funds will lead to over diversification in the sense that many share will be repeated in the mutual fund portfolio. Diversification offered by one Nifty50 index fund and one Nifty Next50 Index fund is enough.
You may think that Nifty is at all-time high at 17500 or 18000 so I will wait till it comes to 16000 then I will invest. This strategy is called as timing the market. But it may happen that Nifty moves to 20,000 and you keep sitting on the side lines having missed almost 10% return. Spending time in market is more important than Timing the market.
In conclusion, start early, start small, increase the amount, stay invested, cut the noise, cut the clutter (buy 1-2 funds only), set goals and tie the investment amount to each goal, invest in instalments, do not try to time the market, have moderate expectation of returns in long term(10%-12%). Keep reading and dip your toes in an informed way.
All the Best.
Happy investing!
It was a great read.