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10 Things to Consider Before You Start Investing in Mutual Funds

Most of us have tried to understand the seemingly complicated world of investing. And all of us have dreamt of becoming overly successful investors, capable of turning a limited infusion of capital into a cash cow.

 

If you’re a newcomer to this world, two things may be true. One, you’re put off by the endless jargon piled upon you. And two, if and when you do acquaint yourself with the mumbo jumbo of investing, you’re left clueless about how to proceed.

 

Stocks, bonds, options, real estate, money market funds – the list of securities or instruments you can invest in is a long one. And many of these products require you to deal with high risk, which may or may not yield success depending on your expertise on the subject, market conditions, and sheer luck.

 

But what if there was a product that diversified and reduced the risks, increased the convenience and gave you a higher likelihood of returns at the same time?

 

This is where mutual funds enter the picture. A mutual fund is an investment fund that pools money from multiple investors to purchase different securities. By investing in a range of instruments rather than one or two, the risk implicitly drops and returns, while perhaps lower than concentrated stock picks, become more probable.

 

Different mutual funds have different objectives, as outlined in their investment objectives, and they are managed by professional money managers.

 

Let’s break down what we should learn about investing in mutual funds into ten questions and answer them one by one.

 

 

Why Should You Invest in Mutual Funds?

 

Three reasons – diversification, convenience, and costs.

 

Mutual funds invest in a basket of securities. Imagine an instrument/product that puts all your money in the shares of Company X and another that puts all your money in the shares of Company X in addition to the shares of ten other companies, various bonds, money market funds, among others i.e. a mutual fund.

 

The latter scenario is naturally more diversified, and this reduces the risks involved. If market conditions are unfavourable for Company X, you lose all your money if you take the first instrument.

 

On the other hand, your losses are likely alleviated in case of mutual funds since any drop for company X may be hedged by gains in others.

 

And finally, costs. For individual investors, the costs for completing each trade can add up quickly. But for those who have banked on mutual funds, the cost of trading is spread over all investors in the fund, thereby lowering the cost per individual.

 

Which Type of Mutual Fund Do You Need?

 

While mutual funds are all about diversification, many also allow investors to buy into only the industries/verticals of their choice. Therefore, there are many categories of mutual funds based on assets involved or theme. Some of these are:

 

  • sector funds or thematic funds (invested in stocks of a particular sector or exposed to a particular theme e.g. telecom, consumer),
  • high-growth funds (invested in stocks with high growth prospects, albeit expensive),
  • value funds (invested in fundamentally solid stocks presently undervalued),
  • debt or fixed income funds (invested in government and corporate bonds),
  • equity funds (invested in stocks only),
  • liquid funds (invested in short-term fixed income securities which can be quickly redeemed at no cost),
  • balanced funds (invested in a mix of equity and debt securities).

 

How do you pick the mutual funds best for you? Besides judging them based on conceptual or “technical” aspects, you need to also ascertain your goals, risk tolerance, commitment to investing and expectations from your foray into investing in mutual funds. These are personal questions dictated by personal choices – investing terminologies and market mechanics don’t play a role here!

 

10 Things to Consider Before You Start Investing in Mutual Funds

 

How Do You Select the Mutual Fund You Need?

 

When it comes to screening and filtering mutual funds, there are a few key metrics to keep in mind. Some of these are:

 

  • Risk profile: This is a measurement of your willingness and ability to take risks for determining a proper portfolio allocation. Based on this, you would want to evaluate the risk-return tradeoff for a mutual fund, which is the correlation between the level of risk and level of potential return on an investment. Simplistically equity funds are relatively riskier and expect to make higher returns. Debt funds sit on the low risk, low return end of the spectrum.
  • Volatility: This is the extent to which a fund’s net asset value (NAV) typically fluctuates. NAV is the net worth or market value of a mutual fund unit. With other factors being equal, a highly volatile fund has more risk associated with it. A measure of volatility is Beta, which is a number that analyses the volatility of an asset/portfolio with respect to the overall market. Beta lower than 1 indicates that the security is less volatile than the market while greater than 1 it indicates greater volatility.
  • Details about the fund manager: If your fund is passively managed, the component assets are based on an underlying index. If it is actively managed, the portfolio is built specifically keeping your needs in mind which is typically characterised by much more frequent buying and selling. In the latter case especially, the fund manager’s role is important. Some factors to keep in mind when selecting a fund manager are their experience, reputation and their track record in outperforming the benchmark, despite all of them being largely backward looking factors.

 

Once you learn these basic facts, it’s time to move to more technical insights. And yes, you can simply hire a broker who would do all the insight-learning work for you, but it doesn’t hurt to be adept at the basics yourself. Keeping that in mind, make sure to keep the below terminologies in mind.

 

What is Mutual Fund Investment Allocation?

 

Investment allocation is simply the various asset categories that a mutual fund invests in. The composition of these assets determines the type of funds. Needless to say, different investment allocations involve different risks and returns. Your investment allocation should be aligned with your risk profile.

 

It would help you make an informed decision if you learnt about the companies the mutual fund you’re looking at is invested in, their ratings, volatility, riskiness, past returns etc. Remember to do some research of your own on the fund you have an eye on. You can simply Google the fund by its name and find its investment allocation (also can be found under "asset allocation" or "holdings"). This is public information and can be found on websites like Value Research, Moneycontrol and FundsIndia.

 

10 Things to Consider Before You Start Investing in Mutual Funds

 

What are Entry Load and Exit Load?

 

In investment-speak, “load” refers to a certain amount of money, usually a percentage of the investment made, that is charged by the investment organisation and paid by the investor.

 

Entry load is the fee levied on the purchase of a mutual fund scheme. Exit load is the fee charged if an investor exits the scheme before a stipulated period of time. Since 2009, SEBI has done away with the practice of charging entry load for mutual funds. Exit loads vary depending on the organisation and type of mutual funds.

 

How are Mutual Funds and Taxes Related?

 

One objective you may have in mind while foraying into investment is exempting yourself from some taxes. But don’t forget that many mutual fund returns are taxable themselves. Depending on holding periods and type of fund, the tax regime varies. Knowing how tax-efficient your mutual fund is is important so that your returns aren’t hurt by them.

 

Taxation on mutual fund returns depends on your holding period, the duration for which you stay invested. This can be a Long-Term Holding Period (>12 months for equity funds, >36 months for debt funds) or a Short-Term Holding Period (

 

Your Long-Term Capital Gains (LTCG) and Short-Term Capital Gains (STCG) taxes will also depend on other factors like your income bracket, property holdings, indexation benefits etc.

 

Check out websites like ClearTax to get more clarity on taxation norms for Mutual Funds.

 

What Are the Charges Associated with Mutual Funds?

 

Besides entry and exit loads and taxes, there are other charges and fees associated with mutual funds. These include intermediary commissions and total expense ratio (TER), which is the total cost associated with managing and operating a mutual fund divided by the fund’s total assets. The calculation of these costs will depend on the route of investment you pick – direct (you invest directly in the fund of your choice on their website) or indirect (here, you invest through an agent/app/intermediary).

 

It’s best to be aware of all the costs related to a mutual fund scheme before opting for it so as to not be duped later on.

 

10 Things to Consider Before You Start Investing in Mutual Funds

 

What is Mutual Fund Liquidity Ratio?

 

This is a fund’s cash-to-asset ratio. It is the ratio that highlights the proportion of the assets held in liquid cash in comparison to total assets held by the fund. A lower liquidity ratio is generally perceived as a bullish fund manager while a higher ratio implies bearish-ness. This is fairly intuitive if you think about it: a high cash component implicitly means that the fund manager thinks that there aren't too many worthwhile opportunities that offer better risk-return profile than cash!

 

What are the Modes of Investment in Mutual Funds?

 

Mutual funds provide for various modes of investing. Some of these are:

 

  • Lump Sum: This is when you invest a big sum of money in one go.
  • Systematic Investment Plan (SIP): When you invest gradually, allowing the scheme to deduct a certain amount of money from your bank account every month or quarter. (More on Systematic Investment Plans here.)
  • Systematic Transfer Plan (STP): Similar to SIP, except that in this case the investor invests in less risky liquid funds and over time transfers a certain amount to another scheme.

 

What are the Modes of Withdrawal from Mutual Funds?

 

Mutual funds also provide for various modes of withdrawing your investment (this is called “mutual fund redemption”). This can be done online or through an agent. Each method has its own taxes and fees associated with it. The two main methods of withdrawing from mutual funds are:

 

  • Lump Sum: This is an ad-hoc method, where you withdraw your entire investment as and when required. It’s usually tax inefficient.
  • Systematic Withdrawal Plan (SWP): In this method, a defined amount is withdrawn at a defined frequency over time. It’s usually more tax efficient.

 

In conclusion, investing in mutual funds is simpler, more convenient and less risky. But it is nonetheless important to be informed about the mechanisms of mutual fund investing before delving into it.

 

PS - Any transaction in a stock market, buy or sell, would require a stock broker – an agent between the market and the participants/investors. Read our article on How to Choose a Stock Broker here.

 

Or, if you’d rather take the tech route and prefer taking on the world of investing from the comfort of your couch, then you might be interested in what robo advisors have to offer. What are robo advisors, you ask? Head to the article What are Robo Advisors and How Do They Help in Financial Planning for a deep-dive into the world where brokers and robots collide!

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