Mutual funds Sahi hai (Mutual Funds are Good) –

How many times one must have heard this advertisement in the recent past. Whether mutual fund “Sahi hai”(are good) or not is a different thing but one thing is for sure that in the past 3-5 years there has been a lot of emphasis on mutual funds as an investment tool and the awareness levels have significantly increased.

History of Mutual Funds in India

The history of Mutual funds in India dates back to as long as 1963 when the UTI (Unit Trust of India) was founded with support for the government of India under the parliament act and RBI was having regulatory and administrative control which was later on taken over by IDBI (Industrial Development Bank of India)

The second phase spanned between 1987 to 1993 when lots of public sector entities entered the Mutual Fund Industry like LIC (life insurance corporation of India), GIC (general insurance corporation of India). In 1987 SBI Mutual Fund was the first “non UTI” mutual fund established followed by the likes of Bank of Baroda, Punjab National Bank, and Indian Bank Mutual Fund.

From 1993 to 2003 was the third phase of mutual funds in India which saw private players entering the market. SEBI (Securities and Exchange Board of India) was already established in 1992 as a regulator for mutual funds in India.

In 1993 Kothari pioneer (later on merged with Franklin Templeton MF) was the first private sector MF registered. In 1996 SEBI (Mutual fund) regulations were applied which govern the industry to date.

By 2003 there were as many as 33 MF with approx 1.2 lakh crore AUM (Asset under Management).

The year 2003 to 2014 saw the fourth phase of the MF industry in India wherein UTI was dissolved into two different entities SUUTI (Specified undertaking of unit trust of India) and UTI MF (regulated by SEBI).

SEBI had done away with entry loads (the amount that was charged as a percentage while investing in mutual funds) which increased the retail participation in MF. But investors were still bruised by the financial crisis of 2009 and were cautious than being resilient to invest.

Mid 2014 is when the fifth (current) phase of MF started wherein many positive measures were taken by SEBI.

 

Growth of Asset Under Management of Mutual Funds in India
AUM Growth of MF

Source – amfiindia.com

The graph shows the growth of assets for the last 10 years which has seen tremendous retail as well as FII (Foreign Institutional Investors) participation providing the Indian MF industry with huge inflows and liquidity.

SEBI and AMFI (Association of Mutual Funds in India) have taken some big steps in promoting MF in India. With the Investor awareness program, advertisement in print and television media with the tagline such as “mutual fund Sahi hai” there has been a huge awareness drive for investors.

With the ease of regulations like removal of entry load, decrease in TER (total expense ratio), rationalization, and reclassification of Mutual Funds, the introduction of direct mutual funds (with lower expense ratio) has paved the way for retail investors.

Investors feel that MF is a safer investment vehicle (as compared to stocks) as they are managed by qualified professionals, fund managers who have considerable experience and understanding which is a fair assumption to make.

But one has to be aware that these mutual funds also bear the risks (loss of capital) which are in congruence with the securities they hold. Though the degree of risk varies depending on the asset class invested.

Concept of Mutual Funds

How does a mutual fund work?

Mutual funds are investment vehicles that pool investment from various investors into different investment options like equity shares, bonds, etc which is managed professionally with a common objective.

Various investors with a small amount as 500 to as high as crores including individual and corporate participate in a pool of funds with an objective that matches their investment objective.

For example, an investor who is conservative and has the prime objective of keeping the capital safe and get slightly higher interest than a fixed deposit (a retired investor) with a definite cash flow might invest in a debt fund (fixed maturity plan or medium or short term debt funds).

Whereas a young salaried individual with the prime objective as capital appreciation over the long term might take a higher risk and invest in an equity asset class with exposure to a large-cap or midcap fund.

Investors are saved from the hassle of identifying individual stocks or bonds and do all the research and the job is done by a fund manager who is a professional in the field and charges the fees (built within the NAV of the fund).

The flow of money in an MF is as follows –

Flow of Money In Mutual Funds in India
The flow of Money in MF

The investor (retail, HNI, or institutions) pools in his money to be invested into different investible options depending on the objective of the mutual funds.

For example, a large-cap fund would primarily invest in blue-chip stocks in line with the benchmark index.

A debt-oriented hybrid fund will invest the majority (75% to 80%) into debt securities and a small amount to equity.

The asset management company (AMC) – are companies that appoint professionals to manage the funds that have been pooled in for investment. 

They are experienced people who have knowledge about the markets and take a call on when to buy and sell particular security depending upon the market conditions and fund objectives. 

Most AMC also has its research team as well. An AMC is monitored by the sponsor who keeps an eye on the fund management style and ethics and regulatory compliances.

Securities – these are the end products where the investor’s money is deployed. These can be shares, bonds, debentures, etc depending on the fund deployment strategy.

Apart from these, various other components constitute the mutual fund structure as well –

Custodian – keep the securities invested in a mutual fund safe. They ensure the delivery and transfer of shares.

Registrar and transfer agent – provide operation support to mutual funds.

CAMS, Karvy, Sundaram are some of the RTA’s in India. They help in keeping the record of investors, application processing, account statements of investors, dividend payouts processing, and adding and deleting investors (joint holders) details.

Are mutual funds risky?

The answer is a simple YES.

Any instrument that is tradable in the market i.e. can be bought and sold has some inherent risks. Let’s understand this with an example.

Have a look around yourself you will find lots of assets around e.g. a laptop, car, television, sofa, etc which can be bought and sold in the secondary market and hence has an inherent risk and can give a gain or loss both.

But these assets when sold will give a capital loss as they are depreciating in nature (value of the asset decreases with time).

Whereas assets such as gold, silver, real estate can also give a gain or loss when sold in the secondary market but they are essentially appreciating in nature (price increases with time) but they are volatile as well ( bears a possibility of a loss of capital as well).

If you compare these with a fixed deposit which is non-transferable and non-tradable instruments (cannot be bought and sold in the secondary market) hence they do not have volatility and only if one wishes to withdraw the money one has to break a deposit (not sell).

Remember if you want to get your money from a deposit you actually “break” or prematurely withdraw from the deposit not “sell” or “redeem” the deposit.

The degree of risk varies from one kind of mutual fund to another depending on their investment objective and the securities they invest in.

Is mutual funds investment without any charges?

The answer is a simple NO.

As we know there are no free lunches.

Yes, you might have come across bankers and advisors telling you that we do not charge anything for the mutual funds suggested or done through us but the truth is there is something called as “Expense ratio” which is the total cost that the fund is incurring and it has to be borne by the investor.

Let us understand this with a simple example.

You walk into a television showroom and the sales agent suggests a new television model at the MRP of 50,000.00 which you buy at the cost mentioned.

So how does the sales agent or the showroom (distributor in case of MF) make the money? They get the commission from the sale which is inbuilt in the MRP (Maximum Retail Price), similarly in the case of MF the expense ratio includes the inherent cost of distribution which is borne by the investors.

The expense ratio also includes a commission paid to the intermediaries hence a regular plan of the same fund has a higher cost as compared to the direct plan.

How do I get returns from a mutual fund?

Unlike savings bank interest or a fixed deposit interest where the interest earned is simply added to the invested amount, mutual funds work on the concept of NAV (Net Asset Value).

NAV can be simply understood as the price one has to pay to buy one unit of the mutual fund. The price of Mutual Funds is a combination of the aggregate price of all the securities owned less the expense. (Concept of NAV is discussed later in this article).

So a return in mutual funds comes from the appreciation of the NAV unit from the time the investment has been done till it has been redeemed/encashed or sold.

So many times the CAGR or past returns are shown in the MF by your banker can be misleading. For example, if a fund has given 10% CAGR in the past 5 years that does not necessarily mean that a similar return will be replicated in the future.

The simple way to understand this is that the NAV of that particular MF has moved from one point to another in the past 5 years which can be translated to 10% CAGR (for understanding sake) as the Annual return is only possible in those asset classes where the cash flow is regular for example fixed deposits or some bonds.

Since mutual funds are volatile and do not guarantee any return hence the increase or decrease in the NAV might not necessarily be continuous or linear hence the return in MF is volatile

Are mutual funds taxed?

Yes, returns from mutual funds are taxed as well.

Any financial asset which has a capital appreciation i.e. capital gain has taxation to it.

In simple terms when the asset class involved is Debt than any capital gain before 3 years is STCG (short term capital gain) and is taxed at the marginal rate (as per tax slab) whereas after 3 year is LTCG (long term capital gain) and taxed at 20% with indexation(inflation-adjusted).

Whereas in the case of equity the STCG (within 1 year) is taxed at 15% and LTCG (after 1 year) at 10%.  The dividend is taxable at 10% with an exemption of 1lakh per year.

So what are the benefits of mutual funds?

Diversification

One of the advantages of investing in mutual funds is diversification.

Instead of investing in a few stocks, an equity mutual fund invests in a collection of many stocks (around 25-50) depending upon the kind of fund.

The fund is invested in multiple sectors as well so that to avoid concentration to a particular sector or stocks and these are regulated as well.

Professionally managed

As an investor, it’s very challenging to identify good stocks or bonds and do all the research.

Mutual funds are managed by fund managers who are professionals with experience in the industry and they also have a research team who does all the hard work for investors and charges a certain percentage called the expense ratio.

Can be invested in small amounts

Unlike some asset class such as real estate which requires the huge amount to invest (in lakhs and crores) investment in mutual funds can be done either as a lump sum (a chunk of money) in a few thousand or lakhs and even on a monthly basis called as SIP (Systematic Investment Plan) to an extent as small as 500 rupees.

Regulated

MF in India is highly regulated and the regulator is SEBI (Securities and exchange board of India) which provides comfort to investors and grievance and redressal mechanisms are set into place which allows investors to contest any issue that they have with the fund houses or distributors or otherwise.

What are the types of mutual funds?

Based on asset class invested

1. Debt Fund

In these funds the money is invested in bonds, treasury bills or any such instrument with has a regular cash flow and is slightly lesser in risk as compared to some other asset classes.

For example funds like corporate bond funds, short and long-term funds, monthly income plans, fixed maturity plans, liquid funds, etc.

2. Equity Fund

These funds invest in stocks/shares. The return comes from the increase in the value of the stocks over a while.

The risk in such a category of the fund is higher than debt funds. Funds like blue-chip, mid-cap, small-cap funds fall in this category.

3. Hybrid fund

These are a combination of equity and debt category of investments with a varied proportion of exposure to these asset classes.

For example, an aggressive hybrid fund will have a higher exposure to equity (to provide extra return) and a lesser debt (to cover for the risk) and vice versa for the conservative hybrid funds.

Based on the structure of the fund

1. Open and closed-ended

Open-ended funds, in this case, mean that there are free entry and exit for an investor i.e. an investor can buy and sell whenever he want s and the fund is always open for subscription.

2. Closed-Ended Fund

Whereas a closed-ended mutual fund is open only for a fixed tenure (has a limited entry) and after the entry window is over there can be no further subscription.

For example, FMP (Fixed Maturity Plan) is open for a specific period and then it is closed for the subscription.

 There are also lock-in funds where once invested an investor cannot withdraw money (hence the name lock-in).

3. Special funds

Wherein the fund manager sometimes takes a sectoral call (sectoral funds) or some specific themes such as value-based investment (value funds), index-based (index funds), emerging market funds, asset allocation funds.

Mutual fund based on cost –

Regular and Direct

Direct mutual funds are those funds wherein an investor buys the fund directly from the manufacturer i.e. AMC.

There are no intermediaries involved (yes you got it right, they have lesser costs) on the other hand regular plans are those where the investor buys it from some intermediaries like banks, brokerage companies, advisors, etc.

Based on the goal of investment –

1. Growth and Dividend

Mutual fund investing primarily give returns in two forms i.e. capital appreciation and income.

When an investor chooses a growth option his investment grows in value in the long run.

There are two types of dividend options a) dividend payout – the growth in value of securities is paid back to the investors and b) the growth in value of securities is used to buy more securities hence the no of units held increases.

2. Income fund

Income funds are suited for investors with a medium-term horizon (2-4 year) where the money is invested among a mix of bonds and debentures. The fund manager avoids credit risks and focuses on quality debt papers and the interest income accrued from the bond.

When to Invest in Mutual Funds –

As it’s commonly said for investments “there is no right time to invest” thus before thinking of when to invest, trying to time the investments first invest (this is applicable for long term horizon) whereas in the short run there are various other factors that come into play.

For the short term which could be even for a few months (liquid funds or ultra short term funds) and medium-term such as 1-3 years sometimes timing becomes important wherein investors hold the money in cash or liquid to avoid any short term loss.

For example, if there is an RBI (Reserve Bank of India) meeting scheduled in a few days and if a rate cut or hike is expected then sometimes investors might wait till the event has happened to make the decision accordingly.

Markets are always volatile, there is no guarantee of returns in the market, there are evident risks in the equity market as well as debt market, there is uncertainty, markets seldom tend to move in a single direction for a longer period of time and there are multiple similar risks and volatility attributes attached to the market hence as an investor it is almost impossible to time the market.

Hence one has to be prudent and aware of the macro and micro factors operating at that point of time to understand the investment timing and deployment method either a lump sum or STP (Systematic Transfer Plan).

Under STP the required amount to be invested is parked in a liquid fund (which earns interest) and the money is systematically transferred to the target funds and is deployed over a while which can be from a few months to few years and serves as a risk mitigation tool.

Types of returns in mutual funds

NAV in Mutual funds (concept, formula) –

When an investor invests in mutual funds he buys the NAV (Net Asset Value) of the mutual fund which is computed as –

Formula for calculation of Net Asset Value of Mutual Funds
Net Asset Value Formulae

Just like any asset has a price, NAV is the price an investor pays to buy one unit of the mutual fund. The prices of stock keep on changing every time during the day but the NAV of a fund is not as dynamic as it’s not possible to calculate the same but NAV is declared by the end of the day.

Any mutual fund is a combination of different securities (stocks for equity and bonds for debt) and the price keeps on fluctuating for the individual securities but the NAV of a mutual fund does not fluctuate on a real-time basis rather the NAV of a fund is declared after the market closing daily.

Types of returns in mutual funds-

1. Absolute returns

These are the point-to-point returns expressed in percentage.

Absolute return is usually used for less than 1 year. For example, if the amount invested is 1,00,000 and it grows to 1,20,000 within 3 months the absolute return (for 3 months) would be 20%.

2. Annual return

This depicts the return given by the asset on an annual basis.

For example, if 1lakh grows to 1,20,000 in 12months then the annual return will be 20% and if it becomes 1,30,000 in 2 years the annual return, in that case, is 15% only whereas the absolute (point to point) return is 30%.

3. Rolling return

Is the fund’s annualized return over a particular period.

It can be daily, weekly, fortnightly, monthly performance of the fund vis a vis benchmark. Since this way is not biased towards any particular period hence it gives an accurate measurement.

4. Total return

It combines both capital appreciation and dividends (if any).

For example, if 1 lakh invested becomes 1,15,000 (15000 capital gain) and a dividend of 5000 is also received then the total return is 20% (15000+5000 = 20000/100000).

5. Trailing return

Refers to annual return for a previous period of which the last date is today or in some cases the last declared NAV of the mutual fund.

It can be calculated as [(Today’s NAV/NAV at the beginning of the trailing period) ^ (1/Trailing period)-1 ].

6. CAGR

Compounded Annual Growth Rate is used when the holding period is more than 1 year.

The formula for calculation is CAGR  = [(current NAV/Beginning NAV)^(1/number of years)]-1

Ok! So how do I start MF investment in India?

Investing in mutual funds is not as easy as you just identify a few random funds and invest in them.

What an investor should look at instead is to create one’s buying process and invest accordingly.

Investing in a mutual fund is simple and easy.

First, you have to get your KYC (Know Your Customer) done which is a regulatory requirement.

Once that is done you can approach a banker or any financial intermediary providing mutual fund services or directly approach the fund house (AMC).

Any investment done through an intermediary will be done into Regular mutual fund type (with intermediary commission), alternatively, an investor can also go for the direct route of the investor through an RIA(Registered Investment Advisor) to save the intermediary commission.

How to purchase MF online in India –

There are multiple online websites and service providers that help the investors with the tools to invest in various mutual funds both regular and direct mode as well.

Also, there are some websites that in the guile of guiding investors, and “financial planning” does provide the platform but encourage investing in regular mode (with higher cost).

An easy way to identify such websites is to look at the bottom of the screen of the home page or the license agreement page wherein they will mention the ARN code (AMFI Registration Number) which means they are distributors and make a commission out of the sale (investment) that is done through the website.