Trading Mutual Funds For Beginners

5 mins read

Buying shares or units in mutual funds can be intimidating for beginners. There are over 4000 mutual funds available in India with different investment strategies and asset classes. In this article, we shall discuss –

What Are Mutual Funds?

How Mutual Funds Trade?

What are mutual funds?

A mutual fund is a financial instrument that pools money from many investors and invests the pooled money in different assets. These assets include shares (stocks), bonds, commodities and even real estate.

An investor who purchases a mutual fund gets a unit allocated. This unit represents an ownership interest in the assets owned by the mutual fund. Mutual funds, by design, are meant for long-term investing and not for frequent daily trading considering their operational and financial structure (fees).

Mutual funds are considered beneficial and attractive for investors because they are widely diversified. Diversification helps minimize the risk of an investment. Also, mutual funds allow an investor to not get into the investment nuances of selecting the stock/bond for the portfolio, which is done by an expert fund manager who brings considerable and relevant experience managing money.

There is a wide variety of mutual funds that can be considered. For example – you have an equity fund, hybrid fund, debt fund, gold fund, etc. These are categories based on the underlying asset class in the fund.

How do mutual funds trade?

The trading mechanism in mutual funds is different from regular stocks or any exchange-listed product. Mutual funds come with a minimum investment amount (for first-time investors) and a different first time and subsequent investment plan. Also, aftermarket closing, mutual funds are generally traded after the end of the day. To trade a mutual fund, a NAV is required, which is the Net Asset Value of the fund (also known as the price of every unit of the fund which an investor pays to acquire one unit of the fund). The NAV is arrived at by dividing total assets in the fund (minus any liabilities) divided by the outstanding number of shares (units).

As in the case of a share or exchanged based instruments (such as Exchange Traded Fund), a mutual fund is not traded using a counterparty. The trading is done between the investor and the fund house.

Also, the fees involved in a mutual fund are different. While there are no entry fees in India, an exit load is applicable if an investor sells the unit before 365 days (this applies to some categories).

What to consider to trade in a mutual fund?

Knowing risk tolerance

Two individuals (even brothers from the same mother) cannot be identical in all aspects. Thus, it is essential to understand every individual before choosing any fund that suits the investor. There are over 4500 mutual funds in India, and there is no rule of one size fits all in the case of mutual funds. Thus, to begin with, the first step is to assess the investor’s risk profile to understand the risk tolerance. Risk tolerance is nothing but the understanding of the capacity of loss an individual can bear without impacting his and his family’s lifestyle/needs. This step includes a thorough analysis of the investor’s income, expense, family size (focusing on the number of dependents), behaviour during different market conditions, preparedness towards the emergency, etc.

Once the risk assessment is completed, it is essential to map the fund’s risk (or portfolio of funds’ risk to the investor’s). For this, selecting the right fund is the key.

How to select the right fund?

Selecting a winning fund remains key for an investor. The process of evaluation is rigorous and involves multiple parameters. The following parameters are identified based on which a fund can be selected for ideal performance –

Performance consistency:

You should look at long-term performance to show the consistency an investor can expect from an investment. A good player scores some runs consistently in every match instead of scoring a century in first and a duck in the next.

Risk:

The past performance (seen above) is essential, but it talks of the past and doesn’t show the future. Thus, you must understand the factor of volatility that can be expected in the fund’s performance in the future. This is nothing but risk. An investor should look at beta, standard deviation, Sharpe ratio as measures of risk/risk-adjusted returns.

Expenses incurred:

Expense ratio (ER) is essential for selecting a fund. It is the percentage of assets that go towards expenses such as brokerage, distribution, commission, etc. While the regulator has capped the expense, it is better to scout for funds with a lower expense ratio as it benefits in the longer term.

Team and AUM:

When an investor puts money, he puts the money on the fund manager and his abilities instead of the stocks. Thus, it is essential to understand the team behind it and its expertise in managing money. Similarly, AUM is meaningful to measure stability while talking about the fund. AUM is the total assets under management that are there in the fund.

To conclude, mutual funds are an excellent tool for investment and offer benefits of professional management, diversification, time flexibility, minimum amount and the likes. Also, mutual funds are highly regulated in India, thereby ensuring that the interest of the retail investors is safeguarded. Mutual funds are instruments that are not meant for trading activity (read intraday or very short-term trading) and are majorly for long-term investment. Some of the categories of funds, such as liquid funds, money market funds which are types of debt funds, could be considered for a short duration given their structure and utility. Lastly, there are many funds to choose from, and thus a systematic and holistic approach that covers a 360-degree review of the fund is the need of the hour for an investor to be successful with their investments.