Investing in Mutual Funds explained

Podcast Duration: 09:51

Dost agar aap mutual funds main invest karna chahte ho, toh I am assuming that you have understood the basic fundamentals of mutual fund investments.

Phir bhi, let us go over the finer details related to the basics quickly, before delving deeper into the concept.

Pehli baat toh suna hi hoga - mutual funds are subject to market risks. Ji haan, mutual funds invest the capital of all their investors in various stocks market instruments jaise ki stocks and bonds. Sometimes a mutual fund will invest in other mutual funds. These investments are chosen by a highly experienced fund manager whose full-time job it is to keep a track on the various stocks, bonds and mutual funds worth investing in. Aapka risk kam rehta hai kyunki the fund manager knows what he or she is doing and because they pick diverse investments (that is they ensure a diverse portfolio). Lekin risk rehta hi hai. You can mitigate or minimize the risk by investing in many different mutual funds, so that any negative returns are offset by positive returns on other mutual funds.

Stocks and mutual funds are like riding the bike yourself versus sitting pillion respectively. If you’re confident, experienced and a good rider, you might prefer to ride the bike yourself (or choose and track stocks yourself). If you have no experience, would rather check your messages during the ride, or are not confident then you might prefer someone else to have control while getting you to your destination. In other words, you would rather someone else do the work of finding and tracking stock market instruments for you.

Point number two - you pay some fee on your mutual fund. Ensure that you check your expense ratio against your earnings from a given mutual fund. The expense ratio is the annual maintenance fee that is charged by the mutual fund house for managing your capital for you. Logically, you must ensure that your earnings from the mutual fund exceed your expense ratio by a reasonable margin.

Point number three - aapke investment goal aur current life situation ke hisaab se there are two options on what happens to your earnings on a mutual fund. Agar aapko hamesha paise ki kami rehti hai toh aap shayad Dividend option choose karenge. Dividend option mein, whatever earnings are made on a mutual fund are paid to the investor by way of regular payouts. Dusra option hai Growth. Growth option mein, earnings reinvest kiya jata hai. Many people ask which option is better but it really depends on your investment objectives and whether or not you need regular payouts. However, dividends are typically taxed to a higher degree than capital gains related to the growth option. From that point of view, one might view the growth option as better.

Point number four - enjoy the benefits of rupee-cost averaging by going the SIP route (that is systematic investment plan) rather than investing a lump sum. I know, I know… when it comes to redeeming your investment, SIP can be seen as problematic by some investors because, just as the amounts were not invested in a chunk but rather in tiny sums, so the redemption too occurs at the same rate. But perhaps you can factor this in while deciding your investment term, tenure or horizon and redeem your mutual fund once the last installment matures? But why? What’s the point, you ask and that is a fair question. The point is rupee-cost averaging. Janvari mein aap 1000 rupees de ke, 100 units pate ho. Feb ke Rs 1000 se 200 units milte ho, March ke Rs 1000 se sirf 80 units, April mein 95 units, same Rs 1000 se, May mein 100 units, June mein 150 units. End mein aapka average cost tha: approx Rs 8.27 per unit. Agar aap pura amount march mein invest kar lete toh you would have paid Rs 12.7 per unit. Of course had you invested in Feb you would have only paid Rs 5 per unit, but do you have the bandwidth to watch various mutual funds that carefully?

You must fully understand these four points before going any further with your mutual fund investments.

Assuming you are clear on the above four concepts, aage badte hai: let us look at the different types of mutual fund investments out there. A whole world of options exist for the discerning mutual fund investor and we’re here to set you on the pathway towards making discerning choices.

The first thing to understand is that mutual funds can be categorised in several different ways - they may be categorised according to the risk involved, the investor’s goals, the asset class and the structure of the mutual fund. Mutual funds may also be categorised according to their investment specialisation.

Let us begin by looking at the various types of mutual funds categorised according to asset class: Equity funds invest in stocks, debt funds invest in bonds and hybrid stocks invest in a combination of both. Money market funds invest in the cash market or the capital market. Money market funds are said to be the most risky, followed by equity funds, hybrid funds and then debt funds. By now toh aap jante ho ki potential risk is inversely proportional to earning potential, so you get the picture.

While on the topic of risk appetite, it makes sense to go over the types of mutual funds categorised according to risk profile. Very low risk mutual funds typically deliver up to 6% interest, low risk mutual funds can be expected to deliver 6% to 8% returns, medium risk funds are touted to deliver 9% to 12% returns while investors usually agree to high risk mutual funds because they have tasted the delight that comes with 15% to 20% returns. But of course, there are no guarantees and the market could swing any way really.

Structure ke hisaab se, mutual funds can be divided into open ended funds, closed ended funds and interval funds. Open-ended funds mein flexibility zyaada rehti hai. Paise kabhi bhi invest kar sakte ho aur jitne units chahiye khareedh sakte ho; ulta closed-ended funds mein aapko deadline ke andar units khareedna hota hai aur mutual fund ka fixed maturity rehta hai. Aap yeh mutual fund ko stock market pe bech sakte ho agar scheme se nikalna chahte ho, lekin early redemption per se, is not an option.

Aapke goals ke hisaab se, you can choose ELSS or equity linked saving scheme in order to save taxes under 80 C, or you can choose between growth funds, income funds, liquid funds, pension funds, aggressive growth funds, capital protection funds or fixed maturity funds. Most of the names are self explanatory though you might like to know that in the case of fixed maturity funds, the fund manager will also invest your capital in schemes or instruments with a similar maturity date.

Mutual funds can also be differentiated by where they invest. Here you have sector specific funds, fund of funds, index funds, exchange traded funds, commodity funds, international funds (which invest in other countries specifically) and global funds (which invest in India as well as other countries - the globe as a whole).

Now dost, give yourself a hearty pat on the back for taking the pains to really understand the exciting world of mutual funds.

One more important area of understanding remains before you can start researching and making informed choices. That is - how do you measure your mutual fund’s performance?

There are five methods for measurement. You can choose between the measurement techniques of Alpa, Beta, R-squared, standard deviation and sharpe ratio to check whether a mutual fund is really performing as well as it is said to be performing. Chaliye, Alpha se suru karte hai: You are looking for an Alpha that is positive - the higher the Alpha the better. Alpha calculations mein, risk-adjusted performance of the fund is subtracted from the performance of a benchmark index. Agar Alpha 1.0 hai toh it means it has outperformed the benchmark by 1%. Agar -1.0 hai toh mutual fund has underperformed as compared to the index by 1%.

If you are a low risk investor, you want a higher Alpha, but a lower Beta because Beta is an indicator of risk. It represents the fund’s propensity to respond to stock market movements or the volatility in the price of its units. A beta of 1.0 means that the fund’s volatility is in line with that of the overall market; less than that means it is less volatile and more than that means it is more volatile.

Where Beta measures responsiveness, R-squared compares overall performance of the mutual fund to a benchmark index. It tells the investor how similar the mutual fund’s performance is, to that of an index, like say the Nifty 50. Now just for transparency, note this: we talked about Index funds earlier. Index funds will have a Beta of nearly 100 because they track and therefore mirror the performance of an index. Basically Beta doesn’t tell you much when it comes to Index funds.

Standard deviation measures how much the actual rate of return of a mutual fund differs from its expected performance based on historical data.

Sharpe ratio tells you whether your mutual fund delivered returns because of wise investment decisions or because of taking very high risks. Its calculation process first off subtracts risk-free returns from the portfolio’s returns. The figure arrived at is then divided by standard deviation. Investors typically look for a higher Sharpe ratio.

Mutual funds mein invest aur evaluate karte samey, Alpha, Beta, r-squared, standard deviation aur sharpe ratio zaroor check karna.

Yaad rakhiye dost, that like all things stock market, mutual fund investments mein you require some amount of risk appetite, a good amount of diligence when it comes to investing regularly and also some attention devoted to evaluating their performance every couple of months. Practice caution and diligence as you would with any stock market linked investment.