Making money on your investments is not as simple as it seems. The market's flooded with schemes. It pays to be careful before the first big step.
The likely returns, its consistency, and safety of your principal are some of the key issues you would have to grapple with before zeroing in on the best option for you. Reading the offer document carefully would be a big first step for a prospective investor. But to better appreciate the risks and possible returns, it would help to first understand what mutual funds are all about.
What Are Mutual Funds?
Simply put, a mutual fund is an investment vehicle that pools in the monies of many investors, and collectively invests this amount in either the equity or debt market, or both. The funds are managed by experts, fund managers, who track the performance and reshuffle the portfolio if need be to ensure the best returns. This means you can access the expert's investment management skills for investing in both the equity and debt markets through mutual funds. But before you take your leap, it would help to get a feel of the debt and equity options available.
Broadly, funds are of three types.
Equity Funds are funds that invest in equity markets. These rank highest in the risk ladder as equities, unlike fixed income (debt) securities, promise no returns to an investor and the equity (stock) markets are volatile. Equity funds normally invest in a number of stocks from different sectors, but there are some like 'index funds' (invest only in stocks in the underlying index) or 'sector funds' (invest only in a specified sector) that restrict their investments only to pre-defined sets of stocks. Equity Linked Savings Scheme (ELSS) is another variant, which offers tax rebate under Section 88 but imposes a three-year lock-in. Equity funds are ideal for investors who have a high risk appetite and are willing to take them on for higher returns.
Debt Funds invest in fixed income products, so they are less risky than equity funds. They invest in a broad range of fixed-income securities like corporate bonds, government securities and call and money markets. Debt funds too offer diverse options. Gilt funds, for instance, invest only in government securities, while liquid funds provide a higher-yield alternative for short-term surpluses lying in your savings account. Debt funds are ideal for investors with a low risk appetite.
Balance Funds, as the name suggests, fall in between equity and debt schemes on the risk scale. Balanced funds invest in equity and debt based on a pre-defined asset allocation range (specified in the offer document). Conservative, low-risk schemes earmark a larger share of the corpus for debt, whilst more aggressive funds allow for greater equity exposure. Thus, from among balanced funds, you could choose the scheme that matches your risk-return expectations.
All the above schemes are either open-ended or closed-end. Open-ended funds are available for sale and repurchase on all working days at net asset value (NAV) linked prices. Investors can enter and exit from these schemes at any time. Unlike open-ended, closed-end funds have a life-period. No investor can enter or exit such a fund until the tenure is over. These funds are open for subscription during their launch, termed the initial offer (IPO) period. Once the IPO period is over, investors cannot enter the fund, and the investment is locked for the scheme's full tenure. But due to the fixed investment term and a virtual non-existence of exit options, such schemes are being gradually phased out and no new closed-end schemes are being launched.
Are Mutual Funds Safe?
Mutual funds do not assure returns or repayment of principal unlike bank deposits. But, points out Rajiv Vij, regional head, India & Middle East, Franklin Templeton Investments: "There is a nice risk-reward ladder which a mutual fund offers where there is a product available for every incremental risk taken." Investors in a mutual fund rely on the expertise of the fund manager to generate market-beating returns for them.
There are strict norms for any fund that assures returns today—it is compulsory for them to establish that they have the resources to back such assurances—because most closed-end funds that assured returns in the early 1990s failed to stick to their assurances made at the time of launch.
SEBI guidelines for mutual funds are quite stringent. "SEBI and AMFI measures effectively take care of risk control and protect the common investor's investment and interest in mutual funds," feels Saravana Kumar, head of fixed income investment, SBI Mutual Fund. SEBI has set caps on the amounts chargeable by Asset Management Companies (AMCS) for fund management and other expenses. Unit holders' approval is also essential for all decisions that could have a significant impact on the interests of investors in the scheme, alternatively in certain cases they need to be provided an exit option from the scheme at NAV without any exit load. "SEBI is putting in a lot of effort to improve the investment climate for investors in mutual funds. Disclosure standards are improving with every passing day," says Nikhil Johri, CEO, Alliance Capital.
Should You Invest In a Mutual Fund?
Your decision must be determined by your need for expert advice, the time you can spare to manage your portfolio and the extent of diversification (to manage risk) you could achieve by investing directly. In some cases, direct access to certain market segments could also be a factor to consider.
Probably the most important factor is the need for professional fund management of your money. This could be because you don't have the required domain knowledge or you find it tough to take out enough time to devote to managing your portfolio. In a mutual fund, the fund manager takes care of your investments. He is an investment specialist, and by virtue of being in the market, he is ideally placed to analyse various investment options.
Also, today, if you want to buy, say, government securities directly, you would have to invest a minimum of Rs 25,000 and then too you would not be buying a basket of securities. Much the same is the case if you want to build a decent-sized portfolio of blue-chip shares. Investment of small sums can limit the extent of portfolio diversification and skew the risk profile for an investor buying directly. Further, there are also certain instruments that a small investor may find it difficult to gain access to, like investments in short-term commercial paper or corporate bonds or overseas debt. In all such cases, mutual funds offer a viable option for investors as they allow you to build a diversified portfolio with as little as Rs 5,000, as they pool in money from many investors and invest the sum collectively. "Diversification and asset allocation is a must as there is no such thing as a safe investment," points out Sanjay Sachdev, CEO, IDBI Principal.
But just desiring a diversified portfolio and lack of financial knowledge is not enough to go to a mutual fund. You may very well invest your money with a mutual fund only to see your principal dwindle in no time. After all, mutual funds will never assure you anything but professional management. Neither your principal nor your returns are assured.
You, therefore, must have a certain risk appetite.So choose a fund that matches your risk appetite and ideally one that has a track record of consistency in delivering returns.
Who Should Invest In Equity Funds?
Invest in equity funds only if you have the highest risk appetite, for equity markets are the most volatile markets. However, you can still choose, even within equity funds, the degree of risk you want to take. Lowest-risk equity funds are index funds and ETFS (exchange traded funds, which are normally index funds whose units can be bought and sold on a real-time basis). Index funds deliver returns that mirror the returns from the underlying index and thus offer a diversified pre-defined basket of securities for investment.
But if you want to earn more than what the markets would give you, go for diversified equity funds and ELSS funds, that actively manage their portfolio in a quest to outperform the markets. But select your fund with care. ELSS funds, though similar to diversified equity funds, impose a lock-in of three years, in exchange for Section 88 tax benefits. So, even if you want to cash in on your gains comes before three years, you can't.
Lastly, sector funds are the riskiest of all funds. Their fortunes depend only on one or very few sectors that the scheme is intended to invest in. Invest in these funds only if you have the highest risk appetite because the high concentrated exposure to a particular sector takes away the cushion offered by diversification. Only investors with significant knowledge of a sector should contemplate investing in such funds.
So if you are willing to take on higher risks for higher returns, then go for equity funds as equities, as an asset class, have outperformed all other classes of investment over a long term. Besides, as M. Sivakumar, CEO, Cholamandalam Mutual Fund, says: "Today the level of alternate earnings is not much to reckon with, because an investor gets just about 7.5-8 per cent returns from assured return options, whereas at the current index levels, I'd expect significantly higher returns from equities."
Who Should Invest In Debt Funds?
As these funds invest in debt securities that promise a steady flow of income, debt funds are safer investment vehicles. Investors seeking stability in income along with a higher protection of principal are better off investing through debt funds. Even a debt fund's NAV could fall if interest rates rise in the economy, but the extent of risk is far lesser than with an equity fund.
But even within debt funds, your investment objectives and investment term would determine the kind of debt fund you should opt for. If you want to park your money in a debt fund for a period of one week to not more than six months, go for a liquid fund. But, if you want to stay invested for well over a year, you could opt for gilt or income funds. While liquid funds offer low returns with extremely low risk, gilt and income funds offer the opportunity to generate higher returns with some additional risk.
Who Should Invest In Balanced Funds?
Balanced funds are a good option for investors who would like greater returns than from debt funds, and are willing to take on a little more risk. These funds have an exposure to both equity and debt instruments. They invest a pre-determined proportion in equity and debt, normally 60:40 in favour of equity.
Investors looking to generate some returns even if the equity markets fail to perform could opt for this class of funds. A balance in the scheme's exposure to the two asset classes also serves as an excellent hedge against excessive volatility in either of the markets.
Before investing in a balanced fund, go through a few of its past fact sheets, and look up the equity-debt split.If you are a conservative investor, opt for a fund where equity investments are capped at not more than 60 per cent of the corpus. However, if you are the aggressive sort, you could even go along with a higher equity holding.
How Should You Evaluate A Mutual Fund?
"Performance is of course critical, but this should be evaluated on three parameters: the returns, the consistency (or volatility) of the returns, and the portfolio quality (or asset quality)," contends Shailendra Bhandari, Prudential ICICI. "In addition, factors such as client service, convenience, accessibility and quality of the sponsor are important," he adds.
Equity Funds: It's always safer to opt for a fund that's been around for a while, as you can study its track record. You can see how the fund has performed over the years, which will facilitate historical comparison across its peer set. Although past trends are no guarantee of future performance, it does give an indication of how well a fund has capitalised on upturns and weathered downturns. Avoid funds that show a volatile returns pattern.
Unless you are willing to take on high risk, avoid funds that have a high exposure to a few sectors or a handful of stocks. Such funds will give superior returns when the selected sectors are doing well, but if the market crashes or the sector performs badly, the fall in NAV will be equally sharp. Ideally, a diversified equity fund should have an exposure to at least six sectors and 20 to 25 scrips.
Just as the fund needs diversified investments, it also needs to have a diversified investor base. This ensures that a few investors do not own a significant part of the fund, as it would belie the very principle of a mutual fund. SEBI regulations stipulate that a fund must publish, in its half-yearly disclosures, details of the number of investors who hold more than 25 per cent of the scheme's corpus. Avoid such funds, as they could well be catering to the interests of the large investors at your expense.
Before investing, always go through its offer document and fact sheet. If the fund house doesn't give out such information regularly, avoid that fund. Funds that do not disclose details on a regular basis to their unit holders are better left alone, as you may not be told what will happen to your money once you invest. Unlike UTI and some public sector mutual funds, most private sector funds disclose their investment portfolios regularly, mostly every month. Besides, most of them have their websites, where the break-up of their scheme's portfolios—quantity of shares in a company and amount invested—are available. Better the disclosure practices, the easier it is for you to discern if your money is being invested prudently.
Debt Funds: The first thing you need to get a fix on is your investment horizon. If you wish to invest in a debt fund for anything up to one year, opt for a liquid fund. Anything above that, you should be looking at a gilt fund or an income fund.
As with equity funds, a debt fund with a good track record is always preferable. To be on the safe side, choose funds that have been in the market for at least one year.
One of the most important factors you need to look for in an income fund is the credit rating of the debt instruments in its portfolio. An AAA credit rating denotes the highest safety, while a rating below BBB is classified non-investment grade. Although rating agencies classify BBB paper as investment grade, you should budget for downgrades, and set the minimum acceptable rating benchmark at AA. In order to ensure the safety of your investment, opt for a fund that has at least 75 per cent of its corpus in AAA-rated paper, and 90 per cent in AA and AAA paper.
In order to generate higher returns while maintaining control on the quality of their portfolio, some mutual fund houses are in the process of launching a new variant of debt funds, "high-income funds".These income funds typically invest a very significant portion of their assets in debt papers whose ratings are below AAA. As lower-rated debt papers offer a higher interest rate than higher rated securities, a high-income fund seeks to give better returns than a normal income fund. This, of course, comes with a higher risk as the scheme compromises on the quality of assets.
An income fund should be reasonably diversified across companies. Say, a fund manager invests his entire corpus in debt instruments of just one company. If the company goes under, the fund loses everything. Now, had the fund manager diversified and invested 10 per cent of his corpus in 10 companies, with one-tenth in the troubled company, his loss would be lower. Assuming the other companies meet their debt obligations, the fund's loss would be restricted to 10 per cent. And similar to the precondition for equity funds, avoid debt funds where a few large investors account for an abnormally high proportion of the corpus.