Mutual funds primer

Overview

The one investment vehicle that has truly come of age in India in the past decade is mutual funds. Today, the mutual fund industry in the country manages around Rs 329,162 crore (As of Dec, 2006) of assets, a large part of which comes from retail investors. And this amount is invested not just in equities, but also in the entire gamut of debt instruments. Mutual funds have emerged as a proxy for investing in avenues that are out of reach of most retail investors, particularly government securities and money market instruments.
Specialisation is the order of the day, be it with regard to a scheme’s investment objective or its targeted investment universe. Given the plethora of options on hand and the hard-sell adopted by mutual funds vying for a piece of your savings, finding the right scheme can sometimes seem a bit daunting. Mind you, it’s not just about going with the fund that gives you the highest returns. It’s also about managing risk–finding funds that suit your risk appetite and investment needs.

So, how can you, the retail investor, create wealth for yourself by investing through mutual funds? To answer that, we need to get down to brass tacks–what exactly is a mutual fund?

Very simply, a mutual fund is an investment vehicle that pools in the monies of several investors, and collectively invests this amount in either the equity market or the debt market, or both, depending upon the fund’s objective. This means you can access either the equity or the debt market, or both, without investing directly in equity or debt.

Mutual funds: The advantages...

And that, naturally, begs the question: why can’t I invest directly in, say, equity? Why go through a mutual fund at all? Here are some compelling arguments in favour of mutual funds:

Professional management

Take equities. Most of us have neither the skill to find good stocks that suit our risk and returns profile nor the time to track our investments–but still want the returns that can be had from equities. That’s where mutual funds come in.

When you invest in mutual funds, it is your fund manager who will take care of your investments. A fund manager is an investment specialist, who brings to the table an in-depth understanding of the financial markets. By virtue of being in the market, the fund manager is ideally placed to research various investment options, and invest accordingly for you.

Small investments

Today, if you wanted to buy government securities, you would have to invest a minimum amount of Rs 25,000. Much the same is the case if you want to build a decent-sized portfolio of shares of blue-chips. Now, that might be too large an amount for many small investors.

A mutual fund, however, gives you an ownership of the same investment pie– at an outlay of Rs 1,000-5,000. That’s because a mutual fund pools the monies of several investors, and invests the resultant large sum in a number of securities. So, on a small outlay, you get to participate in the investment prospects of a number of securities.

Diversified portfolio

One of the oft-mentioned tenets of portfolio management is: diversify. In other words, don’t put all your eggs in one basket. The rationale for this is that even if one pick in your portfolio turns bad, the others can check the erosion in the portfolio value.

Take a simple–even if extreme– example. Say, you have Rs 10,000 invested in one stock, Reliance. Now, for some reason, the stock drops 50 per cent. The value of your investment will halve to Rs 5,000. Now, say you had invested the same amount in a mutual fund, which had parked 10 per cent of its corpus in the Reliance stock. Assuming prices of other stocks in its portfolio stay the same, the depreciation in the fund’s portfolio– and hence, your investment–will be 5 per cent. That’s one of the merits of diversification.

Liquidity

You are free to take your money out of open-ended mutual funds whenever you want, no questions asked. Most open-ended funds mail your redemption proceeds, which are linked to the fund’s prevailing NAV (net asset value), within three to five working days of your putting in your request.

Tax breaks

Last but not the least, mutual funds offer significant tax advantages. Dividends distributed by them are tax-free in the hands of the investor.

They also give you the advantages of capital gains taxation. If you hold units beyond one year, you get the benefits of indexation. Simply put, indexation benefits increase your purchase cost by a certain portion, depending upon the yearly cost-inflation index (which is calculated to account for rising inflation), thereby reducing the gap between your actual purchase cost and selling price. This reduces your tax liability.

What’s more, tax-saving schemes and pension schemes give you the added advantage of benefits under Section 88. You can avail of a 20 per cent tax exemption on an investment of up to Rs 10,000 in the scheme in a year.

...And disadvantages

Mutual funds are good investment vehicles to navigate the complex and unpredictable world of investments. However, even mutual funds have some inherent drawbacks. Understand these before you commit your money to a mutual fund.

No assured returns and no protection of capital

If you are planning to go with a mutual fund, this must be your mantra: mutual funds do not offer assured returns and carry risk. For instance, unlike bank deposits, your investment in a mutual fund can fall in value. In addition, mutual funds are not insured or guaranteed by any government body (unlike a bank deposit, where up to Rs 1 lakh per bank is insured by the Deposit and Credit Insurance Corporation, a subsidiary of the Reserve Bank of India).

There are strict norms for any fund that assures returns and it is now compulsory for funds to establish that they have resources to back such assurances. This is because most closed-end funds that assured returns in the early-nineties failed to stick to their assurances made at the time of launch, resulting in losses to investors.

Restrictive gains

Diversification helps, if risk minimisation is your objective. However, the lack of investment focus also means you gain less than if you had invested directly in a single security.

In our earlier example, say, Reliance appreciated 50 per cent. A direct investment in the stock would appreciate by 50 per cent. But your investment in the mutual fund, which had invested 10 per cent of its corpus in Reliance, will see only a 5 per cent appreciation.

Types of mutual funds

Many people tend to wrongly equate mutual fund investing with equity investing. Fact is, equity is just one of the various asset classes mutual funds invest in. They also invest in debt instruments such as bonds, debentures, commercial paper and government securities.

Every scheme is bound by the investment objectives outlined by it in its prospectus, which determine the class(es) of securities it can invest in. Based on the asset classes, broadly speaking, the following types of mutual funds currently operate in the country.

Equity funds. The highest rung on the mutual fund risk ladder, such funds invest only in stocks. Most equity funds are general in nature, and can invest in the entire basket of stocks available in the market. There are also ‘specialised’ equity funds, such as index funds and sector funds, which invest only in specific categories of stocks.

Debt funds. Such funds invest only in debt instruments, and are a good option for investors averse to taking on the risk associated with equities. Here too, there are specialised schemes, namely liquid funds and gilt funds. While the former invests predominantly in money market instruments, gilt funds do so in securities issued by the central and state governments.

Balanced funds. Lastly, there are balanced funds, whose investment portfolio includes both debt and equity. As a result, on the risk ladder, they fall somewhere between equity and debt funds. Balanced funds are the ideal mutual funds vehicle for investors who prefer spreading their risk across various instruments.

Let’s now take a closer look at the working of each of these three categories of funds, the investment options they offer, and how best you can make money from them.

Equity funds

As explained earlier, such funds invest only in stocks, the riskiest of asset classes. With share prices fluctuating daily, such funds show volatile performance, even losses. However, these funds can yield great capital appreciation as, historically, equities have outperformed all asset classes. At present, there are four types of equity funds available in the market. In the increasing order of risk, these are:

Index funds

These funds track a key stock market index, like the BSE (Bombay Stock Exchange) Sensex or the NSE (National Stock Exchange) S&P CNX Nifty. Hence, their portfolio mirrors the index they track, both in terms of composition and the individual stock weightages. For instance, an index fund that tracks the Sensex will invest only in the Sensex stocks. The idea is to replicate the performance of the benchmarked index to near accuracy. Index funds don’t need fund managers, as there is no stock selection involved.

Investing through index funds is a passive investment strategy, as a fund’s performance will invariably mimic the index concerned, barring a minor "tracking error". Usually, there’s a difference between the total returns given by a stock index and those given by index funds benchmarked to it. Termed as tracking error, it arises because the index fund charges management fees, marketing expenses and transaction costs (impact cost and brokerage) to its unitholders. So, if the Sensex appreciates 10 per cent during a particular period while an index fund mirroring the Sensex rises 9 per cent, the fund is said to have a tracking error of 1 per cent.

To illustrate with an example, assume you invested Rs 1,000 in an index fund based on the Sensex on 1 April 1978, when the index was launched (base: 100). In August, when the Sensex was at 3.457, your investment would be worth Rs 34,570, which works out to an annualised return of 17.2 per cent. A tracking error of 1 per cent would bring down your annualised return to 16.2 per cent. Obviously, the lower the tracking error, the better the index fund.

Diversified funds

Such funds have the mandate to invest in the entire universe of stocks. Although by definition, such funds are meant to have a diversified portfolio (spread across industries and companies), the stock selection is entirely the prerogative of the fund manager.

This discretionary power in the hands of the fund manager can work both ways for an equity fund. On the one hand, astute stock-picking by a fund manager can enable the fund to deliver market-beating returns; on the other hand, if the fund manager’s picks languish, the returns will be far lower.

The crux of the matter is that your returns from a diversified fund depend a lot on the fund manager’s capabilities to make the right investment decisions. On your part, watch out for the extent of diversification prescribed and practised by your fund manager. Understand that a portfolio concentrated in a few sectors or companies is a high risk, high return proposition. If you don’t want to take on a high degree of risk, stick to funds that are diversified not just in name but also in appearance.

Tax-saving funds

Also known as ELSS or equity-linked savings schemes, these funds offer benefits under Section 88 of the Income-Tax Act. So, on an investment of up to Rs 10,000 a year in an ELSS, you can claim a tax exemption of 20 per cent from your taxable income. You can invest more than Rs 10,000, but you won’t get the Section 88 benefits for the amount in excess of Rs 10,000. The only drawback to ELSS is that you are locked into the scheme for three years.

In terms of investment profile, tax-saving funds are like diversified funds. The one difference is that because of the three year lock-in clause, tax-saving funds get more time to reap the benefits from their stock picks, unlike plain diversified funds, whose portfolios sometimes tend to get dictated by redemption compulsions.

Sector funds

The riskiest among equity funds, sector funds invest only in stocks of a specific industry, say IT or FMCG. A sector fund’s NAV will zoom if the sector performs well; however, if the sector languishes, the scheme’s NAV too will stay depressed.

Barring a few defensive, evergreen sectors like FMCG and pharma, most other industries alternate between periods of strong growth and bouts of slowdowns. The way to make money from sector funds is to catch these cycles–get in when the sector is poised for an upswing and exit before it slips back. Therefore, unless you understand a sector well enough to make such calls, and get them right, avoid sector funds.

How to pick an equity fund

Now, that you have an idea of the investment profile and objective behind each type of equity fund, let’s get down to specifics: what you should look for while evaluating an equity fund. First, narrow down your investment universe by deciding which category of equity fund you would like to invest in. That decided, seek the following four attributes from a prospective fund.

Track record. 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 in the past. The fund’s track record also gives an indication of the volatility in its returns. Avoid funds that show a volatile returns patterns.

Diversified portfolio. 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 four sectors and seven to 10 scrips.

Diversified investor base. 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 (Securities and Exchange Board of India) 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.

Transparency in operations. Before investing in a fund, 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 unitholders are better left alone, as you may not be told what will happen to your money once you invest.

Debt funds

Such funds attempt to generate a steady income while preserving investors’ capital. Therefore, they invest exclusively in fixed-income instruments securities like bonds, debentures, Government of India securities, and money market instruments such as certificates of deposit (CD), commercial paper (CP) and call money. There are basically three types of debt funds.

Income funds

By definition, such funds can invest in the entire gamut of debt instruments. Most income funds park a major part of their corpus in corporate bonds and debentures, as the returns there are the higher than those available on government-backed paper. But there is also the risk of default–a company could fail to service its debt obligations.

Gilt funds

They invest only in government securities and T-bills–instruments on which repayment of principal and periodic payment of interest is assured by the government. So, unlike income funds, they don’t face the spectre of default on their investments. This element of safety is why, in normal market conditions, gilt funds tend to give marginally lower returns than income funds.

Liquid funds

They invest in money market instruments (duration of up to one year) such as treasury bills, call money, CPs and CDs. Among debt funds, liquid funds are the least volatile. They are ideal for investors seeking low-risk investment avenues to park their short-term surpluses.

The ‘risk’ in debt funds

Although debt funds invest in fixed-income instruments, it doesn’t follow that they are risk-free. Sure, debt funds are insulated from the vagaries of the stock market, and so don’t show the same degree of volatility in their performance as equity funds. Still, they face some inherent risk, namely credit risk, interest rate risk and liquidity risk.

Interest rate risk. This is common to all three types of debt funds, and is the prime reason why the NAVs of debt funds don’t show a steady, consistent rise. Interest rate risk arises as a result of the inverse relationship between interest rates and prices of debt securities.

Prices of debt securities react to changes in investor perceptions on interest rates in the economy and on the prevelant demand and supply for debt paper. If interest rates rise, prices of existing debt securities fall to realign themselves with the new market yield. This, in turn, brings down the NAV of a debt fund. On the other hand, if interest rates fall, existing debt securities become more precious, and rise in value, in line with the new market yield. This pushes up the NAVs of debt funds.

Credit risk. This throws light on the quality of debt instruments a fund holds. In the case of debt instruments, safety of principal and timely payment of interest is paramount. There is no credit risk attached with government paper, but that is not the case with debt securities issued by companies.

The ability of a company to meet its obligations on the debt securities issued by it is determined by the credit rating given to its debt paper. The higher the credit rating of the instrument, the lower is the chance of the issuer defaulting on the underlying commitments, and vice-versa. A higher-rated debt paper is also normally much more liquid than lower-rated paper.

Credit risk is not an issue with gilt funds and liquid funds. Gilt funds invest only in government paper, which are safe. Liquid funds too make a bulk of their investments in avenues that promise a high degree of safety. For income funds, however, credit risk is real, as they invest primarily in corporate paper.

Liquidity risk. This refers to the ease with which a security can be sold in the market. While there is brisk trading in government securities and money market instruments, corporate securities aren’t actively traded. More so, when you go down the rating scale–there is little demand for low-rated debt paper.

As with credit risk, gilt funds and liquid risk don’t face any liquidity risk. That’s not the case with income funds, though. An income fund that has a big exposure to low-rated debt instruments could find it difficult to raise money when faced with large redemptions.

How to pick a debt fund

It’s evident there is an element of risk associated with debt funds. Hence, some care and thought has to go into picking a debt fund. Here are some factors you ought to look at while scouting for a debt fund.

Investment horizon. 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.

Track record. As with equity funds, a debt fund with a good track record is always preferable. The longer the track record, the better–to be on the safe side, choose funds that have been in the market for at least a year.

Credit quality. 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.

A credit rating of AAA denotes the highest safety, while a rating of below BBB is classified as 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.

Diversification. In order to limit the loss from a possible default, 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.

Diversified investor base. Similar to the pre-condition for equity funds, avoid debt funds where a few large investors account for an abnormally high portion of the corpus.

Balanced funds

As the name suggests, balanced funds have an exposure to both equity and debt instruments. They invest in a pre-determined proportion in equity and debt–normally 60:40 in favour of equity. On the risk ladder, they fall somewhere between equity and debt funds, depending on the fund’s debt-equity spilt–the higher the equity holding, the higher the risk. Therefore, they are a good option for investors who would like greater returns than from pure debt, and are willing to take on a little more risk in the process.

How to pick a balanced fund

The same criterion that applies to selecting an equity fund holds good when choosing a balanced fund. The one additional factor you should check for a balanced fund is the equity and debt split. The offer document will state the ratio of equity and debt investments the fund plans to have. Mostly, this takes on a range, and varies from time to time depending on the fund manager’s perception of the financial markets.

Before investing in an existing balanced fund, go through a few of its past fund 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 60 per cent of corpus. However, if you are the aggressive sort, you could even go along with a higher equity holding.

The intelligent investor's seven rules

It’s one thing to understand mutual funds and their working; it’s another to ride on this potent investment vehicle to create wealth in tune with your risk profile and investment needs. Here are seven must-dos that go a long way in helping you meet your investment objectives.

Know your risk profile

Can you live with volatility? Or are you a low-risk investor? Would you be satisfied if your fund invests in fixed-income securities, and yields low but sure-shot returns? These are some of the questions you need to ask yourself before investing in a fund.

Your investments should reflect your risk-taking capacity.

Equity funds might lure when the market is rising and your neighbour is making money, but if you are not cut out for the risk that accompanies it, don’t bite the bait. So, check if the fund’s objective matches yours. Invest only after you have found your match. If you are racked by uncertainty, seek expert advice from a qualified financial advisor.

Identify your investment horizon

How long you want to stay invested in a fund is as important as deciding upon your risk profile. A mutual fund is essentially a savings vehicle, not a speculation vehicle–don’t get in with the intention of making overnight gains.

Invest in an equity fund only if you are willing to stay on for at least two years. For income and gilt funds, have a one-year perspective at least. Anything less than one year, the only option among mutual funds is liquid funds.

Read the offer document carefully

This is a must before you commit your money to a fund. The offer document contains essential details pertaining to the fund, including the summary information (type of scheme, name of the asset management company and price of units, among other things), investment objectives and investment procedure, financial information and risk factors.

Go through the fund fact sheet

Fund fact sheets give you valuable information of how the fund has performed in the past. You can check the fund’s portfolio, its diversification levels and its performance in the past. The more fact sheets you examine, the better.

Diversify across fund houses

If you are routing a substantial sum through mutual funds, you should diversify across fund houses. That way, you spread your risk.

Do not chase incentives

Don’t get lured by investment incentives. Some financial intermediaries give upfront incentives, in the form of a percentage of your initial investment, to invest in a particular fund. Don’t buy it. Your focus should be to find a fund that matches your investment needs and risk profile, and is a performer.

Track your investments

Your job doesn’t end at the point of making the investment. It’s important you track your investment on a regular basis, be it in an equity, debt or balanced fund. One easy way to keep track of your fund is to keep track of the Intelligent Investor rankings of mutual funds, which are complied on a quarterly basis (log on to iinvestor.com to see the rankings for the quarter ended June 2001). These rankings allow you to take note of your fund’s performance and risk profile, and compare it across various time periods as well as across its peer set. In addition, you should run some basic checks in the fund fact sheets and the quarterly reports you get from your fund.

Equity funds are subject to market volatility, and the pace of change can be quite brisk. Check your fund’s quarterly reports for changes that could have severe implications on your investment. If you find a high degree of concentration in a few stocks or sectors, it means the fund manager is banking on the performance of these sectors. If they keep up to his expectations, you could end up making hefty returns, but if they don’t, chances are that the NAV will depreciate heavily.

In the case of debt funds, check the portfolio distribution and the fund’s holding in AAA and equivalent papers. If you find your fund is holding a significant quantity (above 10 per cent) in below AA-rated paper, your investment is not safe. Remember, even a single default can drag the NAV of your debt down.

If you come across negative reports of the fund, ask your financial advisor or broker about it, especially if there’s a possibility of your investment depreciating in value. If the threat is real, reduce your exposure to the fund.

Source : money.outlookindia.com