Mutual funds offer a variety of options through which you can invest in or divest from them: each option has its own advantages and it is very helpful to know of your various options.

Lump sum investment:

This is the simplest manner of investing in a mutual fund. You have a certain sum of money (lets say, Rs 100) and you want to invest it in one go. You approach the mutual fund company with your cheque for the amount you want to invest.

The main risk with this investing strategy is that you are locked in to the valuations of the underlying security as on a particular date. If, for example, the prices were to go down from this point, you would lose money on the entire investment. Similarly, if you have timed the investment right, you will see a good rise on your entire investment.

Systematic Investment Plan (SIP):

In order to avoid the risk mentioned above, you can instead invest the sum over a period of time. Mutual funds allow you to periodically invest in them (lets say 5 investments of Rs 20 each). You can invest on a weekly, monthly or quarterly basis with the mutual funds.

This way you will avoid the risk of locking in to one single valuation but you will get an ‘average’ of the valuations on the various dates that you invest.

SIP is very helpful in a volatile market. Since you invest a fixed amount, you buy more of the security when its prices fall and less when it is more expensive.

Mutual funds define the dates on which you can make the regular investments (typically 1st/7th/15th/21st of every month). If you are a salaried employee, you will realize that you have surplus monthly savings and hence this can become a preferred option for you. You receive your salary on the 5th of the month and hence you can make the investment every 7th of the month.

You can fill the SIP application form and inform the mutual fund that you want to invest on 7th every month.

Almost all mutual funds provide an Electronic Clearing Scheme (ECS) with the major banks: this means that you can sign an order to your bank that you allow the mutual fund company to take a specified sum of money from your bank account on specified dates for a specified period.

This saves you the hassle of signing post dated cheques or of sending cheques on a periodic basis to the mutual fund.

Systematic Transfer Plan (STP):

In the above example, if you had a lump sum of money and wanted to do an SIP, you would have to park your extra money (i.e., Rs 80, which is Rs 100 minus the first installment of Rs 20) somewhere.

Mutual funds, realizing this issue, offer an STP. Here, you can invest the entire sum of money (Rs 100) with the fund: you put in Rs 20 in the equity fund, while putting the extra sum (Rs 80) in cash or debt funds.

Over the next four months, you can request the fund to transfer Rs 20 (plus the gains/losses) each month to the equity fund. This saves you the hassle of creating a communication between your mutual fund and your bank through ECS.

Similarly, if you believe that you would gradually want to move your exposure in IT to lets say, pharma, you can create an STP between your investments in the IT fund and the pharma fund.

This way you do not suddenly shift exposure in one go, but do it gradually. If you are approaching a milestone, you can use this instrument to move your exposure from equity to debt funds – so that you have more certainty around the final figure that you will receive.

Systematic Withdrawal Plan (SWP):

This is, as the name suggests, the reverse of the STP. Here you gradually withdraw money from the mutual fund. Assume you need Rs 20 over the next 5 months and you have Rs 100 invested in a mutual fund.

You can request the mutual fund to return 1/5th of your money (including the gains/losses) every month for the next five months. If your bank account details are provided, the fund will deposit the money directly in your bank account. This is typically used when you are nearer to a milestone or during your retirement.

Lock-in and capital gains tax:

In all systematic cases, you need to be careful about lock-ins and capital gains tax. Each date of your investment is treated as the date when you made or divested the investment. The first date of your SIP/STP is NOT considered as the investment date for all your subsequent dates.

Hence, if the mutual fund has a lock-in provision, then all different investments will have different dates when the lock-in gets over. Similarly, when calculating your taxes, the date of each investment is used to determine whether the particular sale would attract (the harsher) short term or (the concessional) long term tax rate.

You can devise your investments into mutual funds in a wide variety of ways. Knowing the various options can not only help you get better returns (or lower risk) but also force you into the discipline of savings!

The author is Director, PARK Financial Advisors Pvt. Ltd., Mumbai. He is an IIM-Ahmedabad alumnus. 

When you invest, you can look at the investment from two perspectives: to generate a regular periodic return or to invest for a long term, without bothering about the intermediate returns. Mutual funds are a great avenue for achieving either end.

You can either choose to invest in the ‘dividend’ option or a ‘growth’ option to achieve your objectives.

When a mutual fund invests money on your behalf and makes gains on the same, it can either return the gains to you or keep the gains in the fund on your behalf. You can use either of these options based on your requirements. However, be careful that you know the tax treatment!

Dividend option:

If you are someone who requires money on a periodic basis from your investments, then you should choose the dividend option. This means that the fund will periodically (quarterly or mostly, annually) return some of its gains to you. Note that the fund is under no obligation to declare a certain rate of dividend.

The amount of dividend that it pays out depends on the gains that it has made, and here too, the fund manager/the asset management company can decide to return only part of the gains. A fund cannot dip into its corpus to pay dividend.

For example, assume the fund collects Rs 10 from you and at the end of one year, the fund value has risen to Rs 11. The fund can declare a dividend of any amount up to Re 1. It cannot go beyond Re 1 because then it will have to dip into its original corpus, which it is not allowed to do.

Assume that your fund declares a dividend of Re 0.8. When a non-equity oriented mutual fund declares dividend, it pays a tax of 15% (+10% surcharge and 3% cess, totalling to 15%*1.1*1.03=16.995%) on the dividend amount. Hence, in this example, the fund will need to pay Rs 0.14 (Rs. 0.8*16.995%) as dividend distribution tax.

However, once this tax is paid, the dividend received is tax free in the hands of the investor. Recently, this dividend distribution tax has been increased to 25% in case of liquid funds: the calculations remain similar.

The value of the fund (and your investment) will fall from Rs 11 to Rs 10.06 (i.e. Rs 11 – Rs 0.8 – Rs 0.14). This is an important point because many people do not realize that dividends reduce the value of the investment and also because dividend is considered as tax free. Clearly, your money is refunded to you and also the same goes from your investment to pay the dividend distribution tax.

However, if an equity fund were to declare a dividend, there is no dividend distribution tax. Hence, when a mutual fund declares Rs 0.8 as dividend, you receive Rs 0.8 and the NAV falls to Rs 10.2.

Note that in this option, you face ‘reinvestment risk’ — you need to plan where you will invest the dividend amount.

Growth option:

If you do not want the investment back on a regular basis but would rather wait till the end of your planning horizon for the investment, then you should choose the ‘growth option.’ This option means that the gains that the fund makes are retained in the fund and are invested on your behalf.

Taking the earlier example, the fund will reflect as Rs 11 as your balance in the fund at the end of the year. However, you will receive nothing from the mutual fund as current income. Note that because nothing is paid to you, you do not need to pay anything to the government as taxes.

If you sell a mutual fund with ‘growth’ option, you will have to pay the government capital gains taxes. If you hold the fund for less than a year, you will pay short term capital gains tax at the marginal rate of taxation (30%+10% surcharge+3% cess).

However, if you hold the mutual fund for more than a year, you pay the concessional long-term capital gains tax. If you are holding an equity mutual fund (any fund that invests greater than 65% of its corpus in equities), then the capital gains tax is nil. In case of debt funds, you need to pay 10% or 20% indexed gains.

Dividend reinvestment option:

There exists a provision in many mutual fund forms which asks you whether you want your dividend reinvested. This was a good provision when there was no tax on dividends and the long term capital gains tax was not zero.

Then, it was better for you to have shown the income as dividend and reinvest it: that way you avoided paying long term capital gains tax.

However, now the situation is reversed — we have zero long-term capital gains tax and there is tax on dividends received. Hence, this option does not make sense under any circumstance — though some fund houses still carry it as a legacy option.

Conclusion

If you have a horizon of greater than a year, then the growth option makes sense for you. Similarly, if you do not have a need for a periodic flow of income, growth option is better for you.

Remember two things from this article: a) dividend is your own money back to you and it may not be tax-free, and b) never choose the dividend reinvestment option.

Next, we will look at the various ways of investing in a mutual fund.

The author is Director, PARK Financial Advisors Pvt. Ltd., Mumbai. He is an IIM-Ahmedabad almunus.

We have seen the advantages of investing in a mutual fund. Now let us look at some of the risks and costs of investing in the same.

Risks of investing in a mutual fund:

The biggest risk of investing in a mutual fund is one of underperformance. When an investor decides to invest in a particular asset class, he typically expects to get the return that the benchmark of the asset provides.

For example, if someone is investing in large-cap equity stocks, he would expect to make at least as much return (with similar risk) as a benchmark index, say Sensex or Nifty.

Mutual funds try to maximise the returns on the funds invested through them — but all of the funds cannot succeed an outperforming each other or the benchmark. Hence, some of them under-perform the benchmark.

Similarly, the cost of investing in a mutual fund (discussed below), eats in the returns. In high return years (like the last few years, where returns have been in the high 30% in equity, 2% costs may not make a material impact: however, at more moderate or negative returns, costs can be a big inch).

The other risk with mutual funds is ‘style drift.’ If you invest in a large cap fund and it begins to invest in mid cap stocks, or if you invest in a long term debt fund but it starts to invest a greater proportion in cash instruments, you might not the type of risk-return reward that you have been expecting.

Change of the fund manager can also introduce an element of risk into your portfolio. There is a wide debate as to whether investing is a science or an art: most authorities concede that it is a blend of the two. If so, the artist may contribute to the success of the returns.

Hence, if you invest based on the ability of a fund manager who decides to move on, it presents you with a risk. Change of a fund manager can also cause style drift.

Costs of investing in a mutual fund:

Typically there are three types of charges in a mutual fund: entry load, asset management charges and exit loads. As the names suggest, these charges are applicable when you invest, while you are with the fund and when you exit the fund, respectively. You also get hit by the ‘buy-sell spread.’

Entry load:

An entry load is the charge that the fund charges you for marketing and distributing the fund to you. This money is typically paid to your mutual fund broker. This can range from as low as 0.25% (or lower) in case of debt funds to as high as 2.25% in case of old equity funds. Typically, new equity funds require a lot more marketing and distribution effort and in order to compensate your broker for selling you a fund based only on promises, the entry load is higher (up to 5%).

Now you may say that when you invested in the last new fund offering (NFO), you did not see an entry load. The Rs 1000 that you invested showed as 100 units of Rs 10 each — how then was the entry load charged (or the broker compensated)?

Well, the fund company creates a Contingent Deferred Sales Charge (CDSC) which is the total expenditure that the company has incurred in launching the NFO. It amortizes this amount daily over the course of 3 to 5 years (the lock-in period) which reduces the NAV slightly every day (but with such a miniscule amount that it is hardly noticeable!)

Asset management charges:

While the fund house manages your money, it needs to incur costs in research, brokerage, salaries of hiring the best talent for you, office rentals and overheads, etc. In order to recoup such costs, the fund house charges you a certain percentage of your assets as asset management expenses.

In equity funds, this typically ranges between 1.5% to 2% of the assets per year while in debt funds, it is typically lower than 0.5%.

If you are investing for the long run, you will realize that a low cost fund (in its category) is the best choice for you. Incidentally, the lowest cost equity funds are ‘index funds’ which manage your assets passively by investing based on an index.

While academic research and mutual fund industry veterans (for example, John Bogle) show that these funds perform better and at lower cost over the long run, these funds seem not to have caught the fancy of investors in India.

Exit loads:

Exit loads are loads that the mutual fund charges you when you leave the fund. Exit loads are charged by some funds on a reducing basis on time: hence the load decreases as time passes. This promotes a long term investment from the investor. Also, the fund may charge you an exit load to recover some of the charges of from you.

Buy-sell spread:

When you buy a fund, you will typically be invited to buy at a premium to the prevailing Net Asset Value (NAV) of the fund. Similarly, while selling some funds might require you to sell at prices below the NAV. Hence, you get hit on both the sides. This spread is limited by SEBI to 6%, but typically the range is much lower, indicating a mature market.

When you buy a mutual fund, be careful: while these are great avenues of investment, you need to know the costs and the risks. Now that we have mastered them, we will look at the taxation aspects of the funds.

The author is Director, PARK Financial Advisors Pvt. Ltd., Mumbai. He is an IIM-Ahmedabad almunus.

Having grasped the basic of mutual funds, let us try to understand why you as an investor would want to invest in them.

Professional expertise: Investing requires skill. It requires a constant study of the dynamics of the markets and of the various industries and companies within it. Anybody who has surplus capital to be parked as investments is an investor, but to be a successful investor, you need to have someone managing your money professionally.

Just as people who have money but not have the requisite skills to run a company (and hence must be content as shareholders) hand over the running of the operations to a qualified CEO, similarly, investors who lack investing skills need to find a qualified fund manager.

Mutual funds help investors by providing them with a qualified fund manager. Increasingly, in India, fund managers are acquiring global certifications like CFA and MBA which help them be at the cutting edge of the knowledge in the investing world.

Diversification: There is an old saying: Don’t put all your eggs in one basket. There is a mathematical and financial basis to this. If you invest most of your savings in a single security (typically happens if you have ESOPs (employees stock options) from your company, or one investment becomes very large in your portfolio due to tremendous gains) or a single type of security (like real estate or equity become disproportionately large due to large gains in the same), you are exposed to any risk that attaches to those investments.

In order to reduce this risk, you need to invest in different types of securities such that they do not move in a similar fashion. Typically, when equity markets perform, debt markets do not yield good returns. Note the scenario of low yields on debt securities over the last three years while equities yielded handsome returns. Similarly, you need to invest in real estate, or gold, or international securities for you to provide the best diversification.

If you want to do this on your own, it will take you immense amounts of money and research to do this. However, if you buy mutual funds — and you can buy mutual funds of amounts as low as Rs 500 a month! — you can diversify across asset classes at very low cost. Within the various asset classes also, mutual funds hold hundreds of different securities (a diversified equity mutual fund, for example, would typically have around hundred different shares).

Low cost of asset management: Since mutual funds collect money from millions of investors, they achieve economies of scale. The cost of running a mutual fund is divided between a larger pool of money and hence mutual funds are able to offer you a lower cost alternative of managing your funds.

Equity funds in India typically charge you around 2.25% of your initial money and around 1.5% to 2% of your money invested every year as charges. Investing in debt funds costs even less. If you had to invest smaller sums of money on your own, you would have to invest significantly more for the professional benefits and diversification.

Liquidity: Mutual funds are typically very liquid investments. Unless they have a pre-specified lock-in, your money will be available to you anytime you want. Typically funds take a couple of days for returning your money to you. Since they are very well integrated with the banking system, most funds can send money directly to your banking account.

Ease of process: If you have a bank account and a PAN card, you are ready to invest in a mutual fund: it is as simple as that! You need to fill in the application form, attach your PAN (typically for transactions of greater than Rs 50,000) and sign your cheque and you investment in a fund is made.

In the top 8-10 cities, mutual funds have many distributors and collection points, which make it easy for them to collect and you to send your application to.

Well regulated: India mutual funds are regulated by the Securities and Exchange Board of India, which helps provide comfort to the investors. Sebi forces transparency on the mutual funds, which helps the investor make an informed choice. Sebi requires the mutual funds to disclose their portfolios at least six monthly, which helps you keep track whether the fund is investing in line with its objectives or not.

However, most mutual funds voluntarily declare their portfolio once every month.

We will look at some of the risks of investing in a mutual fund and the costs of the same in the next article.

The author is Director, PARK Financial Advisors Pvt. Ltd., Mumbai. He is an IIM-Ahmedabad almunus. 

We have seen the basic types of assets into which a mutual fund might invest: equity and debt, and how this choice impacts the risk and return characteristics of the funds.

However, you would have noticed funds which have now evolved and try to provide you with more fine-tuned products in a specialised niche. Equity funds, in particular, like to identify newer or better avenues of investment and hence they create products around those new avenues.

Style of a mutual fund:

Equity

An equity fund can invest in a large-cap, mid-cap or a small-cap stock. You might have heard these words being thrown around rather liberally by all the new funds on offer. ‘Cap’ refers to market capitalisation (M-cap) of a stock. M-cap is defined as the total market value of the equity of a company.

For example, if a company has 1,000 shares outstanding and the price of each share is Rs 20, the market value of the total equity of the company is Rs 20,000 (1,000*20). To exemplify, the market capitalisation of Reliance is approx Rs 200,000 crore (Rs 2,000 billion), while that of Hero Honda is around Rs 15,000 crore (Rs 150 billion).

Large cap, hence, refers to companies which have a large market capitalisation (usually above Rs 5,000 crore). Mid-cap refers to companies whose market value lies between Rs 1,000 crore to Rs 5,000 crore.

Any company with market capitalisation of less than Rs 1,000 crore is called a small cap company. Now different fund houses have different definitions of where a ‘cap’ ends and where the other begins but these are rough bench-marks. One of the biggest selling points currently of the new fund offers is that the small cap companies of today will increase in value so much that they will become the next mid-cap or large-cap companies.

Looking at managing equities differently, we say that the fund manager may pick a growth or a value stock. Growth companies are typically ones which are witnessing high amount of growth in their profits (due to growth in underlying demand, increase in prices, new technology, etc).

These firms command a valuation which is superior to firms with a lower growth potential. Value companies, on the other hand, are in mature industries where they offer more stable cash flows and a reasonable valuation to buy them. Note that in a market downturn, a growth stock can become a value stock if it is available cheap!

A fund manager may decide to invest exclusively in growth or value stocks or in a combination of both.

Based on whichever style is chosen, the fund can be ‘boxed’ into the 3*3 matrix below:

Debt

Debt funds can similarly be classified in to long, medium and short tenor funds. While the definitions are flexible again, long funds typically invest in instruments with maturity greater than 5 years, while short-term funds invest in instruments with less than one year of maturity; medium-term funds invest in the 1-year to 5-year range.

Note that the longer the duration (roughly average maturity) of the investments, the more sensitive it is to interest rate movements. Also remember that the price of bonds varies inversely with interest rates.

On the other axis, a debt fund can invest in high quality instruments like government of India bonds, bonds issued by healthy PSUs, top-notch corporates, etc. It can progressively lower its investment quality by investing in not-so-stable corporates or in fixed deposits of co-operative banks. The advantage of lowering credit quality is higher expected returns (with the increased risk of default).

Based on whichever style is chosen, the fund can be ‘boxed’ into the 3*3 matrix above.

Theme of a mutual fund:

A mutual fund can create an investment philosophy around which it wants to invest. In India, this is typically seen around equity funds. A theme serves both the parties: it provides the investor with a specific or new opportunity while providing a new ‘buzz’ to the asset management company. Some of the themes are as follows:

• Sector-specific investments: investment in companies of a particular sector, like pharma or banks or IT
• Investments in a specific segment of the market: large-cap, mid-cap or small-cap
• Investment in a specific asset type: real estate mutual funds will invest in property
• Specific opportunity: The India Growth and Economic Reforms (TIGER) fund of DSPML plays on this opportunity where they bet on companies that will benefit from either India’s growth or general economic reforms or both.
• Tax-related investments: investment with a specified lock in and investing in equities to take advantage of tax incentives.

Styles and themes have their own risk-return profile which is more fine-tuned than the broad asset class. You need to be careful when you choose the style or theme: ensure that these meet your risk-return requirement.

In the next article, we will look at the benefits of investing through a mutual fund.

The author is Director, PARK Financial Advisors Pvt. Ltd., Mumbai. He is an IIM-Ahmedabad alumnus. 

It is almost always assumed that anyone reading an analysis on mutual funds (or the fund management industry) knows the intricacies of the same. This is not universally true and, at all times, there are a) new people trying to understand the basics, and b) people who want to brush up their knowledge of the fundamentals.

We will use this 6-part series to understand mutual funds from their very basic concepts. Here is the first part.

What are mutual funds?

If we break the phrase ‘mutual funds’ and analyze the words, we realize that it refers to funds that are raised and invested mutually, i.e. on behalf of everyone participating in the scheme. If you and your friend both pool your money and invest it jointly, you have created your own mutual fund.

When the concept of companies initially formed, people who knew each other and were willing to take the risk of the venture used to put in the share capital of the company. Slowly, entrepreneurs realized that many are interested in investing financially in the company but do not want to take the day-to-day hassle of managing the company. Thus began the concept of passive investing in companies: with shareholders and executives separated.

Similarly, in the case of mutual funds, people are not interested in the day-to-day management of the funds but are interested in the final outcome of the investment. Hence, they pool their money together, hire an investment manager who manages funds for them and expect to earn a return on them.

Interestingly, while the process started from the point of view of the investor and the fund was the outcome, in today’s time, it is hard to see the reality this way. With rampant (mis?)marketing of the mutual funds, it seems as if the funds came in first and they want the investor money to increase their assets under management.

How do the funds raise money?

The asset management companies (AMCs) that manage the mutual funds define avenues where they think profitable opportunities exist. For example, currently many AMCs believe that small and medium cap stocks will yield significant return over the medium to long term. Hence, they launch a ‘fund’ (called a new fund offer: NFO) which seeks to bring all those investors together who believe similarly.

The AMC releases a prospectus wherein it details the objective of the fund, the credentials of the company and the fund manager and the avenues where the money will be invested. Based on this information, the investor needs to decide whether this fund meets his objective or not. If the investor (or his advisor) believes that the new fund fits his required risk-return profile, the investor invests in the fund.

You might wonder that you have never seen a prospectus but only an application form for investing. Well, sometimes you give the authority to your financial advisor to choose what is best for you (and sometimes, when you lose control, s/he just chooses on your behalf!)

Where do mutual funds invest?

Mutual funds, unlike companies do not take the risk of a business directly. For example, Reliance faces the risk of change in refining margins and Hindalco faces the risk of fall in aluminum prices. Companies take the risk head-on and craft strategies to maximize their competitive position and profits.

Mutual funds, however, take one step back and invest in the companies which take on business risks. Funds which invest in the shares (or equity) of the company are called ‘equity mutual funds.’ Funds like PruICICI Power or Reliance Growth are examples of such funds.

Similarly, funds can invest in government securities (bonds issued by central or state governments, PSUs or other government entities) or corporate debt (issued by companies and banks). These funds are called ‘debt funds.’ Funds like Reliance Income Fund invest primarily in medium and long-tenor debt. Again, there are funds that invest in very short term loans (typically overnight to up to three months): these funds are called money market mutual funds. Examples include HDFC Cash Management – savings plan.

While the above three are the basic avenues for the funds to invest, many funds combine the three types in various proportions and produce ‘hybrid or balanced funds.’ HDFC Prudence and SBI Magnum Balanced are examples.

Based on where the funds invest, they expect returns and have corresponding risks. Equity funds are the most risky followed by debt funds; cash funds are considered almost risk less. Based on the standard theory of finance, the riskiest funds are expected to deliver the highest returns over the long run.

In the next article, we will look at the various styles and themes on which mutual funds raise money.

The author is Director, PARK Financial Advisors Pvt. Ltd., Mumbai. He is an IIM-Ahmedabad almunus.