Pick Right From The Fund Pool
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The sheer diversity of options in the mutual fund market can leave investors befuddled and at a loss as to which funds to pick. Mehrab Irani, General Manager-Investments, Tata Investment Corporation, helps you decide.
Choice is a big problem today – whether at the time of earning, spending, investing or insuring. There is a plethora of choices available, and this can lure us into making inappropriate decisions. Very often, rational, intelligent people commit simple mistakes while making investment decisions in common stocks, and this gets compounded while investing in mutual funds. The mistakes start right from the point of initiating an investment decision by committing your money to the wrong fund.
So, how do you decide which are the best funds for you? Let me attempt to help you in making your choice.
Funds are classified into various categories based on:
- Liquidity – open and close ended; or
- Asset allocation – debt, equity, balanced, commodity; or
- Maturity profile of the underlying investments – liquid, income, gilt, equities, etc.
Without confusing you, let me make a very simple attempt to help you understand what is required for your decision making purposes.[PAGE BREAK]
Types Of Mutual Funds
Liquid/Ultra Short Term Plans
Liquid/Ultra Short Term Plans are best suited for those investors who have a very short investment horizon ranging from one to a few days. In fact, this is not investment but just parking of ‘surplus liquidity’ at one’s disposal. It is a superior alternative to a ‘bank saving account’, allowing you to earn a higher yield. Although these funds don’t carry any interest rate risk, they certainly carry credit risks. The aim of the investor should be to earn accrual interest.
Short Term Plans
Short Term Plans invest in similar kinds of instruments as Liquid Funds do, but with a slightly higher maturity profile. Hence, these funds are best suited for investors with an investment horizon of between three to 12 months. These funds find a place somewhere between a bank savings account and a fixed deposit. These funds carry credit risks as well as some amount of interest rate risk. The investor’s aim should be to earn accrual interest along with some capital gains.
Income/Gilt Funds
Income Funds invest primarily in longer duration corporate papers with some Government of India Securities (GSecs), while Gilt Funds invest only in GSecs. These funds are best suited for investors who have a very short investment horizon ranging from one to a few days.
Interest rates and bond prices have negative relation, i.e. bond prices go up when interest rates come down and vice versa. Hence, timing is critical in case of these funds. The aim of the investor should be to earn accrual interest as well as capital gains.
Fixed Maturity Plans
A Fixed Maturity Plan (FMP) is for a fixed period of time, and hence, locks in at the prevailing interest rate for that period of time. Therefore, it does not have any interest rate risk. However, an FMP has a very high ‘opportunity loss risk’ in the sense that if you lock in yourself into a long term FMP just before the beginning of an interest rate hike cycle, you will lose the opportunity of earning higher yields. Therefore, investments in FMPs should ideally be made at the peak of a short-term policy interest rate hike cycle.
Balanced Funds
As the name suggests, a Balanced Fund invests in both equities as well as debt, and hence, it balances your asset allocation needs. Though the name of the fund is ‘balanced’, in reality it is the most imbalanced of all the funds as it takes the credit of protecting and shielding your money from the major investment robbers – inflation, income tax, interest rates, market volatility and asset allocation. Investors should aim to earn attractive returns during bull markets and stabilise their portfolio during bear markets.[PAGE BREAK]
Equity Funds
Equity Funds invest in equity shares. Over a longer period, equities provide higher returns than fixed income instruments as equity is growth capital. However, timing is important in the markets, and you should possess the courage to buy during cyclical bottoms and sell during structural tops.
There are different types of schemes like large cap, mid cap, small cap, sector funds, theme funds, etc. Many new funds and schemes crop up during times of exuberance. For example, banking funds are launched when banking stocks have performed well, infrastructure funds when the infrastructure stocks are rising, IT funds when a technology boom is underway, and so on and so forth. These sector funds are simply smart tactics to collect money from gullible investors.
Remember that there is no reason to believe that one can pick winning stocks or time the markets. The best solution for any equity investor is to stock up low cost passively managed index funds. Year after year, they would beat at least 75 per cent of the actively managed funds and would, in all probability, beat almost all the funds over the longer term.
Gold Funds
Gold Funds and ETFs are now widely available for the Indian MF investor. These offer ease and safety of holding gold in an electronic format as opposed to the physical format. They also offer tax benefits as they are not subjected to wealth tax and become long term capital assets in one year (as against three years in the case of physical gold).
Investors must remember that the returns on investment in Gold ETFs are as good or bad as investing in the yellow metal itself because the fund holds gold for you. Hence, your view on gold is of paramount importance. I will not try to predict the future price of gold here, as it is a speculative commodity with no real industrial usage. Its value depends on the value of the US dollar and the real interest rates in the US, which in turn depend on nominal interest rates and inflation over there. To add to this is, of course, the value of the Indian rupee against the US dollar.
International Funds
Nowadays, there are many international funds on offer like the feeder funds, where the Indian fund house just acts as a ‘postman’ – collecting funds from Indian investors and putting it in their international funds. There are also ETFs on foreign markets now available in India. Needless to say, if it is difficult to predict the Indian markets then it would be even more difficult to predict foreign markets. Besides the pure returns from those funds, currency plays a major role – the thumb rule being that the weaker the Indian rupee against the US dollar, the higher the returns to the Indian investor.[PAGE BREAK]
| Scheme Name | Category | Investment Time
Horizon | Type Of Risk | Intensity Of
Risk | Return
Expectation | Suitability | Comments |
|---|
| Liquid/Ultra Short Term Plans | Fixed Income | Very Short Term | Credit Risk | Very Low | Low | For parking surplus funds | For temporary parking of funds – a superior alternative to bank savings account. |
| Short Term Plans | Fixed Income | Short Term | Credit Risk & Moderate Interest Rate Risk | Low | Comparatively Low | Opportunistic superior returns for short term funds | For short term better investment in an inverted yield curve scenario. |
| Income/Gilt Funds | Fixed Income | Medium-to-Long Term | Credit Risk & High Interest Rate Risk | High | Medium to High | Opportunistic superior returns for medium to long term funds | For medium-to-long term opportunistic investment in a steep yield curve scenario. |
| Fixed Maturity Plans | Fixed Income | Medium-to-Long Term | Credit & Yield Curve Risk | Low | Comparatively Low | Fixed return for fixed duration | As a superior tax saving alternative to bank FDs. Ideally done at the peak of policy interest rate hike cycle. |
| Balanced Funds | Hybrid - Equity + Fixed Income | Medium-to-Long Term | Credit, Interest Rate & Stock Market Risk | Medium | Medium to High | Ideal for asset allocation | Balance of risk, return and asset allocation with maximum tax advantages |
| Equity Funds | Equity | Long Term | Stock Market Risk | High | High | For long term wealth creation | Moderate risk for superior returns – higher risk and tax adjusted return. |
| Gold Funds | Commodity | Long Term | Commodity & Currency Risk | High | Medium to High | High risk for higher inflation-adjusted returns | For betting on the movement of a commodity and currency. |
| International Funds | Primarily Equity | Medium–to-Long Term | Global Stock Market & Currency Risk | High | High | For diversifying into difficult asset classes along with assuming currency risk | High unknown and immeasurable risk in expectation of better returns. |
[PAGE BREAK]Conclusion
There are many simple and avoidable mistakes that people commit while investing in mutual funds. Simple logical steps work far better in the market place than complex algorithms, theorems, valuations, principles, DCF, etc. Returns from investment come only because of two numbers – cost and selling price. Through this article, I have tried to explain the cost price factor by telling you which funds suit your requirements.
There is no better place to test your virtues than the market – be it common sense, logical thinking, patience, perseverance, mental balance, emotional intelligence, ability to perform under stress, etc. All the qualities that make a successful human being will be tested by the market, which has its own method of finding and exploiting human weaknesses. Investing is not about beating the market or anyone else – it is simply beating your own self and your negative traits. Once you are able to master your own self and become a complete human being, you would also become a successful investor.
Articulate your investment goals, know your time horizon, recognise your risk appetite, understand your need for income and growth, invest regularly though it may be in small lots and do your thinking and research. Once you have done all this, don’t panic just because the market went against you. Accept your mistakes and flaws, and follow these simple rules and principles to select the fund that suits you best. Stop making mutual funds, portfolio managers, brokers, distributors, rating agencies, media, etc. rich with your hard earned money. If you follow these simple principles, you would be able to generate above average returns from your investments repeatedly, putting the best fund manager to shame. All the best!