Want To Know What To Know?
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Everybody in the world wants to maximise his/her wealth. Another very important observation to make along with the first one is that, equity is the only asset class which outperforms all other asset classes in the long run. However, very few people prefer investing in equity. This is because, investments in direct equity are highly volatile and a wrong stock-picking may result n destruction of capital leave aside earning good returns. Wealth creation from investing directly in stocks depends a lot on investor’s knowledge, patience and time dedicated to the investments. However, most retail investors lack in most of these per-requisites and hence avoid investing directly is equities. However, the indirect route or rather the retail investors route to the markets is what Mutual Funds are known as. This route offers several important advantages over direct stock-picking. But, before you get into it, here are some specific notes on what to keep in mind while investing in MFs.
Pre-requisites of Mutual Fund Investments
A Mutual Fund Scheme is a portfolio comprising of several companies which have their own risk-return profiles. Further, through the MF route, one can also invest in other asset classes such as debt, gold or a mix of debt and equity. Mutual Fund investments are less volatile due their very nature where they hold a variety of stocks in their portfolios. This largely smoothens out uneven movements in certain counters even if they happen. Further, MFs offer investors a balanced return, compared to the direct equity investments. But, the selection of the right MF scheme out of hundreds of them available for subscription is a difficult and time consuming task. As a process one has to first identify his/her investment objective, time horizon of investment and risk appetite to arrive at an investment plan. Here are some of the dos and don’ts for selecting schemes.
The first and foremost activity to do is, to clearly identify your goals. There has to be clear choice between Capital appreciation and regular income. Accordingly, the investor needs to allocate his/her savings in various schemes. Identifying goals will automatically help in trimming down the list of schemes to select from.
Further, investors must also consider their financial risk appetite while selecting fund schemes. Is he comfortable with dramatic swings in the portfolio value or is he conservative on the returns? The former can lead to good capital appreciation but also carries the risk of a sudden dip in value.
Finally, the time horizon for the investment is also equally important while investing in fund schemes. The time horizon for the investment depends on the liquidity position of the investor. Equity mutual fund holders should ideally remain invested for at least five years or more in order to make good and consistent returns on their investment.
While selecting and analysing an individual mutual fund scheme, investors need to keep on eye on various factors such as charges & fees, management track record, portfolio allocation, etc. Mutual Funds earn their income by charging various fees such as fund management fees, entry load fee, exit load fee, administrative charges, etc. The fee charged by fund houses to manage and operate the fund is commonly known as an expense ratio. Hence investors should look for the management expense ratio. The higher the ratio, the lower the investor’s return will be at the end of the year. Hence it is very important to look out for well managed funds which have a low expense ratio.
Fund schemes backed by a sound Asset Management Company are an ideal pick compared to unknown schemes available in the domestic market. The AMC management should be competent enough to manage the funds’ activities even if the fund manager leaves the AMC. Further, investors should find out the details about the fund manager who will be managing the scheme. Investors can find answers to these questions by checking upon the historical track record such as
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- Did the fund manager deliver returns that were consistent with general market returns?
- Was the scheme’s return fluctuating more as compared to the broad market indexes returns?
- Was there an unusually high churning in the scheme’s portfolio?
Ideally, the fund manager should have seen through a few business cycles to understand market movements.
This information provides an insight into how the portfolio manager performs under certain market conditions, as well as what historically has been the trend in terms of turn-over and return. Having said that, it pays to keep in mind that, past performance is no guarantee of future results. Knowing the fact that equity funds deliver superior returns only over the long term, it is important that investors should not get biased by a scheme which has delivered excellent returns over a short time period of say six months or a year. Every equity mutual fund scheme has its own investing theme and comparable benchmark index. Investors should always prefer schemes which have outperformed its bench-mark returns.
Finally, one should look at where your money is going to be invested. In simple terms, while you have shortlisted a fund scheme, study its portfolio allocation. Understand the quantum of funds invested in the various categories and stocks. The portfolio allocation study will help investors understand the risk carried by the scheme.
Misconceptions in Mutual Fund Investing
Having discussed the pre requisites of Fund investing here are some common misconceptions about MF investing especially among the retail investors.
1) New Fund Offers are better than existing funds
As explained earlier, before making any investment, it is essential to complete the above state exercise of researching the track record of the fund house and checking on the fund managers expertise. Looking at the consistent track record during various market cycles tells you a lot about the fund manager’s expertise and hence one can expect similar results in future too. However, the NFO loses out on this aspect. Further, the NFOs generally charge higher fees to recover the costs associated with initial marketing, publicity, and commissions that need to be given to agents and distributors. Many investors believe that an NFO offers good opportunity to invest in a fund scheme at its par value. That does not make sense, because positive returns from a fund scheme depend on the constituents of the portfolio, sectoral investments, etc. and also a lot on the way the portfolio is managed. Hence it is important to check out on the uniqueness of the NFO as to what exactly it offers which is new. For example, a real estate investment, a silver or Gold ETF, or an overseas fund in a specific sector, a new asset class that existing funds don’t have in offer. However, please remember that investor must cross check whether the fund scheme matches their investment objective and risk appetite. To sum up, as an investor, it is a prudent strategy to invest in existing fund schemes unless the NFO is really offering something new and looks compelling as NFOs carry higher risks due to lack of past track record.
2) A mutual fund with a lower NAV is better than a fund with a higher NAV
Fund schemes with a lower NAV frequently look attractive to investors. One must remember that when investors invest in a fund scheme, they invest in its existing NAV. The investors buy units at NAV which is calculated on current market price of constituent assets. Thus it is the constituent stocks in a portfolio that determine returns from a fund, the value of the NAV being immaterial. In any mutual fund investment, investors ideally want to buy in the scheme’s performance. Hence, the NAV makes no difference to returns.
3) The dividend option is better
While investing in a mutual fund, investors can choose between the growth and the dividend options. A common misconception is that opting for the dividend option is better, as it provides better returns on account of dividends declared. Most of the investors think that they will earn better dividend adjusted returns compared to the returns in the growth option. However, past experience says that, most of the times, opting for a dividend option does not give better returns, when compared to the growth option. Finally, the investors’ investment objectives and liquidity needs play an important role in deciding which option is chosen. Ideally investors looking out for regular income only opt for a dividend option. Otherwise, growth option is always advisable in the rest investment objectives.
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4) Mutual funds lack excitement
Direct stock investing has always been more fascinating than mutual fund investments. Individual stocks tend to give 50, 100 or 200 per cent returns in a year in a bull market. However, these kinds of returns are practically impossible in mutual funds in a short term. This under performance of MF schemes vis-à-vis direct equity plays heavily against the funds. Everybody in the world wants to see his/her money grow at a faster pace and if equity does this for them, the propensity will naturally be to invest directly in equities rather than doing it through MFs? Definitely, stocks do excite investors. However, bears will ensure that your wealth erodes at a far faster clip when they take over in case you have gone the direct equity route. Direct equity investments may show considerably negative returns in very short time period too. However, the performance of the mutual fund is not as fluctuating over a short term thereby preventing investors’ capital from deteriorating.
5) Mutual funds are too diversified
One of the biggest differences between es direct equity investments Shar and mutual fund investments is diversification. Bond s Debt In fact, one of the biggest advantages of MF investing is the automatic diversification that comes to investors. This is something which is not possible while investing directly in equity. It has been observed that investors tend to get obsessed with winners and are thereby tempted to buy more. Over time, they keep adding the same stock, resulting in an increased allocation to these stocks in their portfolio. This will increase their portfolio performance dependency on performance of these stocks increasing the risk associated with their portfolios. However, this does not happen to mutual fund investors normally.
6) Investing in many funds is better
Normally, a single mutual fund scheme invests in at least 30 to 40 stocks, thus helping investors diversify. Experts always recommend investors to bring down the number of funds in their portfolio. An investor should invest in a maximum of 4-6 good quality funds across debt and equity asset classes in various categories. Investing in few mutual fund schemes helps in better tracking.
Take a SIP – A Prudent Strategy to Invest in the Equity Market
It is frequently observed that investors try to time the market. Everybody in this world wants to buy at the lows and sell at the highs. However, this is practically impossible as nobody in this world can predict the bottoms and tops of the market accurately. Hence for wise investors, who are willing to invest for a longer duration (more than five years) for their financial planning objectives, timing the market is not a prudent strategy. Experts always believe that one should invest regularly to meet his/her investment objectives. And the effective and a hassle-free way of investing regularly is through Systematic Investment Plans (SIPs). Through a SIP, investors need not worry about timing the market as they are investing a fixed amount regularly at fixed intervals such as a week, month or a quarter. Furthermore, investors always have the option open to invest surplus amounts to get a lower average cost when the market corrects further. The SIP route provides investors various advantages such as light on the wallet, irrelevant market timing, and power of compounding.
We have made an elaborate attempt to arm our readers with all that is necessary to get ready and make some profitable investments through the MF route. But as they say, you are your best judge. Read the offer documents carefully, remember, mutual fund investments are subject to market risk.