This article explores some aspects/critical factors while picking a mutual fund that suits your risk appetite & allows your money to work for you.
‘Mutual funds sahi hai’ has been the star campaign for mutual funds to gain attraction over the years. While I am not a fan of mutual funds myself, it goes without saying that there are millions of Indians who trust mutual funds with their savings and have indeed made great returns. For the uninitiated, mutual funds are basically a vehicle through which a company pools in small sums of money from a large number of investors making it a huge corpus of funds and investing in different asset classes, which I have elaborated on later in the article, in order to give them good returns.
The total Assets Under Management (AUM) of the Indian Mutual Fund industry as of 30th September 2020 stood at a whopping Rs. 26.86 lakh crore. In order to put things in perspective, the total AUMs 10 years ago was Rs. 6.57 lakh crore which implies a Compounded Annual Growth Rate of more than 15% against a GDP growth rate of 5.6%. So yes, ‘mutual funds sahi hai’ for a majority of investors. Mutual funds inculcate the habit of savings which is extremely essential for all sections of society (well, maybe the uber-rich might still be excused).
While investing directly in mutual funds, many investors don’t actually know the risks behind it and whether it would suit their risk-taking appetite or not, as opposed to regular (via intermediaries) investing in mutual funds. This article emphasizes the more critical aspects which investors without having any requisite financial knowledge should check before making an investment decision, instead of the usual risk appetite and return requirements most of us consider.
Investors should look at the historical performance of the fund manager and his style of managing funds – active or passive. In laymen’s terms, active management basically means buying and selling frequently in order to outperform the benchmark index, which differs for every manager but usually means the NSE Nifty-50, or BSE Sensex. While passively managed funds replicate a specific index, which implies that there is no active selection of investments in an attempt to BEAT the market, but instead just mimic it. Investors must compare the annual returns of actively managed funds with the index returns after deducting the fees charged by the manager. If the fund is consistently generating extremely higher returns than the benchmark, then investors must tick this box, and move on to the other factors.
Some mutual fund categories have a lock-in period, which is the period during which investors are restricted to redeem or sell their investments.
An exit load is a fee charged by mutual funds when investors want to redeem their investments (partially or fully) before the lock-in period is over. This is essentially done to discourage investors from redeeming their investments at an earlier date. This charge is usually a percentage of the Net Asset Value (NAV) of the mutual fund which the investor possesses.
It is to be noted that the exit load is charged even if the value of the investment has fallen.
Now, this is one of the more technical factors, but an extremely essential one too, so stay with me. It is the excess return of the fund over the risk-free rate of return (usually represented by the return on government-issued Treasury Bills), divided by the risk taken. This helps investors to understand if a high return is the result of high risk taken by the fund manager and whether the risk taken was worth the returns or not. Investors must compare Sharpe Ratios of different mutual funds and must go with the fund which has a higher Sharpe Ratio, other factors remaining constant.
Investors should check out the class of assets a particular mutual fund is investing in. An equity mutual fund only invests in the equity markets, a debt mutual fund only invests in the debentures of corporates and lastly, a hybrid mutual fund invests in a mix of equity and debt. Under equity mutual funds, there are funds that invest in small-cap companies (the companies which have the lowest market capitalization), mid-cap, or large-cap companies. A mutual fund that invests in a mix of these 3 is called a multi-cap mutual fund. Investors must be cautious while investing in debt mutual funds which promise extremely high rates of return. For example, due to the Yes Bank fiasco, many mutual funds which invested in their AT1 bonds (bonds issued by a bank which promise extremely high returns but can be written off completely if the finances of the bank are in a dire state) faced a big blow as their investment value went down to zero and the ultimate burden was borne by the individual investors.
The purpose of diversification is to reduce risk. In simple terms, diversification is the act of spreading risk across different types of assets (instruments) including stocks, bonds, derivatives, and money market instruments. How much of each type of investment a firm buys, depends on the objective of the fund, i.e. if it is growth, then the fund may have a greater allocation of funds on stocks. On the other hand, if the objective is to pay the investors a steady income, then the fund may have a greater holding in bonds and other interest-paying securities.
It is important to note that diversification does NOT mean no loss. It simply implies a minimization of the loss, if the fund is diversified optimally.
These are some of the critical points which should be kept in mind while choosing a specific mutual fund when you are investing directly. More often than not, investors get carried away by the returns which are advertised by mutual fund agencies and do not take other factors into consideration.
The moral of this article is to illuminate that while it stays true that ‘mutual funds sahi hai’, an investor must take into consideration the above factors, which usually do not come to mind when choosing a fund.
Agar rupaya lagana hai kahi, toh mutual funds hai sahi (this is cheesy s**t, but needed something to make y’all laugh after this informative session).
Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the official policy of any agency, organization, employer, or any company. Fintuned Co. LLP shall not be held responsible in any manner whatsover, for any decision/action taken by readers on the basis of the content mentioned in the article. Readers are requested to exercise their best judgement before taking any decision/action. Fintuned Co. LLP shall also not be held responsible for any copyright infringement committed by the author in the process of writing and/or publishing this article and in the event any such offence is found, cooperate with necessary authorities to take remedial action
Thank you Yuva members for organising such a fun and informative lecture. We enjoyed it a lot. Meeting and learning from Mihir Sir was really an amazing experience. And this is not only our feeling but all the students enjoyed his lecture very much and look forward to many such events.