Last month we suggested getting started on personal financial planning and mentioned the investment avenues available. In this issue we take a look at one of first investments you can begin with – mutual funds (MF).

Mutual funds pool money to make investments, thus, allowing each unit holder the benefit of the entire investment portfolio, for the share of money you have put in. There are fund managers who manage the investments, trying to ensure best returns for the investor.

Let us introduce you to the different classifications of schemes, before touching upon choosing one that is most suitable for you.

Functional Classification

In an open-ended scheme, an investor has the flexibility of entering and exiting at will at prevailing NAVs (net asset values), with or without an exit load (fee collected at the time of withdrawal). Such schemes offer liquidity. On the other hand, closed-ended schemes, have to be held for a fixed period. Some of these are listed on the stock exchanges, to offer liquidity.

Portfolio Classification

Equity schemes are the most common in any fund house as these are the instruments that offer maximum returns amongst mutual funds. They invest a large percentage of their corpus in equity, either in diversified sectors or in specific sectors, as per their fund objectives.

Debt schemes are also called liquid funds and these invest for the short term or for fixed income (like Government of India bonds, corporate debt and treasury bonds). These schemes are safer than equity schemes since they have fixed returns.

Balanced schemes invest a part of the corpus in debt and part of it in equity, making it reap the benefit of both.

Special Classification

Tax saving schemes or equity linked savings schemes (ELSS) enable the investor to claim relief under Section 80 C for income tax and are locked in for 3 years.

Sector specific schemes are those that invest in specific sectors like banking, pharmaceuticals, infrastructure and power.

Some of the special schemes may be the index schemes and special situations funds.

For an investor to make best use of these schemes at any given time in his or her investment history, possessing basic knowledge of how each of these work is essential. MF investments do not carry fixed or assured returns, therefore there is always an element of risk. But the risk is minimised since the funds are all pooled in, there is adequate diversification, there is a fund manager in charge and investments are made after thorough research.

The biggest advantage with an MF is that it allows an investor to start small, the minimum being Rs 5,000 for a one time investment and Rs 500 for a systematic investment plan (SIP). The recent removal of entry load (commission that an investor has to pay while purchasing units) on MF schemes has created a lot of value for the investor – you save the 2.25 per cent that used to eat into the investment. You are spared the marketing push from advisors who try to sell schemes that offer better commissions for the broker.

Checklist before you invest in a fund

Mutual funds are best suited for those who prefer to passively participate in the stock market, who have an investment horizon of over three years, and have already made allocations for fixed returns. Here are a few things you have to remember while choosing a fund that works for you:

Identify your goals

Clarity on your goal will help in choosing your fund. For instance, equity schemes work well for longer time frames, and diversified funds give the investor the advantage of exposure to various different sectors.

Your period of investment

While it is best to stay invested in equity schemes for at least a couple of years, if you can remain invested for longer, you can take a higher exposure in equity schemes.

At 25 years of age, you can invest periodically upto 90 per cent of your funds in equity schemes and remain invested for another 10 years. If you are 45- years-old and are looking at a five year time frame, you can place upto 50 or 60 per cent in equity schemes. If you are above 55 years and looking for regular income, you can invest more in monthly income plans (MIPs) and even systematically transfer from your equity schemes saved till then, to safer avenues like fixed deposits.

Assessing your risk appetite

Be sure of the level of risk you are capable of taking. Although MFs are safer than investing directly in the stock market and tracking individual stocks, MFs also invest in shares and thus experience the roller coaster rides of the equity markets. NAVs are just as volatile as the individual stock prices, though the changes may not be so dramatic on a day-to-day basis. Longer time frame of investment reduces your risk.

Choosing between dividends and growth

There are no taxes on dividends from MFs and long term capital gains tax is nil, so the MF investments offer excellent returns compared to fixed deposits or bonds. You can pursue the growth option for a longer term, if you are keen on capital appreciation.

What you need to know about the fund you invest in:

• Though it may a tedious task to go through the entire offer document or research inputs on the various schemes, there are some important points you must study:
• Fund manager’s experience and record.
• Classification of equity schemes into large cap / mid cap / small cap stocks.
• Age of the fund and its dividend record.
• Annualised rate of return that this scheme has posted and how it compares with a fund of the same category and age.
• The Sharpe ratio for the scheme (The Sharpe ratio or measure is a reward to variability ratio, that gives the excess return ( or risk premium ) per unit of risk in an instrument.) A higher Sharpe ratio gives more return for the same risk. You can check with your advisor for this.
• The beta of the particular scheme. This indicates the fund’s price volatility compared to a particular stock market index. It helps gauge how the NAVs of the fund will fare with the movements in the indices. A low beta suggests a safer scheme. Conservative schemes may register a beta of 0.75, which means that when the market declines 10 per cent, your scheme is likely to decline only by 7.50 per cent. If the beta is 1.25, then in the same situation, the scheme will register a drop of 12.50 per cent.
• The expense ratio of the scheme. Expense ratio looks into the cost of owning the scheme (as against cost of buying or selling the scheme, which will be the load). This ratio covers all the administrative costs that get factored into the NAV. If a scheme has a higher expense ratio, it means that more of your money is going to cover the costs, than towards buying the shares for investment.

Mutual funds offer attractive returns, and you must make it a part of your investment portfolio. More exciting times are ahead for the investor as MFs will be available in an online platform called Mutual Fund Service System (MFSS), which is opened by the National Stock Exchange. It has received encouraging response with about 100 brokers entering into tie-ups, around 18 trading members are already registered in MFSS as participants.  The brokers will be able to transact for investors in a manner similar to equity transactions, thus speeding up the processes, making it cheaper and more beneficial to the investor.