How to Invest in Mutual Funds ?

Ten years ago if you had started investing Rs 1,000 every month in funds such as HDFC Top 200 or DSP BlackRock Equity, you would have seen your investment (Rs 1,20,000) growing over 6-7 times by now. Both the funds have given around 30% annualised return over the past 10 years.

There are close to 60 such equity schemes that have given over 20% annualised return in the last 10 years. If only you had invested regularly in any one of them, you could have made big money over the years.

In hindsight, it sounds easy to choose one of these funds and keep investing in them for as long as 10 years to reap the benefits. However, the toughest part in making an investment decision is selecting the right product be it mutual fund schemes, stocks or commodities.

Besides, there is danger in choosing a product purely based on its past performance without giving much thought to other factors such as charges, downside risk, consistency of performance et al. Mutual fund investors often make the mistake, egged by unscrupulous financial advisors, of latching on to a mutual fund scheme that has given very high returns in very short time.

Based on the investment plan, the category of funds should be chosen from debt, equity or hybrid

category. Within a category the right scheme can be selected based on criteria such as past performance of the scheme, comparison with peer set and benchmark, volatility measures and risk adjusted performance of the scheme, scheme size, expense ratio of the scheme.

Standard deviation (SD): Standard deviation measures the volatility of the returns from a mutual fund scheme over a particular period. It tells you how much the fund's return can deviate from the historical mean return of the scheme. If a fund has a 12% average rate of return and a standard deviation of 4%, its return will range from 8-16%.

Sharpe Ratio: This measures how well the fund has performed vis-Ã vis the risk taken by it. It is the excess return over risk-free return (usually return from treasury bills or government securities) divided by the standard deviation. The higher the Sharpe Ratio, the better the fund has performed in proportion to the risk taken by it.

Alpha: The simplest definition of an alpha would be the excess return of a fund compared to its benchmark index. If a fund has an alpha of 10%, it means it has outperformed its benchmark by 10% during a specified period.

Beta: It measures a fund's volatility compared to that of a benchmark. It tells you how much a fund's performance would swing compared to a benchmark. A fund with a beta of 1 means, it will move as much as the benchmark. If a fund has a bet of 1.5, it means that for every 10% upside or downside, the fund's NAV would be 15% in the respective direction.

Consistency is key: Will you invest in an equity fund that gave over 100% returns at a time when the equity markets were witnessing a secular bull run but showed a sharp drop in net asset value (NAV) when the markets were volatile? You don't want a fairweather friend, do you? A good mutual fund scheme is one that consistently manages to outperform its benchmark over 3-5 years.

"Look for consistency in performance over longer tenures like 3, 5 and 10 years, if that is available, rather than the short-term returns. Select schemes that have consistently beaten their benchmark indices (index to which a fund's returns are compared) and compare reasonably with their peer set over the above time frames," says Ajit Menon, executive vice-president and head of sales, DSP BlackRock Investment Managers.

RISK-RETURN TRADE-OFF

Investments in most securities come with a degree of risk and if returns are not in proportion to the risks taken, it is not worth going for such investments.

A good mutual fund is one which gives better returns than others for the same kind of risk taken.

Risk-adjusted returns are evaluated against return given by a risk-free instrument- usually government-backed debt papers or term deposits of banks.

One of the indicators of risk-adjusted return is Sharpe Ratio, which is excess return given by the fund over return given by a risk-free instrument divided by a statistical term called Standard Deviation, which tells how volatile the returns of the fund have been over a period. The higher the Sharpe Ratio, the better the risk-adjusted return is (See Know the alpha, beta of your fund).

PORTFOLIO DIVERSIFICATION

By its very nature, mutual funds are supposed to provide diversification across different asset classes, stocks, sectors and even geographies. A diversified portfolio has lower risk than a portfolio biased towards a particular stock, an asset class or a sector.

Equity: Multi-cap

The average three-year return of this category as on March 31, 2011 was 7.33%, against 7.2% of Nifty and Sensex. The toprated funds in this category (barring the index funds) comfortably outperformed their respective benchmarks during the three-year period.

Franklin India Bluechip Fund, DSP BlackRock Top 100 Equity and ICICI Prudential Top 100 Equity are three 5-star rated funds in this category with 14.20%, 13.41% and 12.35% annualised return respectively during the three-year period ending March 31, 2011.

In the large and mid-cap category (exposure to large caps at 60-80%), HDFC Top 200 emerges as the best fund with a 10-year track record during which it gave an annual return of 31.66%. In the three-year period also, it topped the category with 17.46% return. No surprises for guessing, therefore, that it's a 5-star rated fund.

Equity: Tax Planning

All top 10 funds in this category gave double-digit returns in the three-year period ending March 31, 2011.

However, the biggest gainers are from the multi-cap and mid & small-cap categories. The simple reason for this is the higher allocation to mid and small-cap stocks, which sees a sharper rise (or fall) in rising (or falling) markets.

In the multi-cap category, HDFC Equity topped with 19.55% annualised return in the three-year period ending March 31, 2011, followed by UTI Dividend Yield (19%) and Quantum Long Term Equity (18.17%). In the mid and small-cap category, ICICI Prudential Discovery, Birla Sun Life Dividend Yield Plus, IDFC Small & Midcap Equity and ING Dividend Yield managed regular gains of over 20% annually in the three-year period.

Hybrid funds: Debt-oriented conservative

In the tax-saving category, Canara Robeco Equity Tax Saver, HDFC Taxsaver and Fidelity Tax Advantage Fund grabbed the 5-star ratings with over 15% annual return over the past three years. Seven taxsavings funds in the top 10 have been in existence for over 10 years and each of these seven funds have given over 20% annual return during the 10-year period ending March 31,2011.

This makes them one of the best tax-saving options available to you. Sadly, from April 2012, these funds would cease to exist thanks to the new Direct Taxes Code.

Among the hybrid funds, which have a combination of debt and equity instruments in their portfolio, Reliance MIP and HDFC Prudence emerged as the best funds in the debt-oriented and equity-oriented hybrid fund categories respectively. The hybrid fund category is gaining popularity and significance with most goal-based and asset allocation schemes such as child plans, monthly income plans and retirement plans belonging to this category.

Hybrid funds: Equity oriented

In the debt category, we have rated funds that are more relevant to retail customers than the institutional investors. Among debt funds we have rated funds in the short term, income and liquid fund categories.

In these categories small and medium fund houses such as BNP Paribas Mutual Fund, DWS Mutual Fund and Sahara Mutual Funds have performed better than many large fund houses.

If invested systematically, mutual funds could prove to be great tool for long-term wealth creation. In our story, Go for a Regular Exercise, we once again reiterate the virtues of long-term systematic investment in mutual funds. There are as many as 60 funds (check the mutual fund listings) out of 570-odd equity schemes that have given more than 20% annual return in the past 10 years. Most of these funds feature among the top 10 funds in their respective category.

Debt: Income

What amazes though is the sheer dominance of a few fund houses in the list of toprated schemes. Barring a few small and midsized players such as Quantum Mutual Fund, Taurus Mutual Fund Sahara Mutual Fund, ING Investment Management, Principal PNB Mutual Fund and Canara Robeco Mutual Fund, most of the 4 and 5-star rated funds are from larger fund houses such as HDFC Mutual Fund, DSP BlackRock Mutual Fund, Franklin Templeton Mutual Fund, ICICI Prudential Mutual Fund, Reliance Mutual Fund, Fidelity Mutual Fund and UTI Mutual Fund. In our story, Small Funds, Big Returns, we look at some of the schemes of small fund houses that have been keeping pace with the funds of larger AMCs in terms of overall performance. We will also discuss the pros and cons of investing in smaller fund houses.

A fund's performance is a function of many factors and the biggest of them all is the abilities of the fund manager. Despite all processes and systems in place, a fund manager has the biggest influence on a fund's performance. In our fund manager's section View from the Driver's Seat, we tried to nudge the 'star' fund managers to reveal a few tricks of their trade. We managed to convince some, but a few politely asked us to 'excuse' them.

Debt: Liquid

Since fund managers play a crucial role in active fund management, their failure to deliver could prove costly for thousands of investors. For those who want to nullify this risk (also called fund manager's risk), index funds (or exchange-traded funds) could be a good option.

Index funds are passively-managed funds, which build its portfolio with stocks of a particular index in exactly the same proportion in which the index has been formed. This limits the fund manager's role to merely replicating the index. We have done a comparative study on index funds vis-Ã -vis actively managed funds in our story, Sidestepping the Fund Manager and tried to get the answer whether they yet have relevance in India where actively managed funds are consistently outperforming their respective benchmarks.

 Ranking Methodology

There were 11 fund categories considered for this study primarily from the point of view of the interests of the retail investors.

Five of them are from the equity category: large cap, large and midcap, mid and small-cap, multi-cap, and tax-savings; two from hybrid: equity-oriented and monthly income; and three from the debt category: short-term, income and liquid funds. We considered past three years data for equity and hybrid funds, and past 18-month data for debt categories.

SIPs best way to create wealth via mutual funds

The idea here is to invest in such a way that your purchasing power is always more than what the rate of inflation is able to destroy.

They inculcate discipline in investors, help negotiate volatility in the long run.

At the very basic, wealth creation refers to the process of deploying your money in a manner that there is real-value accretion over the long run. In other words, you should deploy your savings in such a way that the rate of return on your money beats the rate of inflation.

For example, today you spend Rs 100 to buy Product A. Now the rate of inflation in the economy is, say, 8% per annum. So we can assume that one year from now, the cost of the same Product A will be Rs 108. So to create real value, you should deploy your Rs 100 today in such a way and in such products that after a year, after paying for taxes if any, you should still have more than Rs 108. If your savings after one year is just Rs 108, you have not created any value, while if the value of your savings is less than Rs 108, you have actually destroyed value in real terms.

The idea here is to invest in such a way that your purchasing power is always more than what the rate of inflation is able to destroy. It is true that you may not be able to beat the rate of inflation in the short term, like in every year. But the aim should be to beat the inflation rate over the long term, that is over 10, 15, 20 years.

In India, over the past several years, stocks, gold and real estate have beaten the rate of inflation, while instruments like bank fixed deposits and bonds have not been able to do that in any significant way. So financial planners advise their clients, who are not very financially savvy, to take the equities route for wealth creation with some parts of the money going into debt, gold and real estate.

What is Systematic Investment Plan or SIP?

SIP works on the principle of regular investments. It is like your recurring deposit where you put in a small amount every month. It allows you to invest in a MF by making smaller periodic investments (monthly or quarterly) in place of a heavy one-time investment i.e. SIP allows you to pay 10 periodic investments of Rs 500 each in place of a one-time investment of Rs 5,000 in an MF. Thus, you can invest in an MF without altering your other financial liabilities. It is imperative to understand the concept of rupee cost averaging and the power of compounding to better appreciate the working of SIPs.

SIP has brought mutual funds within the reach of an average person as it enables even those with tight budgets to invest Rs 500 or Rs 1,000 on a regular basis in place of making a heavy, one-time investment.

While making small investments through SIP may not seem appealing at first, it enables investors to get into the habit of saving. And over the years, it can really add up and give you handsome returns. A monthly SIP of Rs 1000 at the rate of 9% would grow to Rs 6.69 lakh in 10 years, Rs 17.83 lakh in 30 years and Rs 44.20 lakh in 40 years.

What is a Systematic Investment Plan?

A Systematic Investment Plan or SIP is a smart and hassle free mode for investing money in mutual funds. SIP allows you to invest a certain pre-determined amount at a regular interval (weekly, monthly, quarterly, etc.). A SIP is a planned approach towards investments and helps you inculcate the habit of saving and building wealth for the future.

How does it work?

A SIP is a flexible and easy investment plan. Your money is auto-debited from your bank account and invested into a specific mutual fund scheme.You are allocated certain number of units based on the ongoing market rate (called NAV or net asset value) for the day.

Every time you invest money, additional units of the scheme are purchased at the market rate and added to your account. Hence, units are bought at different rates and investors benefit from Rupee-Cost Averaging and the Power of Compounding.

Rupee-Cost Averaging

With volatile markets, most investors remain skeptical about the best time to invest and try to 'time' their entry into the market. Rupee-cost averaging allows you to opt out of the guessing game. Since you are a regular investor, your money fetches more units when the price is low and lesser when the price is high. During volatile period, it may allow you to achieve a lower average cost per unit.

Power of Compounding

Albert Einstein once said, "Compound interest is the eighth wonder of the world. He who understands it, earns it... he who doesn't... pays it." The rule for compounding is simple - the sooner you start investing, the more time your money has to grow.

Example

If you started investing Rs. 10000 a month on your 40th birthday, in 20 years time you would have put aside Rs. 24 lakhs. If that investment grew by an average of 7% a year, it would be worth Rs. 52.4 lakhs when you reach 60.

However, if you started investing 10 years earlier, your Rs. 10000 each month would add up to Rs. 36 lakh over 30 years. Assuming the same average annual growth of 7%, you would have Rs. 1.22 Cr on your 60th birthday - more than double the amount you would have received if you had started ten years later!

Other Benefits of Systematic Investment Plans

· Disciplined Saving - Discipline is the key to successful investments. When you invest through SIP, you commit yourself to save regularly. Every investment is a step towards attaining your financial objectives.

· Flexibility - While it is advisable to continue SIP investments with a long-term perspective, there is no compulsion. Investors can discontinue the plan at any time. One can also increase/ decrease the amount being invested.

· Long-Term Gains - Due to rupee-cost averaging and the power of compounding SIPs have the potential to deliver attractive returns over a long investment horizon.

· Convenience - SIP is a hassle-free mode of investment. You can issue a standing instruction to your bank to facilitate auto-debits from your bank account.

How To Pick A Good Mutual Fund

Are you thinking about investing in a mutual fund, but aren't sure how to go about it or which one is the most appropriate based on your needs? You're not alone. However, what you may not know is that the selection process is much easier than you think.

Identifying Goals and Risk Tolerance

Before acquiring shares in any fund, an investor must first identify his or her goals and desires for the money being invested. Are long-term capital gains desired, or is a current income preferred? Will the money be used to pay for college expenses, or to supplement a retirement that is decades away? Identifying a goal is important because it will enable you to dramatically whittle down the list of the more than 8,000 mutual funds in the public domain.

In addition, investors must also consider the issue of risk tolerance. Is the investor able to afford and mentally accept dramatic swings in portfolio value? Or, is a more conservative investment warranted? Identifying risk tolerance is as important as identifying a goal. After all, what good is an investment if the investor has trouble sleeping at night?

Finally, the issue of time horizon must be addressed. Investors must think about how long they can afford to tie up their money, or if they anticipate any liquidity concerns in the near future. This is because mutual funds have sales charges and that can take a big bite out of an investor's return over short periods of time. Ideally, mutual fund holders should have an investment horizon with at least five years or more.

Style and Fund Type

If the investor intends to use the money in the fund for a longer-term need and is willing to assume a fair amount of risk and volatility, then the style or objective he or she may be suited for is a long-term capital appreciation fund. These types of funds typically hold a high percentage of their assets in common stocks and are, therefore, considered to be volatile in nature. They also carry the potential for a large reward over time.

Conversely, if the investor is in need of current income, he or she should acquire shares in an income fund. Government and corporate debt are the two of the more common holdings in an income fund.

Of course, there are times when an investor has a longer-term need, but is unwilling or unable to assume substantial risk. In this case, a balanced fund, which invests in both stocks and bonds, may be the best alternative.

Charges and Fees

Mutual funds make their money by charging fees to the investor. It is important to gain an understanding of the different types of fees that you may face when purchasing an investment.

Some funds charge a sales fee known as a load fee, which will either be charged upon the initial investment or upon the sale of the investment. A front-end load fee is paid out of the initial investment made by the investor, while a back-end load fee is charged when an investor sells his or her investment, usually prior to a set time period, such as seven years from purchase.

Both front- and back-end loaded funds typically charge 3 to 6% of the total amount invested or distributed, but this number can be as much as 8.5% by law. Its purpose is to discourage turnover and to cover any administrative charges associated with the investment. Depending on the mutual fund, the fees may go to a broker for selling the mutual fund or to the fund itself, which may result in lower administration fees later on.

To avoid these sales fees, look for no-load funds, which don't charge a front- or back-end load fee. However, be aware of the other fees in a no-load fund, such as the management expense ratio and other administration fees, as they may be very high.

Other funds charge 12b-1 fees, which are baked into the share price and are used by the fund for promotions, sales and other activities related to the distribution of fund shares. These fees come right off of the reported share price at a predetermined point in time. As a result, investors may not be aware of the fee at all. The 12b-1 fees can, by law, be as much as 0.75% of a fund's average assets per year.

One final tip when perusing mutual fund sales literature: The investor should look for the management expense ratio. In fact, that one number can help clear up any and all confusion as it relates to sales charges. The ratio is simply the total percentage of fund assets that are being charged to cover fund expenses. The higher the ratio, the lower the investor's return will be at the end of the year.

Evaluating Managers and Past Results

As with all investments, investors should research a fund's past results. To that end, the following is a list of questions that perspective investors should ask themselves when reviewing the historical record:

Did the fund manager deliver results that were consistent with general market returns?

Was the fund more volatile than the big indexes (meaning did its returns vary dramatically throughout the year)?

Was there an unusually high turnover (which can result in larger tax liabilities for the investor)?

This information is important because it will give the investor insight into how the portfolio manager performs under certain conditions, as well as what historically has been the trend in terms of turnover and return.

With that in mind, past performance is no guarantee of future results. For this reason, prior to buying into a fund, it makes sense to review the investment company's literature to look for information about anticipated trends in the market in the years ahead. In most cases, a candid fund manager will give the investor some sense of the prospects for the fund and/or its holdings in the year(s) ahead as well as discuss general industry trends that may be helpful.

Size of the Fund

Typically, the size of a fund does not hinder its ability to meet its investment objectives. However, there are times when a fund can get too big. A perfect example is Fidelity's Magellan Fund. Back in 1999 the fund topped $100 billion in assets and it was forced to change its investment process to accommodate the large daily (money) inflows. Instead of being nimble and buying small- and mid-cap stocks, it shifted its focus primarily towards larger capitalization growth stocks. As a result, its performance suffered.

So how big is too big? There are no benchmarks that are set in stone, but that $100 billion mark certainly makes it difficult for a fund manager to acquire a position in a stock and dispose of it without dramatically running up the stock on the way up and depressing it on the way down. It also makes the process of buying and selling stocks with any kind of anonymity almost impossible.

The Bottom Line

Selecting a mutual fund may seem like a daunting task, but knowing your objectives and risk tolerance is half of the battle. If you follow this bit of due diligence before selecting a fund, you will increase your chances of success.

What is NAV ?  

NAV means Net Asset Value.   The investments made by a Mutual Fund are marked to market on daily basis.   In other words, we can say that current market value of such investments is  calculated on daily basis.  NAV is arrived at after deducting all liabilities (except unit capital) of the fund from the realisable value of all assets and dividing by number of units outstanding.   Therefore,  NAV on a particular day reflects the realisable value that the investor will get for each unit if the scheme is liquidated on that date.   This NAV keeps on changing with the changes in the market rates of equity and bond markets.    Therefore, the investments in Mutual Funds is not risk free, but a good managed Fund can give you regular and higher returns than when you can get from fixed deposits of a bank etc.

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WHAT ARE VARIOUS TYPES OF MUTUAL FUNDS :

A common man is so much confused about the various kinds of Mutual Funds that he is afraid of investing in these funds as he can not differentiate between various types of Mutual Funds with fancy names.  Mutual Funds can be classified into various categories  under the following heads:-

(A) ACCORDING TO TYPE OF INVESTMENTS :- While launching a new scheme,  every Mutual Fund is supposed to declare in the prospectus the kind of instruments in which it will make investments of the funds collected under that scheme. Thus, the various kinds of Mutual Fund schemes as categorized according to the type of investments are as follows :-

             

               (a) EQUITY FUNDS / SCHEMES

               (b) DEBT FUNDS / SCHEMES (also called Income Funds)

               (c ) DIVERSIFIED FUNDS / SCHEMES (Also called Balanced Funds)

               (d) GILT FUNDS / SCHEMES

               (e) MONEY MARKET FUNDS / SCHEMES

               (f) SECTOR SPECIFIC FUNDS

               (g) INDEX FUNDS

B) ACCORDING TO THE TIME OF CLOSURE OF THE SCHEME :  While launching  new schemes, Mutual Funds also declare whether this will be an open ended scheme (i.e. there is no specific date when the scheme will be closed) or there is a closing date when finally the scheme will be wind up.  Thus, according to the time of closure schemes are classified as follows :-

          (a) OPEN ENDED SCHEMES

          (b) CLOSE ENDED SCHEMES

Open ended funds are allowed to issue and redeem units any time during the life of the scheme, but close ended funds can not issue new units except in case of bonus or rights issue.   Therefore, unit capital of open ended funds can fluctuate on daily basis (as new investors may purchase fresh units), but that is not the case for close ended schemes.   In other words we can say that new investors can join the scheme by directly applying to the mutual fund at applicable net asset value related prices in case of open ended schemes but not in case of close ended schemes.  In case of close ended schemes, new investors can buy the units  only from secondary markets.

C) ACCORDING TO TAX INCENTIVE SCHEMES :  Mutual Funds are also allowed to float some tax saving schemes.   Therefore, sometimes the schemes are classified according to this also:-

         (a) TAX SAVING FUNDS

         (b) NOT TAX SAVING FUNDS / OTHER FUNDS

(D) ACCORDING TO THE TIME OF PAYOUT :  Sometimes Mutual Fund schemes are classified according to the periodicity of the pay outs (i.e. dividend etc.).  The categories are as follows :-

         (a) Dividend Paying Schemes

         (b) Reinvestment Schemes

  

The mutual fund schemes come with various combinations of the above categories.  Therefore, we can have an Equity Fund which is open ended and is dividend paying plan.   Before you invest, you must find out what kind of the scheme you are being asked to invest.   You should choose a scheme as per your risk capacity and the regularity at which you wish to have the dividends from such schemes.

 How Does a Mutual Fund Scheme Different from a Portfolio Management Scheme ?

In case of Mutual Fund schemes, the funds of large number of investors is pooled to form a common investible corpus and the gains / losses are same for all the investors during that given peirod of time.  On the other hand, in case of Portfolio Management Scheme, the funds of a particular investor remain identifiable and gains and losses for that portfolio are attributable to him only.  Each investor's funds are invested in a separate portfolio and there is no pooling of funds.

We have already mentioned that like all other investments in equities and debts, the investments in Mutual funds also carry risk.  However, investments through Mutual Funds is considered better due to the following reasons :-

(a) Your investments will be managed by professional finance managers who are in a better position to assess the risk profile of the investments;

(b) In case you are a small investor, then your investment cannot be spread into equity shares of various good companies due to high price of such shares.  Mutual Funds are in a much better position to effectively spread your investments across various sectors and among several products available in the market.   This is called risk diversification and can effectively shield the steep slide in the value of your investments.

What are risks by investing funds in Mutual Funds :

We are aware that investments in stock market are risky as the value of our investments goes up or down with the change in prices of the stocks where we have invested.  Therefore, the biggest risk for an investor in Mutual Funds is the market risk.  However, different Schemes of Mutual Funds have different risk profile, for example, the Debt Schemes are far less risk  than the equity funds.   Similarly, Balance Funds are likely to be more risky than Debt Schemes, but less risky than the equity schemes.

What is the difference between Mutual Funds and Hedge Funds :

Hedge Funds are the investment portfolios which are aggressively managed and uses advanced investment strategies, such as leveraged, long, short and derivative positions in both domestic and international markets with a goal of generating high returns .  In case of Hedged Funds, the number of investors is usually small and minimum investment required is large.   Moreover, they are more risky and generally the investor is not allowed to withdraw funds before a fixed tenure.

Some other important Terms Used in Mutual Funds

 Sale Price : It is the price you pay when you invest in a scheme and is also called "Offer Price". It may include a sales load.

Repurchase Price : - It is the price at which a Mutual Funds repurchases its units and it may include a back-end load. This is also called Bid Price.

Redemption Price : It is the price at which open-ended schemes repurchase their units and close-ended schemes redeem their units on maturity. Such prices are NAV related.

Sales Load / Front End Load : It is a charge collected by a scheme when it sells the units. Also called, ‘Front-end’ load. Schemes which do not charge a load at the time of entry are called ‘No Load’ schemes.

Repurchase / ‘Back-end’ Load : It is a charge collected by a Mufual Funds when it buys back / Repurchases the units from the unit holders.

How Mutual Fund SIPs have created wealth over the last 15 years: Large Cap and Diversified Equity

Systematic Investment Plans (SIPs) were introduced in India almost 20 years back by Franklin Templeton. Since then, SIPs in good funds have generated excellent returns and created wealth for the investors. SIPs offer a simple and disciplined way to accumulate wealth over the long term. Mutual Fund SIPs work pretty much like bank recurring deposits, except they generate superior risk adjusted returns compared to recurring deposits. There are a number of benefits of retirement planning through Mutual funds Systematic Investment Plans (SIP):-

The biggest advantage of SIPs is that, they make the need to time the market irrelevant. It is not possible to predict accurately how markets will behave. By investing at a regular frequency, e.g. monthly, one is invested both at the high and the low points of the market. SIPs work well in volatile markets, by averaging the cost of the investment.

SIPs engender a disciplined approach to investing. By investing a fixed amount out of regular your savings, you will be able to build a corpus for your long term financial needs. Money not invested often gets spent on things that you may not need.

Mutual Funds are very flexible instruments. There are no restrictions and penalties on regular SIP payments and withdrawals, unlike PPF or ULIPs. You can start a SIP with a monthly investment, as low as Rs 500. Some mutual funds have even lower minimum investment limit.

For the smart investor, mutual funds offer more choices and transparency. You can select products based on your risk profile, track record, and fund objectives.

Equity oriented mutual funds are more tax efficient than most other investment products. Long term capital gains for equity mutual funds are tax exempt. Most debt investments, with the exception of public provident fund, are taxable.

Different Types and Kinds of Mutual Funds

The mutual fund industry of India is continuously evolving. Along the way, several industry bodies are also investing towards investor education. Yet, according to a report by Boston Analytics, less than 10% of our households consider mutual funds as an investment avenue. It is still considered as a high-risk option.

In fact, a basic inquiry about the types of mutual funds reveals that these are perhaps one of the most flexible, comprehensive and hassle free modes of investments that can accommodate various types of investor needs.

Various types of mutual funds categories are designed to allow investors to choose a scheme based on the risk they are willing to take, the investable amount, their goals, the investment term, etc.

Let us have a look at some important mutual fund schemes under the following three categories based on maturity period of investment:

I. Open-Ended - This scheme allows investors to buy or sell units at any point in time. This does not have a fixed maturity date.

1. Debt/ Income - In a debt/income scheme, a major part of the investable fund are channelized towards debentures, government securities, and other debt instruments. Although capital appreciation is low (compared to the equity mutual funds), this is a relatively low risk-low return investment avenue which is ideal for investors seeing a steady income.

2. Money Market/ Liquid - This is ideal for investors looking to utilize their surplus funds in short term instruments while awaiting better options. These schemes invest in short-term debt instruments and seek to provide reasonable returns for the investors.

3. Equity/ Growth - Equities are a popular mutual fund category amongst retail investors. Although it could be a high-risk investment in the short term, investors can expect capital appreciation in the long run. If you are at your prime earning stage and looking for long-term benefits, growth schemes could be an ideal investment.

3.i. Index Scheme - Index schemes is a widely popular concept in the west. These follow a passive investment strategy where your investments replicate the movements of benchmark indices like Nifty, Sensex, etc.

3.ii. Sectoral Scheme - Sectoral funds are invested in a specific sector like infrastructure, IT, pharmaceuticals, etc. or segments of the capital market like large caps, mid caps, etc. This scheme provides a relatively high risk-high return opportunity within the equity space.

3.iii. Tax Saving - As the name suggests, this scheme offers tax benefits to its investors. The funds are invested in equities thereby offering long-term growth opportunities. Tax saving mutual funds (called Equity Linked Savings Schemes) has a 3-year lock-in period.

4. Balanced - This scheme allows investors to enjoy growth and income at regular intervals. Funds are invested in both equities and fixed income securities; the proportion is pre-determined and disclosed in the scheme related offer document. These are ideal for the cautiously aggressive investors.

II. Closed-Ended - In India, this type of scheme has a stipulated maturity period and investors can invest only during the initial launch period known as the NFO (New Fund Offer) period.

1. Capital Protection - The primary objective of this scheme is to safeguard the principal amount while trying to deliver reasonable returns. These invest in high-quality fixed income securities with marginal exposure to equities and mature along with the maturity period of the scheme.

2. Fixed Maturity Plans (FMPs) - FMPs, as the name suggests, are mutual fund schemes with a defined maturity period. These schemes normally comprise of debt instruments which mature in line with the maturity of the scheme, thereby earning through the interest component (also called coupons) of the securities in the portfolio. FMPs are normally passively managed, i.e. there is no active trading of debt instruments in the portfolio. The expenses which are charged to the scheme, are hence, generally lower than actively managed schemes.

III. Interval - Operating as a combination of open and closed ended schemes, it allows investors to trade units at pre-defined intervals.

Which scheme should I invest in?

When it comes to selecting a scheme to invest in, one should look for customized advice. Your best bet are the schemes that provide the right combination of growth, stability and income, keeping your risk appetite in mind.

High NAV vs. Low NAV – The Tale of Two Numbers

The Net Asset Value or the NAV is the price at which a single unit of a particular mutual fund is traded. It is calculated by dividing the total net value of the assets held by the fund, to the number of outstanding units.

NAV = Net Assets / Outstanding Units

How NAV differs from Stock Price?

While the NAV might seem to be similar to stock price, the two differ a lot. Since the NAV is based on a bunch of underlying assets, its value is declared only once (at the end of a day), once the trading in those underlying assets is completed. In comparison, a stock price (although fluctuating) is available throughout trading hours. Moreover, unlike a stock price, the NAV does not give you an idea about the performance of mutual fund scheme.

NAVs - The Highs and Lows of it

If you are planning to invest your money in a mutual fund, do not let the high and low NAV values influence your decision about short-listing a fund. As discussed, unlike shares, the absolute value of a mutual fund NAV does not say much about the performance of the fund.

· Low NAV - When a fund house launches a new fund (New Fund Offer - NFO), the units of the fund are available for a standard NAV of Rs. 10 - this shouldn't be a deterrent. Further, as the formula above states, a fund could have a lower NAV because its net assets are low or the no. of outstanding units is high (due to a temporary transition like NAV split, etc). Also, a fund's NAV decreases proportionately, whenever it pays out dividends.

· High NAV - Similarly, a high NAV could be because of a good performance over the years. But then, with mutual funds, the past performance is never a guarantee for future performance.

Myth 1 - Low NAV means More Units = More Dividends

Investors should refrain from being attracted to low NAV funds just because you realize that your money can fetch you more units and that this might be beneficial when the fund declares a dividend. Here, the investor will not really benefit because a dividend is nothing but their own money being paid out. In fact, after the dividend is paid out, the NAV is adjusted accordingly!

Myth 2 - Fund with High NAV have reached their potential

Another common myth is that mutual funds with a high NAV have maxed out their potential and that they are no longer as lucrative. Now, one must remember that mutual funds have an underlying portfolio of stocks, which are chosen by an experienced fund manager who has a well-thought strategy for entering and exiting stocks. As soon as a particular stock has met its objective, the fund manager sells the stock and buys newer ones that are likely to provide returns in line with the scheme objectives.

One must understand that at the end, it is the fund performance that should matter and not the absolute value of the NAV. The money growth will depend on how the fund is performing and not on the NAV value. Hence, a 20% growth with NAV of 20 is the same as 20% growth with NAV of 200.

What's a mutual fund SIP?

The best funds to invest in

How you can invest in a mutual fund

There are two ways in which you can invest in a mutual fund.

1. A one-time outright payment

If you invest directly in the fund, you just hand over the cheque and you get your fund units depending on the value of the units on that particular day.

Let's say you want to invest Rs 10,000. All you have to do is approach the fund and buy units worth Rs 10,000. There will be two factors determining how many units you get.

Entry load

This is the fee you pay on the amount you invest. Let's say the entry load is 2%. Two percent on Rs 10,000* would Rs 200. Now, you have just Rs 9,800 to invest.

NAV

The Net Asset Value is the price of a unit of a fund. Let's say that the NAV on the day you invest is Rs 30.

So you will get 326.67 units (Rs 9800 / 30).

2. Periodic investments

This is referred to as a SIP.

That means that, every month, you commit to investing, say, Rs 1,000 in your fund. At the end of a year, you would have invested Rs 12,000 in your fund.

Let's say the NAV on the day you invest in the first month is Rs 20; you will get 50 units.

The next month, the NAV is Rs 25. You will get 40 units.

The following month, the NAV is Rs 18. You will get 55.56 units.

So, after three months, you would have 145.56 units. On an average, you would have paid around Rs 21 per unit. This is because, when the NAV is high, you get fewer units per Rs 1,000. When the NAV falls, you get more units per Rs 1,000.

How to invest in a mutual fund

Here are some FAQs on the SIP

1. Is there a load?

An exit load is a fee you pay the fund when you sell the units, just like the entry load is a fee you pay when you buy the units.

Initially, funds never charged an entry load on SIPs. Now, however, a number of them do.

You will also have the check if there is an exit load. Generally, though, there is none. Also, if there is an entry load, an exit load will not be charged.

An exit load may be charged if you stop the SIP mid-way. Let's say you have a one-year SIP but discontinue after five months, then an exit load will be levied. These conditions will wary between mutual funds. 

2. What is the minimum investment?

If you do a one time investment, the minimum amount that you have to invest is Rs 5,000.

If you invest via an SIP, the amount drops. Each fund has their own minimum amount. Some may keep it at least Rs 500 per month, others may keep it as Rs 1,000.

3. How often does one have to invest?

It would depend on the fund.

Some insist the SIP must be done every month. Others give you the option of investing once in three months or once in six months.

They also give fixed dates. So you will get the option of various dates and you will have to choose one. Let's say you are presented with these dates: 1, 10, 20 or 30. You can pick any one date.

If you pick the 10th of the month, then on that day, the amount you have decided to invest in the fund has to be credited to your mutual fund.

4. How must the payment be made?

You can opt for the Electronic Clearance Service from your bank; this means the mutual fund will, as per your instructions, debit a certain amount from your account every month.

Let's say you have a SIP of Rs 1,000 every month and you have chosen to invest in it on the 10th of every month. Under this option, you can instruct your mutual fund to directly debit your bank account of Rs 1,000 on the due date.

If you don't have the required money in your account, then for that month, no units will be allocated to you. But, if this continues periodically, the mutual fund will discontinue the SIP. You need to check with each mutual fund what their parameters are.

Alternately, you can give cheques to your mutual fund. In this case, they may ask for five Post Dated Cheques upfront with your first investment.

Since these cheques are dated ahead of time, they cannot be processed till the date indicated.

The importance of choosing the right funds

5. Must I state for how long I want the SIP?

Yes. You will have to state whether you want it for a year or two years, etc. If, during the course of this period, you realise you cannot continue with the SIP, all you have to do is inform the fund 15 days prior to the payout.

The SIP will be discontinued. You can continue to keep your money with the fund and withdraw it when you want.

6. Do all funds offer SIP?

No. Liquid funds, cash funds and floating rate debt funds do not offer an SIP. These are funds that invest in very short-term fixed-return investments. Floating rate debt funds invest in fixed return investments where the interest rate moves in tandem with interest rates in the economy (just like a floating rate home loan).

All types of equity funds (funds that invest in the shares of companies), debt funds (funds that invest in fixed-return investments) and balanced funds (funds that invest in both) offer a SIP.

7. Tax implications

Let's say you have invested in the SIP option of a diversified equity fund.

If you sell the units after a year of buying, you pay no capital gains tax. If you sell if before a year, you pay capital gains tax of 10%.

Let's say you invest through a SIP for 12 months: January to December 2005. Now, in February 2006, you want to sell some units.

Will you be charged capital gains tax?

The system of first-in, first-out applies here. So, the amount you invest in January 2005 and the units you bought with that money, will be regarded as the units you sell in February 2006.

For tax purposes, the units that you sell first will be considered as the first units bought.

Most volatile mutual funds

8. How will an SIP help?

When you buy the units of a fund, you may do so when the NAV is really high. For instance, let's say you bought the units of a fund when the bull run was at its peak, leading to a high NAV. 

If the market dips after that, the value of your investments falls and you may have to wait for a long while to make a return on your investment. But, if you invest via a SIP, you do not commit the error of buying units when the market is at its peak. Since you are buying small amounts continuously, your investment will average out over a period of time.

You will end up buying some units at a high cost and some units a lower price. Over time, your chances of making a profit are much higher when compared to an one-time investment.