Magazine Cover Stories June 2000  

10 THINGS YOU MUST KNOW ABOUT MUTUAL FUNDS

It is often said that to earn is not enough, one must save. To save is also not enough, one must invest. Even to invest is not enough, one must invest wisely. However, every person has his unique investment requirements. And, the market offers a plethora of options. To select the one which is most suited to one’s needs is certainly not an easy task. Experts suggest that mutual funds offer good returns. It is a good idea to route your investment through mutual funds. Mutual funds offer a number of schemes to invest in debts, issued by private companies, public sector undertakings, government bonds and any other debt instruments. If you invest in debt-based mutual funds, you save yourself from the problem of hunting for the most suitable and profitable bet. You also don’t need to maintain paperwork for transfer of instruments, dividend warrants and redemption dates. The best bargain in mutual funds is that you can enter an equity fund with an investment of only Rs 500 whereas an individual would need much higher amount to invest in a good share. Today, many investors have started to see mutual funds as the best way to invest in debts. They see debts as a safer bet as compared to bank fixed deposits. Why? One, because debt funds are more transparent than any other form of investment — the investor is aware where his money is being used. Two, debts are less risky than equities though the returns from the latter are more. Go for debt funds if you prefer steady, though less,

returns over the roller-coaster graph of returns from the equities. Besides regular and steady income, debt funds are also known for easy liquidity without the risk of volatility. Add to it the advantage of tax benefits. Section 10 (23D) of the Income Tax Act says that mutual funds do not have to pay taxes. When you invest in a growth plan of an equity or debt fund, you get benefit of claiming capital gains on appreciation in the value of the fund. Thus, you need to pay lower tax of 10 or 20%, along with the indexation benefit. Moreover, the dividend to investors from mutual funds is exempted from income tax. The choice for investors in mutual funds is comparatively simpler. If you want a steady income, choose a monthly income scheme that gives regular income. If you want your wealth to accumulate, pick a growth plan that lets your savings grow. And if income and growth are the factors you are looking for in an investment scheme, there are ample plans to meet your requirements. Most investors rely on their financial advisor or consultants to choose the right income fund for them. “Specify your budget, state your requirements and relax,” says Udayan Chaudhury, a marketing executive in a leading advertising agency. “Like any other working couple, we do not have time. We also do not have the expertise to choose the right fund. Our advisor does the homework for us,” he says. Professional advice is helpful in picking a fund. Actually, it all depends on your investment need, returns requirement and risk capabilities. But the market is brimming with fund options, each offering one or the other benefit. Unless you do your homework well, it is not easy to make sense of these. Till recently, choice was not an issue on the investor’s mind but today, there are a number of mutual funds in the market. You should choose a fund that matches your investment needs – for capital growth, regular returns, or safe savings.

Things you should know

Mutual funds provide the safety of debt and returns of equity, along with the advantages of flexibility and liquidity. The success of an income fund depends on its ability to manage risks. But there are somethings you should know about your mutual fund. In fact, you can also compare the features of one fund with another using these factors. These 10 factors are discussed below.

The Available Options

The variety of options available is enough to confuse a general investor. A developed financial market like ours offers equity funds, debt funds (with the income, growth and both options), liquid funds and gilt funds to choose from. Debt/Income Schemes. These offer the best returns as compared to the other kinds of schemes. These are considered good for consistent income and capital preservation. Returns range from 10 to 14 per cent. The schemes are not limited to any one kind of debt and most of them have a good mix of retail and corporate investors. These are recommended for those who seek superior returns and do not mind a little risk. Since these comprise a good mix of debts, risk comes mainly from the quality of papers and sometimes, large exposure to specific companies or sectors. Go for these if you prefer long-term investment, at least one to two years. The latest offering of these debt schemes is the choice of dividend reinvestment, which means the tax-free dividend is reinvested in the fund, getting you more units. Since most people think that they might have spent this dividend otherwise, they prefer this option which makes Income Funds a more efficient tool for capital building. Equity Funds. Equity funds are mutual funds that invest predominantly in equity shares of the companies. Theses are the high-returns-high-risk funds. The high returns of the equity market are coupled with high risk factor as well. Use these as idle long term investment. It is always better to invest in equities through mutual funds.Stock markets are not only volatile,they also change very fast. Equity funds give you the safety and security to earn from such a market. The returns depend on the market fluctuations. Liquid/Money Market Schemes. Ideal for institutions and corporates. The short-term investment option (20 days to three months) helps them put their idle surplus funds in debt market to earn gain on it till they find end users. Returns range from 8-11 per cent, depending upon the condition of the money market. Even salaried people can use these for short-term deposits as they give better returns than saving accounts. In short, good for those who generate regular cash flows like doctors, travel agents, exporters etc. Some funds even give cheque writing facilities. Gilt Schemes. For consistent returns and lowest credit risk, invest in gilt funds. Gilts, or government securities, are the most liquid form of debt funds. They offer excellent returns, along with the least risk-tolerance. Many mutual funds have also launched gilt schemes, most of them open-ended, and ensure liquidity. The returns range from 9 to 12 per cent. Gilt schemes do not face credit risks, but there is market risk.

1.Fund Manager’s Track Record
The first parameter to look for in a mutual fund is how the scheme will perform for you. Rely on the fund manager’s experience and background. Study the performance of the funds handled by them to get an idea on their expertise to gauge market trends. Check the performance of the schemes with benchmark index, and other schemes of the same category. This will give a good idea to judge how the scheme has performed in different market conditions. A track record of good returns can be assuring, but do not take it as a future guarantee. Prefer established names, as they have a reputation to maintain. Moreover, it is easier to judge consistency of performance of a scheme only if it has been around for some years. A consistent good record hints at efficient fund management. On the other hand, not-so-good returns in the past shows that the fund managers have been slow or incompetent to anticipate market trends. The background of the fund manager is also important: if they are found to be job-hoppers, who alter their business opportunities depending on the market changes,your investment is not in very safe hands. Also make sure where the commitments of your fund managers lie. The overall allocation of funds should be consistent with your tolerance for risk, time horizon and return objectives. Give preference to schemes with a longer and consistent track record.

2.Portfolio Quality
Since mutual funds comprise a portfolio mix, their returns are a reflection of the quality of their choice. Good debt funds hold instruments with the best ratings. Ratings are measure of the credit risk. High credit ratings of investments mean that your fund is investing in low-risk instruments. If there are poor quality instruments, and they do not backfire, you might get high returns. But speculative instruments are very risky and can backfire anytime. If the fund manager shows the trend of getting swayed by the market momentum, the safety of your investment may be low. Some funds have even set the limit for sectorwise investment. Find if these are followed strictly. Also check the asset allocation. Sudden changes may spell boom, or doom, depending upon the market situation. Another point to be checked is the performance of the schemes, whether these have outperformed the market, and if so, is this trend consistent or just a flash in the pan.

3.Size of fund
Size does matter! And like many other things in life, bigger the better adage applies to mutual funds as well. A bigger size of fund gives access to opportunities not available to smaller funds. But for a big fund, good quality paper is not easy to find. A bigger fund many also sometimes mean inclusion of mediocre papers, which ultimately results in lower returns. Large fund also means inclusion of various types of portfolios, from varying sectors and different companies. Even if there are upswings or downswings in a particular sector, the performance of the fund is not affected largely. But a small fund does not have scope for many varying portfolios. This means a little upswing can make you happy, and if there is a downswing, you sit with your fingers crossed. Bigger funds are marker performers while smaller funds can either be ..... or outperform the market. Check with you risk profile the ability to tolerate such stress before opting for any fund.

4.Average holding size
Another important factor you must know about your mutual fund is the average holding size of the fund, and the number of retail investors. After all, it is your hard-earned money! Though small funds are easier to deploy and manage, they are always at a risk: even if a few investors leave, it could be in trouble. Though not many funds are open about the number of investors, check the size of the investors. If there are a large number of investors with small holdings, they would have a negligible effect on the performance of the fund. However, if a small number of investors have large holding, exit of even one of them would affect the fund adversely.

5.Focus of Fund
If you find that your diversified equity fund has focused unjustifiably to a particular sector or company, it is time to get alert. This selective exposure may work for a sectoral fund. But is is more or less like putting all your eggs in one basket. Agreed, that any upward trend in that sector will bring a windfall because of the fund’s focused investment. But, what if the sector, or the company showered with attention starts moving downhill? The downward trend in the fortunes of the company or sector will also put returns from your investment under pressure. The recent boom in the technological and IT sector is one such example. Experts predict that media, entertainment and pharma sectors will rule the fund market in the coming days. But that doesn’t mean you rush to invest in these. Measure your risk profile before making an investment. In the market where speculation is the key word and where credit rates are dependent on a number of factors, you have only one shield: caution. You need to be very alert and would require to study market trends regularly. Always invest in a sector in which you have confidence.

6.Maturity Periods
Long-term investment means you will have to put your money in a longer lock-in period. Longer maturity positions may take away flexibility of the investment, but promises bigger returns. There are some other benefits of longer lock-in period. Longer maturities protect against periodic downward slide in interest rates. That means a greater safety of returns. But this also means that you lose out on the short-term upswings in the interest rates. The maturity profile of the investments is closely related to the interest rate movements. Prefer long term investment when going for an equity fund, at least two to three years. Maturity period for a debt fund should be according to your requirements. If you are putting money in savings accounts, you can gain more by investing in debt funds, ideally for one to two years. If your investment needs are short-term in fact very short, go for the liquid money market funds. These are good for idle short periods of funds with you. Gilt funds are preferred by those with investment needs of six months to one year.

7. Dividend Frequency
A major advantage of investing in a mutual fund is that dividend on these is tax-free. Tax-free dividends give regular returns, but frequent dividends affect capital growth. If you are looking for consistent returns from your investment, go for a mutual fund that gives regular attractive dividends. But regular dividends may affect capital growth. If capital building is your objective, go for funds that reinvest your dividend into the fund. So, you get more units from the money you would have otherwise spent. If regular income from mutual funds does not charm you, choose the dividend reinvestment option. Some experts ague that reinvesting dividend in the same fund is not a good idea. Good returns by a fund at present are no guarantee of their performance in future. Things may go wrong somewhere and by reinvesting in the same fund, you may block your growth prospects. They advise to take the dividend and put it in some other investment vehicle. Spending the dividend otherwise is not advisable in the interest of capital growth. As said earlier, there is no clear rule to judge a mutual fund. It all depends on your needs and preferences. But to choose the right one from the plethora of options available even among these, rely on professional advice.

8. Change in NAV/Portfolio
Closely watch any changes in the NAV or portfolio of your fund. A sudden change may bring good returns, or sometimes more risks. The managers may decide to revamp the portfolio for good, to bring in better returns for you. Look forward to such changes. But sudden changes may also expose you to the market risk due to change in the investments. Here, the track record of the fund manager also comes in the picture again. If they have the expertise to sense market changes well in time, the results would show in their NAV. A consistent good show with one or two slumps indicates their stability and thus safety of your investment.

9. Load
Some fund schemes have an entry load or exit load. This helps to ensure a stable holding of the fund. As said earlier, a small fund can be in trouble if some investors leave. Thus, loads help in managing funds better. Load makes sure the promised returns on the basis of pre-calculations are realised. Loads, therefore, keep short-term investors out. But on the other hand, the exit load may affect your returns. They directly cut into your returns if your investment horizon doesn’t match with that of the fund.

10. Philosophy of the Fund
Closely study the philosophy of fund management. A philosophy that doesn’t matches with yours will be a disappointment in the long run. But that means the fund has to be transparent with information. “If a fund looks stingy in giving information, stay away from it. You may get lesser returns elsewhere, but certainly more peace of mind,” suggest experts. The choice of your fund should be governed by the your objective. If you have long-term capital growth in mind while making the investment, the fund’s objective should also match with yours. For example, if you are investing for your retirement, your objective is to amass funds to maintain the same lifestyle, even after retirement, or capital growth. Check if the fund managers have provided enough information to you about the fund’s constituents, holdings, size, and other details. So a tight balance is required between these. Safety has to be the first criteria of any investor while choosing any investment instrument. Liquidity and return come later. Investors do not mind lower returns if the fund promises to be secure. To balance the credit and interest rate risks, a period of at least one to two years is the most preferred term to invest in debt instruments. This reduces the chances of default and interest rate risk. A word of advice: Shuffling portfolios to accommodate good quality instruments is beneficial to fund as well as the investor. Asset allocation is not a one-time exercise. Over the time, variables that determine the asset allocation change, like investment objective, tax status and risk profile. This calls for changes in your asset allocation according to the new requirements.