Thursday, October 28, 2021
Finance

Understanding Mutual Funds: the Best Investment Plan for You

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 Introduction

The market has witnessed a dream bull run in the past year, with several new investors entering the markets and companies listing themselves through IPOs. Sensex, for instance, stands at its all-time high currently.

Consequently, the probability of you not being a part of a conversation about the stock market is highly unlikely.

But, direct investing is not everyone’s forte. Most people end up overwhelmed by denser topics like PE ratio or candlesticks.

Are you one of those people? Then, let us discuss one of the best investment plans, which gives you market exposure and is managed by experts on your behalf: mutual funds.

Contents

  1. What are mutual funds?
  2. How do mutual funds work?
  3. Types of mutual funds
  4. A mutual fund guide for analyzing your investments
  5. An investment plan that suits you

What are mutual funds?

Before we begin our mutual fund guide, we need a basic understanding of what this product is. In broad terms, mutual funds are an investment vehicle that allows newbies to invest in the market through financial experts’ experience.

Let’s understand this with an example. Let’s suppose you have to travel from Mumbai to Pune. You have two options: you can drive yourself or hire someone to drive you there. In the first case, you must be a proficient driver, know the routes, and have the necessary information.

But, in the second case, you can rely on the experience of the professional you hired. You can travel hassle-free by just paying a certain amount to the professional for their service.

Here, the first case is direct investments in the stock market. The second case is what mutual fund investments are.

How do mutual funds work?

Each mutual fund company has its portfolio of stocks that fund managers usually pick. So whenever you buy their mutual fund, you become the owner of a certain number of units, not the companies in their portfolio.

However, it makes you the indirect owner of the shares. It is because each unit of the mutual fund represents a specific part of the whole portfolio. So if you own one unit, you indirectly own some of each share of their vast portfolio.

To not complicate things, simply assume that you own shares of each company that the fund manager has invested in. You are also eligible for benefits like dividends declared by the company.

Types of mutual funds

While equity mutual funds are the most common type of fund, several types are available in the market to suit all investors’ risk profiles and return expectations.

There are umpteen types of funds to deliver the best investment plan. We will discuss the most common ones here.

  1. Equity mutual funds
    All the advertisements succeeded by the “Mutual fund investments are subject to market risk” are for equity funds.
    In these funds, the whole Asset Under Management, or simply the money received by the fund house, is invested in equity. In simple terms, the stocks of companies listed in the stock exchange are only purchased.
  1. Debt-oriented funds
    Debt funds are fixed-income funds that carry a very low risk of capital depreciation. The expected returns are lesser than equity-oriented funds but usually more than fixed deposits.

These are more suitable for people who have a low-risk profile or are at the later stages of their career and nearing retirement.

  1. Hybrid funds
    Equity and debt mutual funds have prevailed in the market for a long time. But in reality, no investor has a risk profile that suits only one type of fund. Thus, hybrid funds were introduced.
    These funds invest their AUM in Equity and Debt-oriented securities in a fixed percentage, usually 60% equity and 40% debt. They provide decent returns in both bear and bull market phases and are thus also called all-weather funds.
  2. Money market funds
    These are fixed-income mutual funds that invest in short-term debt only. This characteristic makes them very liquid and an ideal choice for investors who have funds lying in their bank accounts. However, they are not suitable for long-term investing.

A mutual fund guide for analyzing your investments

Before you invest your hard-earned money into any fund, there are a few factors you have to consider.

  • Past performance

It is perhaps the most strategic factor you must consider. Data of the compound annual growth rate (CAGR) of the fund is readily available.
However, you should look at records of at least the past 5–10 years. Also, basing the decision on high returns without considering the risk taken is not a good practice.

  • Expense ratio and exit load

The expense ratio is a measurement of what the fund house charges to manage your investments. Suppose the investments earn a 15% return for the year, but the expense ratio is 1%. Effectively, the return of investors will become 14%. The lower the expense ratio, the better.

Similarly, exit load is what you must pay if you redeem your funds before a stipulated time. If you must encash them early on, ensure the exit load is very low or not applicable at all.

  • Asset Under Management

It is one of the primary requisites because as more money is invested in the fund, it becomes increasingly difficult for the fund manager to fetch similar returns.

AUM below 5,000 crores for large-cap funds and 2,000 crores for midcap and small-cap funds is preferable.

An investment plan that suits you

The best investment plan for you will depend on numerous factors like your goals, risk profile, dependants, brand value, and patience. A common thumb rule most mutual fund guides advocate is to invest (100 – your age)% of your money in debt and the rest in equity.

However, there is no hard and fast rule to select the best investment plan. Invest according to what suits you, but avoid investing all your money in equity as far as possible.