Mutual Funds, Sahi Hai?

Anyone who watches television on a regular basis in India would have definitely seen one of the ‘Mutual Funds Sahi Hai’ ads. And while the advertisements make a pretty compelling reasoning for you to invest in mutual funds but before you can start dreaming of the opportunity of earning high returns on investments and plan your finances accordingly, the last few lines bring you back to reality in a snap. “Mutual Funds Schemes are subject to market risk. Read all scheme related documents properly before investing”. And these last 2 sentences are exactly the reason which creates a sense of fear in the minds of the common man and deter him from investing in Mutual Funds. But the question still remains, is it worth taking the risk of investing in mutual funds?

What are mutual funds?

First, let’s understand what mutual funds are. Simply put, mutual funds are businesses which take your money and invest them in different financial instruments for you. Say, you invested Rs. 10,000 in a mutual fund. What the mutual fund company will now do is invest them in the share market or in bonds for you. The profits that the company earns on this investment will be the returns that you get from your investment in the said mutual fund.

Mutual funds take money from 1000s of people and invest them in multiple financial instruments. This allows them to operate on a large scale. The total profit that the mutual fund earns is divided among its investors in proportion of their investment amount.

It is important to understand that the profit that we are speaking of is not realized until you withdraw from the scheme. That is, as long as the investment is not liquidated, you will not see any real money in your bank.

How to buy a mutual fund?

To buy mutual funds, you need to be KYC compliant and need a bank account. After that you can by mutual funds directly, or indirectly through an intermediary.

The investment that you make in a scheme is translated into a certain number of ‘Units’ in the scheme. Thus, an investor in a scheme is issued units of the scheme. Typically, every unit has a face value of Rs. 10. The face value is relevant from an accounting perspective. The number of units issued by a scheme multiplied by its face value is the capital of the scheme – its Unit Capital.

The scheme earns interest income or dividend income on the investments it holds. Further, when it purchases and sells investments, it earns capital gains or incurs capital losses. These are called realized capital gains or realized capital losses as the case may be.

Fresh purchase or initial purchase of mutual fund units in a scheme can be made during the new fund offer (NFO) period or even subsequently depending on the type of scheme. Alternatively, mutual fund units can also be bought on the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE), but only if the mutual fund decides to list its units on these platforms.

Why take the Mutual Funds route?

Now the question that most people will ask is that if all that mutual funds do is, that take my money and put it in shares and other securities, why should I buy mutual funds and not invest directly myself. The reasons for that are:

Professional Management makes tasks and decisions easier

Mutual funds offer investors the opportunity to earn an income or build their wealth through professional management of their investible funds. These professionals are expert in their field, hence, there is a high probability of their investments earning higher returns than your investments in the same market.

Also, investing in the securities markets will require the investor to open and manage multiple accounts and relationships such as broking account, demat account and others. Mutual fund investment simplifies the process of investing and holding securities.

Tax Deferral and Benefits

Mutual funds are not liable to pay tax on the income they earn. If the same income were to be earned by the investor directly, then tax may have to be paid in the same financial year.

Specific schemes of mutual funds (Equity Linked Savings Schemes) give investors the benefit of deduction of the amount subscribed (upto Rs. 150,000 in a financial year), from their income that is liable to tax. This reduces their taxable income, and therefore the tax liability.

Types of Mutual Funds

Mutual Funds can be categorised into various types:

Open-Ended Funds, Close-Ended Funds and Interval Funds

Open-ended funds are open for investors to enter or exit at any time, even after the NFO. The scheme does not have any kind of time frame in which it is to be closed. The on-going entry and exit of investors imply that the unit capital in an open-ended fund would keep changing on a regular basis.

Close-ended funds have a fixed maturity. Investors can buy units of a close-ended scheme, from the fund, only during its NFO. The fund makes arrangements for the units to be traded, post-NFO in a stock exchange through listing of the scheme in a stock exchange. Such listing is compulsory for close-ended schemes.

Interval funds combine features of both open-ended and close-ended schemes. They are largely close-ended, but become open-ended at pre-specified intervals. The benefit for investors is that, unlike in a purely close-ended scheme, they are not completely dependent on the stock exchange to be able to buy or sell units of the interval fund. However, between these intervals, the units have to be compulsorily listed on stock exchanges to allow investors an exit route.

Actively Managed Funds and Passive Funds

Actively managed funds are funds where the fund manager has the flexibility to choose the investment portfolio, within the broad parameters of the investment objective of the scheme.

Passive funds (or Index Funds) invest on the basis of a specified index, whose performance it seeks to track. Thus, a passive fund tracking the S&P BSE Sensex would buy only the shares that are part of the composition of the S&P BSE Sensex. The proportion of each share in the scheme’s portfolio would also be the same as the weightage assigned to the share in the computation of the S&P BSE Sensex. Thus, the performance of these funds tends to mirror the concerned index.

Equity, Debt, Hybrid and Solution Oriented Schemes

Equity funds invest in equity instruments issued by companies.

Debt funds invest only in debt instruments. That is, those where the primary source of return is in the form of interest payed on the borrowings. The interest is typically known at the time of issue and may be guaranteed either by an undertaking of the government or by security created on the physical assets of the issuer.

Hybrid funds have an investment charter that provides for investment in both debt and equity. Some of them invest in gold along with either debt or equity or both.

Schemes with an investment objective that is directed towards a particular goal aimed in future such as retirement solution or investments for children are called Solution Oriented Schemes.

(The above funds can be further sub-divided into different categories. Sometimes the same fund may overlap two or more categories. I have kept them out of this blog to keep things simple. You can read more about them on the internet.)

Comparison of returns

Now, let’s look at the difference in absolute returns given by mutual funds and fixed deposits over a 5-year period. The mutual funds chosen by me are the top 5 best performing mutual funds (among both close and open-ended types) in the last 5 years and the fixed deposit chosen are those of the 3 banks (having national presence) which give highest interest on fixed deposits.

It is assumed that the deposit made in each of the investments is Rs. 100.

MUTUAL FUNDS

FIXED DEPOSITS

Note: All rates in the above two tables are as of 25^th January 2019. Annualized Rates in case of Mutual Funds may change from time to time as per returns earned and Interest Rates on FDs are subject to change as per the respective banks’ decisions, from time to time.

It is clear from the above calculations that investing in mutual funds give much higher returns than investments made in Fixed Deposits.

In conclusion, Looking at all the above details, one would need a very compelling argument why he or she should not invest in mutual funds. Mutual funds not only give you high returns but also manage your money professionally, which reduces the risk of losing your money. Mutual funds are a great way of earning high return on investments, in the long run, even for those who do not have any idea on shares and securities.

Note: In this blog, I have only summarized the basics of mutual funds, which investors and potential investors should know. The idea is was to keep it short and simple. There are a lot more things pertaining to the subject which I have excluded since it would only complicate the matter. This is an informative blog meant for those who want to understand the basics of mutual funds. Investing primarily on the basis of information received from this blog is not recommended.