Chapter 3: Understand This Before Investing in Mutual Funds
Whether you’re a beginner or an existing investor, you should know a few fundamental things about mutual fund investing.
Investing in mutual funds offers a lot of adaptability
Mutual funds (MFs) are an incredible tool for wealth creation for long-term investors looking to participate in stock markets and generate some alpha over returns. That’s not all; MFs also provide a full array of opportunities for short-term investors as they offer various schemes that invest in short-term debt instruments.
There’s always something for every investor in the mutual fund world, provided that the investor is well-equipped to participate and is willing to explore! – the endless opportunities/solutions that mutual funds have to offer.
MF schemes come with a cost
Although mutual funds are very simple, useful, and by far the best tool for retail investors as they allow them to participate in various asset classes, access to mutual fund schemes that provide these solutions comes with certain costs involved, such as the expense ratio.
As we have learned, the expense ratio is deducted from the returns, and the fund is generated over a given period. Certainly, suppose you compound this small percentage of the expense ratio over a longer time period. In that case, the result can be a significantly large portion carved out as expenses out of the total return generated.
But the flipside to this is that a retail investor who has very little or lacks knowledge of how to invest or doesn’t have the time to look into investment opportunities should look at mutual funds as a solution and the expense ratio as the cost of getting access to professionals who help these investors in their wealth-creating journey.
In our forthcoming chapter, we will discuss this in-depth and explain how to choose the best mutual fund for you. For now, it’s important to understand that there are no free lunches when it comes to mutual fund investing.
Currently, when an investor invests in any mutual fund scheme, the costs that an investor has to bear is
a. Expense Ratio – Every scheme’s expense ratio may differ depending on the fund type and plan type (Regular or Direct Plans). On average, the expense ratio ranges from 0.02% to 2-2.5% or even more in some specific schemes and is deducted from the NAV.
b. Exit Load – This is only applicable at the time of redemption if the redemption is before the lock-in period stated by the mutual fund scheme. On average, the exit load may vary from 1% to 2%, depending on the fund type.
c. Opportunity Cost – Technically, the concept of opportunity cost is theoretical and not applicable in reality, but there’s always an opportunity loss if an investor delays his/her investments in mutual funds (if he/she agrees with the risk associated with it). Most investors ignore this since this cost is not actually charged by the mutual fund house. Still, it would make great sense for an investor to do the maths and understand the cost of not investing early or at all, which can significantly impact your wealth in the future.
Risk Factors Associated with Mutual Fund Investing
By now, we know mutual funds have multiple benefits for investors, but investing in mutual funds comes with certain risks. These risks may vary depending on the schemes that an investor chooses to invest in.
There’s a standard risk that applies in mutual fund investing is –
“Mutual fund schemes are not guaranteed schemes.”
As the price or interest rates of the securities in which the Scheme invests fluctuate with any change in the market movements, the value of your investments in a mutual fund Scheme may go up or down. This basically means volatility in a core part of mutual fund investing, which every investor should know.
Since mutual fund schemes invest in various asset classes, such as equity/shares, debt instruments such as money market instruments, bonds, certificates of deposits, etc., and even precious metals like gold and silver, the risks that these individual asset classes carry are passed on to the investors directly.
For example, an equity-oriented mutual fund scheme that invests in shares has the inherent risks that are associated with equity market investing (loss of capital, price risk, systematic / event risk)
Similarly, any debt mutual fund scheme that invests in bonds, G-Secs, or money market instruments also carries the inherent risk associated with debt investing (interest rate risk, credit or default risk, liquidity risk).
Entry and Exit Loads and Lock-Ins
As we have learned, a ‘load’ is an additional fee levied by mutual fund houses (AMCs) on investments made by investors in various mutual fund schemes. These loads are adjusted in the NAV on redemption.
Although SEBI has banned all mutual fund AMCs from charging entry loads to any of the mutual fund schemes, AMCs are allowed to charge an Exit load, which they have to clearly specify in the Scheme Information Document that is offered to investors.
As explained in our jargon section, exit load is the cost charged if an investor’s funds are under management via any scheme and are withdrawn before the lock-in period.
Most mutual fund schemes levy an exit load on withdrawals, which are usually before 1 year. However, this may vary from scheme to scheme within a fund house and may also differ between various AMCs.
The exit load is deducted from the NAV after redemption. For example, if you bought 100 units of an MF scheme at a NAV of 10 rs per unit on January 1, 2024, the exit load is 1% applicable on withdrawals before 1 year. You decided to sell the units when the NAV increased to 15 rs per unit on March 31, 2024 (within 3 months).
So the applicable NAV for you would be = ₹15 – *(1-01) = ₹14.985/-
The payout would be = 100 units * ₹14.985 (applicable NAV after the exit load).
Knowing Your Risk Profile
As an investor, it’s always advisable to know your risk profile before investing in any asset class. Knowing your risk profile profoundly helps you accept volatility and also helps you make informed decisions while choosing an asset class.
Each mutual fund scheme has some risks involved, and therefore, an investor who is aware of his/her risk-taking ability is likely to choose the mutual fund scheme that suits him/her best. Moreover, that investor will also stay invested under extreme volatility.
Most investors panic when they invest in mutual fund schemes that do not suit their risk profile, and ultimately, they fail to meet their goals by cashing out early.
Knowing Your Goals
What’s a plan without a reason or an end goal? Defining your reason/goals for investing in mutual funds and setting the right timelines sets a realistic expectation of returns from your investments. Moreover, attaching your mutual fund schemes to a particular goal can help you stay focused on achieving the goals.
For example, if child education is a goal for an investor who has a 1-year-old child, he/she can start investing in mutual funds with the objective of funding his/her child’s education through SIPs. Investing small amounts every month for the next 18 -20 years is much easier than shelling out a lump sum after 20 years, isn’t it?
And since the time horizon is longer, the investor can take some risks and invest in an equity mutual fund or choose any fund that suits the risk profile and let compounding work wonders in the longer term. In fact, not only does the investor get the ease of building a corpus in installments, but the power of compounding can amplify the returns in the longer term. Thereby, the investor can save less and get more.
Selecting a mutual fund scheme based on your goals and time horizon
This is the most crucial aspect of mutual fund investing that many investors struggle to understand. Most investors start investing in mutual funds with a defined goal but fail to choose the right scheme to help them achieve that financial goal.
For example, an investor who has started saving via mutual funds to buy his dream car in a year’s time chooses a very aggressive mutual fund scheme and invests in volatile stocks.
As we all know, stock markets can be quite volatile in the short term. If the markets do not perform or crash within the desired time frame, chances are that the investor won’t be able to buy the desired car or might delay the purchase due to the shortage of funds.
Therefore, it is very important to select the right mutual fund scheme based on the goal and the time required to achieve that goal.
Past Performance of the Fund
Although the past performance of any mutual fund scheme does not guarantee future returns, it’s important to study past results to gauge the performance and pedigree of the mutual fund managers.
The average past returns of 1, 3, or 5 years can be studied to look for consistency and performance and establish trust and confidence in the mutual fund manager and the overall AMC.
However, past performance should never be considered in isolation. An investor should use various qualitative and quantitative measures to evaluate the fund’s performance over a long period and then make an informed decision before choosing the right fund scheme and fund house.
“Mutual fund schemes are not guaranteed schemes.”
We don’t mean to scare you, but it’s good practice to know what you are getting into, isn’t it? Thanks to our market regulator, SEBI, every mutual fund house that issues its schemes to invest in has to offer proper documents that have detailed descriptions of the mutual fund house, its managers, which assets the managers will invest in, and most importantly, all the risks associated with investing in that scheme.
Documents such as SID, KIM, and SAI, which are published by every mutual fund AMC on their websites, contain the above information.
These documents explain the nature of the schemes and give an in-depth understanding of where the MF fund manager has deployed money in the past and how he will invest in the future.
Why is this important? These documents will enable every investor to make an informed decision since they help to determine whether the scheme is suitable for them.