Mutual funds have slowly become a mainstay of young investors in India. This concept has been a hit in developed economies for decades now, but it has taken its time to build trust among investors in developing countries. Investment in these funds from domestic investors is hitting all-time high every passing month. So what is causing this sudden surge of trust and money coming into such schemes? Let’s try to understand mutual funds in detail in this article.
What are mutual funds?
Mutual funds are essentially investment vehicles which
- pool money from interested investors,
- are managed by highly qualified professionals for a small percentage of investment as managing fees,
- invest in stock, money or bond markets as per the mutual fund schemes and market situation.
Mutual funds have to register with SEBI (Securities and Exchange Board of India) before starting collecting funds from investors. In 1996, SEBI created the Mutual Funds Regulations which regulate how mutual funds can operate in India. Apart from SEBI, mutual funds are controlled by RBI, Indian Ministry of Finance, Companies Act, Stock Exchange and Indian Trust Act. Lot of stringent requirements are to be met before a company can start a mutual fund, which can be seen by the fact that only the biggest houses present in India like HDFC, Reliance, BlackRock, L&T etc. have been able to start their funds.
The assets under control of the mutual fund are the property of the investors of the mutual funds. Every gain/loss made in the portfolio is divided proportional to their investment among the investors by the fund after deducting their managing fees and other charges. You can either invest in lump sum or via SIP route in your fund.
Though it is always suggested to go via SIP to take benefits of bear market where you can buy more shares of the fund with the same amount of money and average out your per unit cost. You don’t directly buy the assets but buy units at the current NAV of the fund.
Why investing in mutual funds is better than regular FDs
Mutual funds can generate pile of cash for you but you got to have the right temperament. Why? Because mutual funds have generated about 9% to 25% returns year on year for their investors in the long run. Your bank gives you a mere 3.5 % – 7.5 % if you invest in the best FD/RD scheme. So you essentially don’t or at best barely meet inflation rate i.e. about 5-6 % every year. Which essentially means that you lose money (due to decreased purchasing power or the fact that prices of commodities increased at a higher rate than your interest from bank) once you store it in banks.
If you are a new investor, don’t know much about markets, have extra money to invest which you are ready to park and wait for at least 5-10 years, mutual funds are the go to option for you.
We will discuss different funds in detail below which will help you select most relevant fund category for you. Which fund you want to invest in that category is up to your own/ investment advisor’s discretion. I will try to suggest right fund in the comments section if required.
Comparison of returns from different investment options
Let’s see this through an example. Consider you park Rs. 50,000 per month in your local bank, or invest it in your well advised FD or invest it in good mutual funds. What should be your expected returns over time? Find here a synopsis of what your money is going to give you back over the years.
|Duration||SIP Amount||Future Value|
|From your bank saving rate (3.5%)||From your FD (7.5%)||From my mutual fund portfolio (18%)|
|5 years||50000||32.8 Lakhs||36.5 Lakhs||48.8 Lakhs|
|8 years||50000||55.5 Lakhs||65.9 Lakhs||1.1 Crores|
|10 years||50000||71.9 Lakhs||89.5 Lakhs||1.7 Crores|
|12 years||50000||89.6 Lakhs||1.2 Crores||2.5 Crores|
|15 years||50000||1.2 Crores||1.7 Crores||4.6 Crores|
|18 years||50000||1.5 Crores||2.3 Crores||8.1 Crores|
|20 years||50000||1.7 Crores||2.8 Crores||11.7 Crores|
|22 years||50000||2 Crores||3.4 Crores||16.9 Crores|
|25 years||50000||2.4 Crores||4.4 Crores||29.1 Crores|
|28 years||50000||2.9 Crores||5.7 Crores||50 Crores|
|30 years||50000||3.2 Crores||6.8 Crores||71.6 Crores|
|35 years||50000||4.1 Crores||10.2 Crores||175.5 Crores|
Can you see the difference here? Compounding effect can dramatically change your returns over time if invested in the right investment vehicle. It is up to you to choose where you want to park your investments.
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Why people shy away from mutual funds?
Biggest reason for people opting for FDs/RDs is the cushion against the high volatility in the markets which can change your mutual fund returns to even negative if invested for short period. Though if invested in the right fund, returns in short term can still be as high as 8-10%. Fixed deposits give you risk free 7-8% per year which you happily accept and reduce the risk involved.
People who are weak hearted or are investing for a short duration, should stay away from markets and save their money in bank/post offices. Nothing wrong with that really, having a low risk appetite is no crime, nor is not having enough time to be invested for a longer duration. But if you have both those luxuries, you know now where your money needs to go.
People who invest in mutual funds should be ready to handle negative returns over multiple quarters or even years, but over long period of time, be rest assured, nothing will give returns compared to these funds if invested smartly.
Benefits of investing in mutual funds
Mutual funds offer a plethora of benefits which are not available in other investment instruments. Let us discuss a few here for you:
- You don’t need too much money upfront: Mutual funds can be invested via SIP route and you don’t need to make a high down payment to start investing. You can start with as low as Rs. 100 per month!
- Power to control your investment: You can start/stop investing anytime you like or need due to other financial commitments. This is not advisable since investment should be a habit so even if you can invest lesser than previous months, do try to do it.
- Professional management: People managing your money are highly qualified and trained professionals who keep an eye on your money day in and day out so that you can take care of your other responsibilities. Their back end research team works day and night to ensure your money is invested in the right stocks/bonds. This is done by charging a small sum of money from your corpus.
- Governed by regulations: SEBI has strong control over such instruments so that investors are not cheated by them or overcharged. Recently only, SEBI had issued guidelines ceiling the expense ratio that can be charged by such funds so that maximum benefits can be transferred to the investors. Overall trading practices are being regulated and regularly audited by the respective authorities.
- Benefit of risk diversification: Mutual fund managers invest your money in a lot of stocks simultaneously which provides you a hedge from being invested in a single investment. So if a stock is not performing well, there are other stocks which will lift your portfolio to give good returns.
- Several choices: There are various type of funds which invest your money in different proportions among debt and stock markets. You have the power to choose which one you want to invest in considering your tenure of investment, risk appetite, age, expected returns, etc. This we will discuss in the next section.
- Tax benefits: Gone are the days when you had to invest in banks to earn a meagre 6-8% return on your FDs/RDs to get tax benefits. And how do you think banks gave you that much return? From the markets only! Then why not invest directly into the markets which offer the same tax benefits. Schemes like ELSS, ULIPs etc. which are tax exempted can be used to generate high return.
- Benefits arising from economies of scale: In mutual funds, you can start to invest from as low as Rs. 100, yet you are an owner in the fund which holds let’s say Eicher Motors which currently is valued at close to Rs. 25,000! How? Because you have pooled money with other small investors who will collectively buy good stocks and make money for each other. Isn’t that great!
- Strong discipline in investing: This is the most important aspect which is so under rated. Mutual funds MAKE YOU invest your money for a longer period and avoid short term trades, where nobody has ever made money. Read any celebrated investor to get this confirmed. You ONLY make money when you invest and not trade. This discipline goes a long way to make you rich which you never thought could be possible given your 9am – 5pm jobs.
Different types of mutual funds in India
There are many types of mutual funds in India which are nothing but a combination of different percentage of equity linked and debt linked assets. Let us discuss different types of mutual funds in India below:
Classification of mutual funds basis underlying asset class
- Equity linked funds: These funds invest in share market to generate returns for their investors. They typically have high returns, and involve high risk. Such funds should be an ideal choice for young investors who can take risk with their money and have a longer horizon of investment. If you are risk averse person, you can avoid them or invest in funds which invest in blue chip or large cap companies. They have lesser return and substantially low risk. Typical returns can vary from 12-30% depending on the duration and underlying asset combination. Be prepared for negative returns over a longer period as well.
- Debt funds: These funds invest in company debentures, bonds issued by sovereign governments, and fixed income assets. These funds are very safe investments and should be an ideal choice for people nearing their retirement or people with very low risk profile. Typical returns can vary from 7-10%. But the return is very much comparable to what private banks have now been offering (i.e. 5-6%).
- Hybrid mutual funds: Hybrid mutual funds also called balanced mutual funds are a mix of debt and equity linked securities in different percentages of both of them. These funds have the luxury to move in/out of equity market whenever the markets are low and park their assets in debt market and then come back when the equities are on the run. These are also safer investments as compared to simple equity funds since debt part gives a cushion where a fixed return can be expected from the market to give a basic minimum return to the investors. A return of 12-15% can be expected from such schemes.
Classification of mutual funds based on their structure
- Open ended funds: These funds do not have a lock in period and can be purchased at any point of time at the NAV of the fund by the investors. Here you have more control over your investments and you have the luxury of timing the markets to reduce your average buy value.
- Close ended funds: Investment in such funds can only be made initially and can only be re-deemed after a fixed period of time. Lock in period is the big concern here plus not able to take advantage of bear markets. To provide liquidity to the investors these funds trade like normal stocks over the stock exchange.
Piece of advice on how to invest in mutual funds for beginners
If you don’t have much time to follow the market or you don’t have too much knowledge of financials, go SIP route. Mutual funds investment for beginners can be a tedious task and it makes no sense to wait till you learn to invest. Start your SIP today and keep learning. See this can seem a bit biased from my end, but since this is my blog, I have the luxury to do that. I strongly suggest investing through SIP if you are looking to invest. There are lots and lots of benefits which you get due to this mode of asset build up. Few of them which I have seen with my investments are:
- You don’t need to screw your life to invest all you have earned in your investment and live a boring life the rest of the month/year. Make a healthy investment routine, and stick to it. And with rest of the money, please enjoy your present life. The moments lost today won’t come back. I have been to 2 foreign trips and many short trips in India and have been able to stick to my investment schedule as well. I don’t earn much, I just invest first and avoid wasting money on unnecessary liabilities.
- It helps you to take advantage of bear market. So when the next time markets crash, you aren’t sad, you are happy! That’s because the market regularly corrects itself, it is the intrinsic nature if this market. But now you can take advantage of this correction since you are going to make your monthly investments anyhow. So, you get to buy more shares/units of your mutual funds with the same amount and lower your buying average, hence better returns.
- You don’t have to time the market and focus on your time in the market. So you can invest and relax. Always wanted to use this quote! 😀
It is the amount deducted by mutual fund managers and other charges incurred by you when you invest in mutual funds. The deductions can be from 1.5 to 2.5% of your portfolio, so do check how much you are going to pay in your mutual fund. With a return of 16% annual return, 2.5% is a lot of take away. So invest wisely. Read more about expense ratio here.
Start investing in mutual funds today if you are planning to do so. You can either invest directly through AMC websites or through brokers which charge a minuscule amount to provide such services.