Diversified portfolio, flexibility and liquidity make mutual funds an attractive investment option, says Priya Desai

As I was shuffling through newspapers recently over a cup of tea, I spotted a graphic 30-page insert booklet, ‘Making Investing Simple for Supandi with Prof Simply Simple’. Curious as to who was going the Amar Chitra Katha way to educate investors, I turned the pages to discover that it was an investment education initiative by Tata Mutual Fund.

India has millions of mutual fund (MF) investors. While some find their investments blooming, others find them wilting.

Confusion galore

When it comes to the concept and functioning of MFs, there is less clarity and more confusion. To make an informed decision, it’s important to seek answers to certain questions:

• Why am I investing in an MF scheme?
• What is the nature of the scheme?
• What is the timing of the investment?
• Why does one scheme of an MF vary from another?
• Why do similar schemes of different MFs not necessarily result in similar gains or losses?
• What is the likely quantum of income from the investment, and over what period and why?
• How will the investment return change depending on duration?

Stocks, bonds and mutual funds are some of the popular financial instruments for those looking to invest in avenues other than fixed deposits. Investing in stocks by small investors can entail high risk depending on how the stock prices move. If on the other hand the same amount is invested in one or more MFs, the investor has a better chance of benefitting from diversification in more stocks. Let us see how this happens.

The fundamentals

There are a large number of MF companies such as HDFC Mutual Fund, UTI, Tata Mutual Fund, Reliance Mutual Fund, Religare Mutual Fund and other big and small fund houses. Each fund has a large number of MF schemes under rubric such as equity, equity and debt, sectors, tax exemption, etc.

With an unending list of schemes to choose from, an average customer finds it difficult to differentiate between the options and choose the right ones. This often leads to investing in schemes marketed by brokers, agents and sometimes even those recommended by friends.

The mechanism

MF houses pool together money invested in a particular scheme floated by them, and invest in various stocks. The fund manager, an expert in stock market and investing, decides the stocks and bonds in which the collected amount is to be invested through an asset allocation mechanism. Thus, an investor is indirectly investing in the stock market, while banking on the expertise of a fund manager. Depending upon stock market movements, the composition of stocks is varied from time to time. Naturally, the volatility of the stock market will be reflected in the value of investment in any mutual fund.

An investor is allocated a number of units in an MF depending on the amount invested and the value of a unit at a point in time. The base value is normally ₹ 10. Once the scheme is floated, this value either increases or decreases, depending upon the asset holding of that fund, and is available on a daily basis. This is called Net Asset Value (NAV): value of a unit of the scheme at a given time. Thus, if an investor has invested ₹ 1,000 at a NAV of 12, he gets 83.3333 units. If after a year its NAV is 13.5 and he sells them, he gets ₹ 1,125. His gain is ₹ 125 or 12.5 per cent.

Flexibility and liquidity

An important feature of an MF investment is that investors can buy any number of units and remain invested according to their choice. Again they can sell the number of units of their choice. This can be done through a broker, agent or directly through the fund house. The amount due to sale gets credited to their account. Thus, flexibility and liquidity are two important features of a MF. By investing a predetermined sum on a regular basis for a long term, an investor can take the benefit of a systematic investment plan (SIP). This has the advantage of averaging the costs owing to the ups and downs in NAVs.

The rules of dividend earning, short and long-term capital gains and loss applicable to MF investment are the same as those for stock and share investment. MFs declare dividend at different intervals. Dividends are completely tax-free. If any gain accrues owing to sale of units in less than a year, it is taxable, but long-term gains are non-taxable.

Dividend disbursal

After a fund announces the dividend per unit, for instance ₹ 2.5, the value of the unit goes down to that extent on the day of distribution. Some funds give dividends two or even three times a year, while many announce dividend just once a year. Some skip the dividend for one, two or more years. While a well-managed MF generally announces dividend once a year at least, it is not mandatory.

Whether an investor gets the announced dividend depends upon the dividend, reinvestment or growth option selected at the time of buying. If a dividend option is chosen, dividend will accrue as and when declared. In a reinvestment or growth option, the dividend earned is converted into units at the price on the dividend distribution date and added to the account. Thus the magic of compounding often makes your investment grow multifold over a number of years. For instance, if ₹ 100,000 was invested at the initial unit price of ₹ 10 in HDFC Growth Fund in 2000, its present value will be over ₹ 1,200,000 at the current NAV.

Mind-boggling choices

An investor has a wide choice while deciding to invest in an MF. Under each fund there are different schemes with different features. An investor benefits by deciding the goal, duration, etc, before opting for a particular fund or scheme.

• Equity funds – large, medium and small cap
• Debt funds (also called income funds)
• Diversified funds (also termed balanced funds)
• Gilt funds
• Money market funds
• Sector-specific funds like power, technology, banking
• Index funds

There are equity-linked saving schemes (ELSS) that meet the requirements of tax exemption. Investment in such schemes with a lock-in period of three years is ideal for tax purposes. It is important to read the fine print of a selected scheme.

A mixed bag

Like other vehicles for financial investment, MFs too have pros and cons. An investor benefits from professional fund managers charged with the responsibility of tracking share market movement and investing with the goal of appreciation in the investment. Individual investors may lack the valuable experience to handle their investment in shares. Investors also benefit from the diversified portfolio of an MF as well as the liquidity aspect. MFs are relatively simple to handle, as the units are easy to buy or sell. But as with other such schemes, everything is not hunky-dory with MFs too. Professional managers are no guarantee that a MF will perform well. It is important for every investor to know that share market volatility will be passed on to MFs. Costs of administration too are passed on to investors, affecting the final dividend.

No single mantra

It is advantageous to buy units of a scheme when prices are low. When the market is bullish, unit prices increase handsomely, resulting in large gains. SEBI, the market regulator, has made it compulsory for MFs to mention the distribution commission and expense ratio on the biannual consolidated account statement received by investors. But it is the investor who needs to call the shots by tracking the NAV at regular intervals. The test of an MF scheme is in its dividend record and appreciation of the investment. If it’s long-term gains an investor is looking at, mutual funds could well be the answer.

The author is an economist based in Mumbai

Photo: iStock
Featured in Harmony — Celebrate Age Magazine
May 2016