The word investing brings to mind a few vehicles – stocks, gold, real estate, etc. Out of these, a very popular tool to invest money is mutual funds. These passive investment vehicles have a long history in the Indian financial world, and they’re not going away anytime soon either!

Let’s brush up our basics about this passive way of investing!

The definition speaks for itself when it says that it is a “type of financial vehicle made up of a pool of money collected from many investors to invest in securities like stocks, bonds, money market instruments, and other assets. Mutual funds are operated by professional money managers, who allocate the fund’s assets and attempt to produce capital gains or income for the fund’s investors.”

Each fund has an objective (mentioned in the prospectus) and all efforts and strategies are directed towards achieving the same. 

Unlike a share of a company that gives you partial ownership in the same, buying into a mutual fund means buying into the value of its portfolio. Hence one shares in the profits and losses of the same. 

The price of a mutual fund is referred to as the NAV (Net Asset Value) per share. The formula is dividing the total value of the securities in the portfolio by the total amount of shares outstanding. Unlike stock prices, the NAV does not fluctuate during the day but is set at the end of each trading day

Investing in a mutual fund has many advantages

One can get the benefits of diversification at substantially lower prices. Even if a particular company does not perform, it is averaged out with the other stocks present in the portfolio. The diversification is also present at the industry level – a particular industry may not perform due to business cycle fluctuations, unforeseen events etc, but it is canceled out by the well-performing industries. Similarly for debt, one can invest in instruments with varying interest rate conditions and overall maturity terms. Thus one can achieve diversification cheaper and faster than if one invests in traditional securities individually.

You can earn money from mutual funds in multiple ways:

• From the dividends on stocks and interest on bonds held in the fund’s portfolio. 
• From any capital gains (if the fund sells its stake)
• From price appreciation of the fund itself. (which can they be sold by the investor)

Another key advantage is the fact that industry experts are making these investment decisions. They have years of experience in managing money as well as an acute understanding of macroeconomic and other strategic factors. The fund manager (also called investment advisor) is legally obligated to work in the best interest of mutual fund shareholders.

Lastly, the mutual funds industry is heavily regulated. This ensures accountability and transparency and the efforts taken by the authorities go a long way in safeguarding the interests of the investors.

Types of Mutual Funds

1. Equity funds

As the name suggests, this fund invests its capital into the equity market. There can be further sub categorisations – like small, mid or large (referring to the market capitalisation of the companies they invest in). Another method to categorise them is using their objectives –  it can be aggressive growth or income generation among others.

2. Fixed income funds

 This category of mutual fund focuses on investments that pay guaranteed return at periodic intervals. Examples of assets that they invest in include Government and corporate bonds and other debt instruments. This does not imply that the fund is immune to risk. There is still interest rate risk as well as risk of default when investing in risky bonds to fetch higher returns.

3. Index Funds or ETFs

Probably the most passive mutual fund out of all,l this category usually invests in stocks that make up the index. (Nifty or Sensex) The rationale here is that it is very tough to beat the index consistently and so investors must be allowed to exploit any opportunity by investing in the index itself.

4. Balanced funds

These funds invest in a plethora of asset classes – both equity and debt to reduce risk and increase return by building an optimum portfolio. Sometimes the allocation strategy among asset classes is fixed, and sometimes it is dynamic and adaptive to the business cycle and other macroeconomic conditions.

5. International/Global Funds

These funds invest in the equity markets of other countries – The most popular one being the American stock market. 

India is home to many mutual funds that offer a wide range of products. Here are India’s top mutual funds by AUM (Assets under Management)

AUM is the overall market value of all the assets that the mutual fund holds. It is an indicator of the size as well as the success of a particular fund.

How to identify MFs? What parameters to look at in short-listing MFs?

Obviously investing in mutual funds is safer than investing in stocks – that is one of the very key advantages of the same.

Before one delves into the correct mutual fund, they must introspect and figure the following extremely personal factors that play a huge role in determination. The first is an individual’s personal goals – this includes whether one wants a long term capital gain or a steady flow of income etc. Next is their risk taking capacity. This depends on how comfortable one is with huge fluctuations in their portfolio. Goes without saying that the risk has to be matched with the reward expected. Lastly the time horizon also place a crucial role in determining the correct fund. Do you have any liquidity requirements in the near future and other such concerns. 

If for example the goal is capital appreciation in the longer run (> 5 years),then a growth fund is ideal given that the investor is comfortable with the risk and volatility involved. (as most of the fund is invested in the equity market). The drawback here is that they usually do not pay any dividends or interest thus any requirements for liquidity or a constant flow of income will not be met.For those goals, an income fund should be considered. Different funds are available depending on the time horizon wanted. They invest mostly in debt instruments like government and corporate bonds, and have lower volatility.

They also have a negative beta usually i.e they react in a way that is opposite to the stock market. (if the market is down, they usually perform well). A good strategy here would be to use them to diversify one’s portfolio. However they are still subject to interest rate risk (which may fluctuate) and default risk (usually in the case of corporate bonds).

A balanced fund is a great option since it gives the benefits of both of the above.

The next aspect to consider is the expense or the fees that one has to pay to own the mutual fund. Some funds have an associated fee known as a ‘load’. This can be charged either when the investment is purchased or when it is exited.

Next is the expense ratio. This is basically the annual fee that an investor is charged in exchange for the services provided (of the fund manager along with other administrative expenses.) If you invest Rs. 10,000 in a fund that has an expense ratio of 2%, you need to pay Rs. 200 as fees to the fund house to manage your money.  Obviosuly a higer expense ratio implies lower profits to the investor. Plus the expense ratio  is usually lower for funds with a higher asset base as they can cover their expenses more easily.

As per these regulations, the total expense ratio (TER) allowed is 2.5% for the first Rs.100 crore of average weekly total net assets, 2.25% for the next Rs.300 crore, 2% for the next Rs.300 crore and 1.75% for the rest of the AUM. The limit for debt funds is 2.25%.

The next step is to determine whether one wants an actively managed or a passively managed fund. The former seeks to outperform the index and has a whole team of advisors, managers and analysts to conduct research and transact accordingly. A passively managed fund is known as an index fund aims to duplicate the performance of the index (like NIFTY or SENSEX). They are gaining popularity recently due to the inability of actively managed funds to outperform the index consistently. They are also more diversified and have lower costs involved. 

Lastly, one needs to look into the fund’s past results. This includes checking if they were consistent with the market’s performance, and their relative volatility compared to the index as well as their peers, along with other parameters.

A fund which falls slightly less than the index in a down market, and outperforms the index in a rising market is the most optimum option. 

However, there is a saying ‘History does not repeat itself’ and judging a fund solely on the basis of its past performance may not be the most ideal strategy. 

Experts often use other financial parameters like the risk adjusted return. They also look into the quality of stocks and how diversified they are. Remember here that one should evaluate a mutual fund with respect to their own portfolio. A fund may not be diversified across sectors in itself, but it can help your overall portfolio reach that level.

The bottom line here is that looking for the perfect mutual fund may not a daunting if not impossible task. However, with the correct research and clarity one can get there. Remember to follow the key parameters discussed and keep investing!