Mutual funds pool in a lot of money from people like us and the fund manager who takes all the decisions will choose where to invest the money to get best possible returns for the risk you are taking.
Let us say, you invest Rs. 100 in X mutual fund. Portfolio of X mutual fund is that they have invested 20% in Infosys, 20% in TCS, 20% in HDFC bank, 20% in RBI bonds and 20% is kept as cash. So, the 100 rupees that you have invested is divided equally into these stocks (securities). When you buy a unit of mutual fund, you are buying a part of its portfoilio value. Unlike stocks, mutual funds do not give you shares. You get units which represents your investment in many different securities. The value of this unit is termed as Net Asset Value (NAV). The value of mutual fund company depends on the performance of the securities they have decided to buy. The choice for us now is to choose which mutual fund to invest in.
Before getting to selecting a fund, we must understand different type and categories of mutual funds. This is where a lot of us find it difficult to comprehend. We will in this chapter dissect everything we need to know in very simple ways to understand what each of them are and hence make the right choice that suits us. No fund is perfect for all of us. No strategy is perfect for each one of us. We have to be able to make our decisions that suits our risks and goals. We have seen what level of risks we can afford to take in the previous chapter.
First level classification of mutual funds is based on ‘where is the money invested’. If the fund is invested in debt instruments like corporate bonds, it will be classified as debt funds. If the fund is invested majorly on equity market i.e in stocks of different companies, it will be termed as equity funds.
Debt Funds
These invests in fixed income instruments such as Government Bonds or Corporate Bonds. Basic idea here is that a government body or a company borrows money from the market promising a fixed return at the end of the tenure. These are relatively a safer place to be invested in. They give stable returns and are low cost structure. Hence, the funds that invests in these instruments are also lower in costs, more stable and a lot safer. These are ideal for investors whose requirement is to get fixed and regular income and are risk averse.
Fixed deposits are also a debt instrument. Here, bank borrows money from you with a promise of fixed return. Debt funds, because they are slightly higher riskier than fixed deposits, offer more or less similar or better returns than savings account or fixed deposits. The safer the instrument is, the less returns they give. That is the reason why we will see lower returns on bonds issued by RBI or other government bodies. Debt funds are best suited if you want to protect your money and can stay invested for a long time. If your parents have a lumpsum amount, debt funds can be a great option. If you have saved a good chunk of money for your wedding that is expected to be happening in a year or two and you are not sure how the market will fluctuate, short term debt funds can be a better option to consider than FDs as you would want this money to be accessible at different times like buying jewelries. They are stable and secure. Your money is relatively safe and can be accessed when needed.
However, there is one major use case for young people like us who wants to be more concentrated in higher revenue generating instruments. Remember when we spoke about emergency funds? These are the ones that we want to be able to access as and when required. But parking this in a savings account does not fetch even a decent return. FDs lock up our money and breaking an FD is a headache and not cost effective. This is where debt funds come into play. It is ideal to keep large part of your emergency fund in these debt funds. There are multiple types of debt funds but we will stick to two of those – Liquid Funds & Short term debt funds.
Liquid Funds
These are the class of debt funds that invest in fixed income securities that mature in less than 90 days. Fund houses buy multiple securities with varying maturity days – 1 week, few weeks, 1 month, 2 months or even few months. As per the regulations, the average maturity should be less than 90 days. Fund houses are also required to keep at least 10% of the total fund size (also called as AUM – Assets Under Management) in cash. These two requirements make this type of fund very liquid. They are so liquid that some of the funds can deposit your money within 30 minutes from the time you place a sell order. In worst case scenarios and if you have placed your sell order after 3PM, you may get the money deposited latest by next day.
Ultra Short Term Funds
These are slightly more risky than liquid funds. However, since these funds get invested largely in good quality bonds, these are also considered a safe heaven for investment. Maturity period however for ultra short term funds is higher than liquid funds. Money will be deposited into your bank account by the next business day. If your horizon to park your money is between 3-6 months, these funds can be a good choice. Since these have a larger time horizon, they can access few bonds that give higher returns in exchange for longer holding duration. Hence, this makes it a bit more attractive when it comes to returns.
In both cases, there is no requirement of taking out the money after a defined period. You can keep your money in these funds for as long as you like. What you need to consider is the time horizon you want to keep and the quality of securities the fund house buys. A fund house can get a little greedy and invest in low quality securities to gain higher returns. Since we are investing in a debt fund, our primary goal has to be the quality of securities. You can check this in any platform you use. The fund must be invested more into bonds issued by government bodies like RBI, government of India, National Board of Agricultural Development (NABRD), NHAI (National Highway Authority of India) and other bonds which have AAA ratings.
Deb
t Funds
There are other types of debt funds for longer duration like low duration fund, short duration fund, mid to long duration fund etc. They can be chosen based on the duration that you are willing. But duration exceeding a couple of years in debt funds in most of our cases would not be an ideal choice. Equity market, where the real money is would be a better place to be in as they give much better returns for your investment. According to me, only the emergency fund and the fund that you definitely need in short duration should be parked in debt instruments as they will safe guard your money and are easily accessible.
Now, let us get to the more interesting part which most of us have been waiting for. Equity Mutual Funds – the one where larger chunk of our investment is put in stocks.
Equity Mutual Funds
This is where most of us are aware of and in all probabilities you may be already investing. But to get the best out of these funds, you have to understand it a little better.
Why are these funds present in the first place? Can’t we invest in the stocks directly? In the case of debt funds, we understand that we would need a higher sum to buy the bonds and they are not very accessible. But in equity market, it is as easy as shopping on Amazon. There are different stocks, buy one of them you think will be good and comes in your budget. Maybe we would need to learn a little about analyzing stock and we should be good right? Wrong. This is a very dangerous market. It is huge. We hardly know names of few stocks. There is so much to learn about equity market and it is not meant for a layman like us.
First, we do not know which stock to buy. Your friend might suggest one and you hear the name very often. You feel it is good stock and you buy it. Maybe it earned some money. But what is the guarantee that the stock you choose every time will give you positive results. Most of us unless we are extremely lucky, we tend to lose more than we gain. Almost all the time. And our goal is not finding one stock that does well for us and boast about it to our friends. We have a long term goal in mind. We want to get wealthier for a very long time and retire happily.
Second, we can not keep monitoring the developments around the stock we buy or wish to buy. You may keep up with all the news on the company, but it gets tricky to understand what economical factors outside the company would affect the company. There will be developments in unrelated industries that can get effected as well. It will be really hard to cop up with all the developments in and around the company we are invested in.
Third, how will you understand if the company you invested is doing well today and has the potential to grow tomorrow. Unless we learn in depth about the balance sheets, annual reports and other documents that can aid in our analysis, it will be very difficult for us to track the company. We will not be able to compare which company is growing at a faster rate and which is slowing down.
Fund houses have experts doing the calculations for us. They have teams to do all of these for us. They will take up the responsibility of understanding different companies and analyzing them. They will try their best to give the best possible returns on your investments. It is what they do - day in and day out. They are definitely in a better place to make judgements. Another advantage that mutual funds bring is they are well diversified. When you buy a few stocks, they are more concentrated. The capacity that we would possess to maintain all the stocks will be limited. These funds can have more than 30 well analyzed, quality stocks from multiple sectors already in them. So, you achieve a great degree of diversification right from the word go.
Market Capitalization is the aggregate market value of the company. We can arrive at Market Cap value by multiplying the current stock price by the outstanding number of shares for that company.
Based on the market cap of all the companies in the share market, they are divided into different categories.
Large Cap stocks – 1st to 100th companies in terms of market capitalization
Mid Cap stocks – 101st to 250th companies in terms of market capitalization
Small Cap stocks – 250th onwards
Equity mutual funds is the most popular type of fund among retail investors like us. There are many different categories or styles of investing in equity based mutual funds. One has to choose their style of investing depending on their risk-taking ability and the returns they wish to gain. We will discuss a few important types of funds that would make sense for people like us to get invested in. Once we understand these, we will be in a better position to make the right choice that suit our nature.
Large Cap funds – A large cap equity fund as the name suggests invests in large cap stocks. They have a pool of top 100 funds in terms of market capitalization to choose from. Usually, these are the companies that have been in the market for a very long time and have been the market leaders in their industries. These are the likes of TCS, Infosys, Reliance, Asian Paints, ITC, HDFC Bank, HUL etc. These are considered to be very stable and safe.
Portfolio of a large cap fund predominantly consists of large cap stocks (~80%). It is up to the fund manager and his/her strategy to pick some of these stocks that they believe will yield higher returns and assign corresponding weights to each of those stocks.
The main objective of the investor investing in large cap funds is capital appreciation from quality stocks with lowest possible volatility. These are the stocks that have stood the test of time. They know how to navigate through difficult times. They have been in the market and have been the market leaders. In fact, they possibly are still the market leaders. This means that they are more likely to remain stable and gradually grow. As a result, they tend to give lower returns than the following types of equity funds. These are less risky and more likely to give you good returns, but the returns are lower compared to other type of funds. If your target is to be in line with the market growth, these funds will do exceptionally well.
If you are willing to take slightly higher risk, the next type of funds would interest you.
Mid cap funds – the fund manager now has 250 stocks to select from. Though these does not include top 100 stocks, the next 250 stocks in terms of market capitalization would be the pool for the fund manager to choose from. A fund manager’s challenge will be to identify quality stocks that have growth opportunities. Sometimes, some of these stocks will have a great potential to challenge and replace the large cap stock. Since these companies are smaller, they have a greater chance of growing faster than the large cap stocks. However, this could also mean that they could be more vulnerable to market conditions compared to large cap stocks. It must be quite clear now that the possibility of better returns is with mid cap stocks, but the risks are also higher.
Small cap funds carry the similar nature. They will be much more riskier but will have the potential to yield brilliant returns. The fund manager will be challenged here. The skills of the fund manager will be tested here. There will be a few bad stocks among the large pool of stocks to choose from. Identifying quality stocks will be a challenging task. But it is some of these stocks that will disrupt the market. They will be the new trend setter and will have great growth potential.
Investors should understand that both mid cap and small cap funds are highly volatile. They will be the ones to fall badly when the market falls. Though these carry the potential to grow fast they carry a lot of risks. Management risks are also high in small and mid cap companies when compared to large cap stocks. These stocks might as well yield negative returns in short term – 2 or 3 years. But over a longer period, they have given far better returns than large cap stocks.
Above is the chart for average annual returns of 5 best performing stocks in each of the categories for the last 5 years. As you can see, Small cap funds have given better returns when compared to mid cap which has in turn given better returns than large cap. However, we have to understand that small caps funds have greater chance of giving negative returns as compared to mid cap funds and large cap funds at least in short term horizon. So, it is invariably important that you stay invested for long term if you are investing in small cap and mid cap funds. By long term I mean for over 7 or 10 years.
For the ones who want best of both worlds, enter Large & Mid cap funds. These funds must have a minimum of 35% of the stocks from large cap and 35% from mid-cap group. If you want to enjoy low volatility, be invested in tested and proven stocks and yet be included in the growth stories, these funds are a match made in heaven for you. They tend to give slightly higher returns compared to large cap and are also less volatile compared to mid and small cap funds.
Multi-cap funds – We will always have a dilemma of which category of fund to choose. While large cap funds give us the stability we are comfortable with, midcap and small caps give the returns we seek. Multicap funds allows you to be in each of these categories. They mandatorily have to invest a minimum of 25% in each of three groups – large, mid and small cap. This makes it more challenging for the fund manager to put his/her skills to test. Fund manager simply has larger pool of stocks to choose from and hence he/she must have great amount of knowledge and skills to do well. With Flexi-cap funds, the fund does not have any minimum threshold for investments in large, mid and small caps. Some flexi caps even have international exposure. About 30-40% of their portfolio could even be the stocks that are listed in US. The likes of Facebook, Amazon, Netflix or Google.
Index funds – In India, there two major Indices – Sensex and Nifty. Sensex is managed by Bombay Stock Exchange (or BSE) and Nifty is managed by National Stock Exchange (or NSE). We refer to these Indices to gauge India’s economic situation. When we hear people say the market is falling down or the market is doing well, it is these indices that they are referring too.
Sensex is comprised of India’s 30 largest and most actively trading stocks in BSE. Nifty 50 is comprised of top 50 largest and most actively trading stocks in NSE.
There are many more indexes in both BSE and NSE. Nifty 100 comprises of 100 largest stocks. Similarly, there is Nifty 500. Nifty Next 50 has next rung of 50 stocks after Nifty 50 stocks. There are indexes for each sectors too. Like Nifty Auto tracks few Auto stocks trading in NSE. These indexes act as a benchmark for fund houses.
In the previous types of funds that we discussed earlier, the fund manager tries to beat a corresponding benchmark. A large cap fund could be benchmarked against Sensex or Nifty 50. A mid cap fund could be benchmarked against Nifty Next 50. Since the fund manager always tries to modify the portfolio to beat the benchmark, they are called active funds. All the funds that we discussed previously are active funds. With Index funds, the objective of the fund manager is not to beat the benchmarks but rather just copy the index.
Now the obvious question is why would anyone want to be involved with Index funds. The core belief here is that it is too expensive and risky to actively manage the portfolio. It takes a whole team with years of experience and several months of analysis to converge on 20-30 good quality stocks that have great potential to grow. The cost is borne by you at the end of the day. Index fund says that you do not have worry about any of those. Just replicate what is there in one of these Indices and save cost. It is as simple as that. If an active fund charges 1.4% and an Index fund charges 0.10%, the active fund has to earn that much more percentage (1.3% extra) to just match the benchmark. They can only beat the benchmark after attaining the difference. The risk we take in active funds is also higher comparatively.
Common belief is that it gets too complicated and pricy to actively manage the stocks and beat the indices. Not all funds have managed to beat the index funds in the past. This is more so evident in the west where the market is matured. In countries like US, the market has been competing for decades and have attained some level of saturation. But in countries like India, where the growth is just starting to begin, active funds have higher degree of opportunities to beat the index. But it requires some level of understanding and analysis to choose the right fund that can beat the index fund by a good margin. With index funds, one cannot be greedy. You can only expect the returns that the market has to offer.
Balanced or Hybrid funds
These funds invest partially in equity market and partially in debt market. The claim is that you get best of both worlds. Growth from the equity market and stability from the debt market. They have better ability to sustain themselves during market crash as some %age of your investments are put into debt funds. However, these do not have the legs to run as fast as pure equity funds when the market is on the rise. I would rather prefer to be invested in Large cap funds than in balanced funds.
ELSS funds – If you fall under the taxable bracket, this is a gold mine for you. You might've heard about this category of funds. Not all funds can be used for tax deductions. ELSS (Equity Linked Savings Scheme) funds come with a minimum lock in period of 3 years. These are largely invested in large cap stocks. These funds are best for two kinds of people - one, who needs to save tax & two, who panics during market falls. Since there is a lock in period, you are forced to stay invested the period and more often than not, it is a good thing.
Now understand how to select a mutual fund.
Comments