Mutual Fund 101

Manoj Yadav was arguing with his 18-year-old son, Prakash, about how he should start saving his pocket money and not spend all of it on unwanted things. Prakash, who is still in that playful age, argues back, saying that, this is his age to enjoy life and not think about saving. ‘Saving is for old people’ is what Prakash says. Manoj knows that whatever he says further, will not make a difference to Prakash’s thinking. He thinks of other ways to inculcate the habit of saving. Suddenly, an idea strikes him, he reduces Prakash’s pocket money and uses it to invest in mutual fund.

Savings is a habit you cannot force on anyone. It has to come naturally. People have to understand the importance of it, that’s the only time they’ll take the initiative to start. Telling an 18-year-old to save is like teaching a one-year-old, how to say the alphabets. They are still dependent on their parents at that age, so they won’t even think of saving. Before telling someone to save, tell them the importance of it.

Let us start with the basics of mutual funds. Mutual funds are a pool of investments, collected from different investors. These investments are invested across different sectors of the market, like oil and gas, IT, FMCG, pharmacy, etc. They are professionally managed and monitored by different fund managers, to make sure, the fund is right on track. All mutual funds carry risk, but they are divided into less risky and risky funds. On TV adds you might have the disclaimer on mutual funds, ‘Mutual fund investments are subject to market risk, read all scheme related documents carefully. ‘ This basically tells you to invest at your own risk, because the returns are not guaranteed.

A mutual fund is one of the best options available to start investing for the beginner. It’s not rocket science, but yes it is important to understand the scheme properly. There are so many schemes, that it is difficult to explain each and every scheme. Let’s just cover the main topics. There are 3 steps to be considered before choosing your fund.

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Step 1 :- Are you willing to take the risk? 

If you are at a younger age, it is always good to take risks, as you still have time to make up, in case you make a loss on your investments. It’s not so in the case of an older person. He/she may be nearing to their retirement and we all know retirement means no income, so here risk can’t be taken. So just be comfortable in what you invest.

Step 2 :- How long do you want your fund to grow? 

Now 2 things you need to keep in mind here, one is equity funds are suggested to be kept for a longer term, while debt funds can be kept for short terms. The reason being that equity works well over a longer period of time, due to market fluctuations. Debt funds have easy liquidity and are safer as compared to equity.

Step 3 :- How important is your goal?

Now here you have to put in a little thought. I’m sure you have many goals. Prioritize, is what you need to do. Like if your going to retire soon and you want to go on a vacation too, your first priority should be given to retirement, because that is a goal you cannot co promise on. I’m sure now you know how to decide your goals. All goals that cannot be compromised on top.

Now that you know what fund you want to go for. You have 2 options to choose from in a mutual fund:

1. Growth Funds: Basically this option just allows your corpus to grow either through a lump sum investment or through SIPs and at the end of the term, you can withdraw that whole corpus. So it’s just growth on the amount in your fund account.
2. Dividend option: If you opt for this, you receive a dividend as well.It depends on the company’s performance and when they declare it.

All companies are separated into small cap, mid cap and large cap. It is explained as follows:

• Small Cap funds: These funds are invested in companies which have a small market capitalization. Companies with a market capitalization between $300 million to $2 billion, come under this fund.

• Medium Cap funds: These funds are invested in mid-sized companies, which have a market capitalization between $2 billion to $10 billion.

• Large Cap funds: These funds are invested in large companies, that have a market capitalization of more than $ 10 billion.

Mutual funds can be either invested in small, mid and large cap companies separately or they can invest in all the 3 caps together.

Now let us see the different types of mutual funds:

• Equity Funds: These funds are completely invested in different sectors or a particular sector of the equity market. It is riskier to invest in a particular sector than invest across various sectors. For example, I invest in an equity infrastructure fund,  after few years, the infrastructure sector is not doing too well, so my whole fund will not do well too. Now let’s take another example, I invest in a diversified equity fund (i.e. different sectors of the equity market), a few years later, the banking sector is not doing well, the whole fund will not get affected much since only one sector is not performing. So even if the banking sector is not performing, the other sectors will be performing well, this way the whole fund doesn’t get affected. It is always advisable to keep your funds invested for a long time in equity to benefit properly from it.

• Debt funds: These funds are invested in all fixed income securities, like government securities, corporate bonds, treasury bonds, basically low-risk securities. Debt funds can also be invested in particular security like debt gilt (Government securities), debt income, debt FMP, debt bonds, etc. The return on debt funds does not fluctuate, as much as, the returns on equity. Debt funds have easy liquidity also as compared to equity funds. These funds are good for people nearing their retirement age, as they cannot afford to take risks.

Must Read :– Benefits of Investing in Debt Mutual Funds?

• Hybrid Funds: These funds are invested in equity and debt. This more like a balanced fund, for those who do not want to take much risk. It has easy liquidity too. The rate of return is also high.
• ETF – Exchange Traded Funds: These are liquid securities which are invested in commodities, bonds or index funds. On the stock exchange, they trade like common stocks. Their price keeps changing since they are bought and sold throughout the day. Like debt funds, they have easy liquidity too, another plus point is that their expense ratio is low.

Let us look at the taxation part of mutual funds:

Note : ELSS is the only mutual fund which has a lock in for 3 years, and after that it is tax-free. It is also the only mutual fund which is allowed as a deduction under section 80C.

POWER OF COMPOUNDING 

Power of compounding means earning interest on the ‘interest’ you receive. An example would help make it clear if Mr. A invests Rs. 7000/- in a fund, having an interest rate of 12% p.a. (i.e. 1% per month), look at the below table to understand better: 

You can notice from the table above, that the interest per month is calculated on the SIP amount and on the opening balance as well (which includes the SIP and interest of the previous month). This is how compounding works. So, just imagine,  after 15 to 20 years, what amount can be accumulated.

This table is just to give you glimpse of after 10, 15 & 20 years, what the corpus will be. 

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It’s surprising how just investing Rs. 7000/- per month, can grow so much. Well, that’s the magic of compounding. The rate given above is taken at its minimum. Some funds have gone to an average of 18% and above also.

These are all the main funds you need to know about while looking out for a mutual fund. You can always consult an adviser, to explain to you in depth. You’ve seen the power of compounding work, now work your magic, by making your money work for you! So happy investing!

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