12 Things You Should Know Before Investing In Mutual Fund

Mutual Funds Sahi Hai!!! We all would have heard, read or seen this ad multiple times and by now know that Mutual Fund is one of the convenient and relatively safe ways for investing and building your wealth. But as with everything, it is important to have right knowledge to maximize the gains. In this article, I will explain 12 Things You Should Know Before Investing In Mutual Funds.

Understand What Mutual Fund Is

Let us start with the basics. In simple terms, Mutual Funds are a collection of stocks and bonds. If it invests majorly in stock market, it is Equity Based mutual fund and if it invests majorly in government / corporate bonds, TBills etc, it is Debt based mutual fund. Also note that depending on category of mutual fund, your money will be invested. So a large cap fund may have higher percentage of funds allocated to large-cap stocks.

Define Goal And Timelines Before Investing In Mutual Fund

Your goals, time horizon and risk appetite should dictate the Mutual Fund you have to invest in.

You should have a clear idea of your goal for which you want to invest in Mutual Fund. What is the goal, how much money you need for that goal, how much time do you have to achieve the goal should be the first thing you should write down.

Few of the goals common for all are emergency fund, annual vacations, gadget purchase, buying house, saving for children and retirement. These can be segregated based on the time available to achieve these goals.

Map Goals To Mutual Fund Type

Once you have the goals and timelines, you will be able to get an idea of the type of Mutual Funds you can opt for – whether to invest in Stocks (Equity Mutual Funds) or Bonds/Securities (Debt Mutual Funds). For Short term goals, invest in Debt Based Mutual Funds while for Medium to Long term goals, invest in Equity Based Mutual Funds.

For example, if your goal is to create or maintain an emergency fund, then you will most likely have to invest in Debt Mutual Funds. But if your goal is retirement which is 20 years away, you will be of investing in Equity Based Mutual Funds.

Identify Your Risk Appetite

Just selecting Mutual Fund Type is not enough. You should also be able to identify the Category.

So if you have decided to invest in Debt mutual fund, it is time to decide on which type of debt mutual fund to purchase – will it be Liquid Mutual Fund or Short Term Debt Fund or Medium Term Debt Mutual Fund. Similarly, if you want to invest in Equity mutual fund, you will have to decide if it will be in Large cap, mid cap, small cap, sectoral fund, index fund, international funds etc.

This decision will come from your returns expectation and risk taking ability – how much of risk you can take and for how long you can take the risk. Think of a scenario where market crashes and your returns are in negative. How much losses can you bear and for how long can you wait before you decide to pull out your money and what are your returns expectation. If you want high returns, then be prepared for high risks – you can even loose your investments if market crashes.

For your convenience, I have created a table mapping risks, returns and holding period with the type of mutual fund you should select.

Identify The Right Mutual Fund

Now that you know which mutual fund category to invest in, the last thing remaining is to find out the actual Mutual Fund in which to invest. For this, you should do some research.

Check various parameters like who is the AMC managing the fund, what is the asset size (AUM), what are the entry/exit charges and lock-in period for this mutual fund, what are the historical returns (xirr as well as rolling returns) across 1-3-5-7-10 years and how do they compare with benchmark and competitors, who is the fund manager and since how many years has (s)he been handling the mutual fund, what is the minimum SIP amount allowed, how do the fundamental ratios look and compare against competitors, what are the key sectors and stock holding of that mutual fund etc.

If all these information resonate with you, then last step should be to check their rankings/ratings on few good websites like ETMoney, Value Research, MoneyControl etc. Note that this should be last step and not first step of process.

Once you have zeroed in on your mutual fund, just start the SIP either directly with the AMC House or via any 3rd party app selling Direct Mutual Fund. Only thing to remember is to buy a Direct plan instead of Regular and opt for Growth instead of IDCW (Dividend payout).

Direct vs Regular, Growth vs IDCW

All mutual funds come in 4 flavors – Regular vs Direct and Growth vs IDCW. So it can be Regular-Growth, Regular-IDCW, Direct-Growth, Direct-IDCW

In previous point, I mentioned that you should go for Direct mutual fund instead of Regular. The reason for this is that both Regular and Direct mutual fund have same portfolio. They invest in exactly the same stocks/bonds and in same percentage. The only difference is in their expenses. Regular mutual funds have to pay money to distributing agents and hence pass their commissions to you. That is the reason you will always see Regular Mutual fund having high expense ratio than a Direct mutual fund.

Hence, unless you feel charitable and want to donate money to intermediate agents, opt for Direct mutual fund.

Tip – You can save between 0.5 – 2% on expenses for every SIP by opting for Direct Mutual Funds instead of Regular Mutual Funds

The decision on Growth vs IDCW is personal. In Growth based funds, the dividends declared by companies are invested back on your behalf by the mutual fund. In IDCW based fund, these dividends are passed on to you. So if you are someone who likes regular dividend in bank account, then go for IDCW. My personal choice is to always go for Growth option as that allows more money to be invested in my mutual fund thereby increasing the corpus in long run.

Set the Right Expectations

While looking at historical returns is one of the key parameters to decide a mutual fund, one should remember to not rely on it too much. Past returns are not a guarantee for future performance as no one can predict the future.

Stock prices fluctuate on multiple factors few of which are foreseen (like company performance, debts, profit margins etc, competition, growth prospects, fundamental ratios, supply chain disruptions etc) and remaining unforeseen (civil and political unrest like those happening in Sri Lanka and Pakistan , act of God – famine, floods etc, pandemic like Covid, currency depreciation, raw material cost increase etc). Hence, always have realistic expectations for future returns.

Different mutual fund categories have different risk levels. You will not get the same returns every year

That is the reason you will see that in long run, everyone advocates Debt fund returns to average around 8% and Equity fund returns to be around 12%.

Lump-sum vs SIP

Another common question for many is whether to opt for SIP or do Lump-sum investment. Generally speaking, SIP are always better because for following 5 reasons mentioned in this short video of mine:

That being said, there may be occasions when you have money (like getting annual bonus) and want to invest in MF. In such scenario, best option is to distribute it evenly as one time lump-sum investment across the multiple SIPs you have. Alternatively, park it as lump-sum in some Debt MF and then via STP, transfer it to your existing SIP.

Do Not Rely on NAV

Net Asset Value or NAV is the cost of buying one unit of a mutual fund. But it should not be used to compare mutual funds or decide one to buy.

Just like a slice of pizza will cost different depending on the ingredients, base, type of crust and toppings chosen, same is the case with mutual funds. Even in large cap mutual funds, no two funds will have same NAV because they invest different % in the large cap stocks. So you cannot say that Fund A with NAV of 30 is cheaper than Fund B of NAV 74. Hence, never rely on NAV to buy or compare performance.

Get the Right Diversification

Put your egg in different basket is the popular phrase to justify diversification. But many people understand it wrongly and buy multiple mutual funds even in same category in the name of diversification. This altogether defects the purpose as funds within same category more or less invest in same stocks.

Let us look at an example.

As above image suggests, about 72% of holding is common between Canara Robeco Blue Chip and SBI Blue Chip which are both Large Cap Mutual Fund which more or less defeats the Diversification purpose.

Hence, aim to have max 1 or 2 mutual funds in each category. Diversify across categories. So maybe 1 fund each in Large Cap, Mid Cap, Small Cap, Index, Foreign, Debt etc will give you better returns.

Periodic Re-balancing

It is not enough to do all the homework at beginning and just start SIP. You have to constantly keep a track of progress and re-balance if required.

Ideally you should review the performance of your portfolio every 6 months or max every year. If you see any fund not doing well, red flag it and try to find out the reason for bad performance. Has something changed which has impacted its performance, how is it doing wrt other competitors of same category and with benchmark, are there changes in the holding patterns or fund manager etc. These will give you some idea about the situation.

Monitor the red flagged funds closely for another 6 months to 1 year to see if things are improving. If you think that there are signs of improvement and the dip in performance was just a temporary one, continue holding the fund. But if you see consistent downgrade in performance, it is time to switch to another fund.

Remember that it is not necessary that a mutual fund ranked #1 will continue to remain#1 even after 3 or 5 years. Do not get swayed by rankings and switch to buy the new #1. Stay invested if you are happy with how the fund has performed and been consistent (maybe always been in top 5 or top 10).

Also remember that at times, due to inflation or low returns, you may not be able to achieve your goals. For this situation, it is recommended to regularly review your funds and keep increasing the SIP amount every year. You can opt for auto increase in SIP to be in-line with your annual salary hike.

SIP-SWP-STP-Lump-sum

Understanding this difference is important in the world of Mutual Funds. Systematic Investment Plan (SIP) and Lump-sum are while investing phase where we decide how much to invest and how frequently to invest.

STP stands for Systematic Transfer Plan where we plan to switch fund from one category to another within same AMC. For example, if I want to switch from HDFC Large Cap to HDFC Midcap mutual fund, I will initiate a Lump-sum Withdraw and Reinvest or a STP.

SWP is related to withdrawal where your money is withdrawn and transferred to your bank account at regular intervals.

Hope these tips will help simplify the process to investing in mutual fund. If you liked this article, please also read my other article – 10 Things To Know Before Investing In Stocks

Looking forward to your comments and feedback.