Planning to invest in mutual funds? Understand these 5 decision points

As per Association of Mutual funds in India (AMFI) data, average assets under management (AUM) of MF industry touched Rs.23.4 lakh crore in June quarter, from Rs.19.51 lakh crore last year. These figures indicate growing popularity of mutual funds amongst investors in India. But before you join the bandwagon and start investing in mutual funds, make sure you are well-versed with following decision points:

Decision 1: Debt or equity funds

Debt funds invest in fixed income instruments like government bonds, treasury bills, corporate bonds, non-convertible debentures etc. These generally offer around 7% returns for one year period and 8-9 per cent for three year period. These are meant for low risk takers expecting low to moderate returns, or for the ones who are and looking to invest for short term goals such as family vacation or maintaining emergency fund.

On the other hand, equity mutual funds principally invest shareholder’s money in stocks (equity and equity linked instruments). These involve higher risk than debt funds, since equities are volatile in nature due to sensitivity towards economic fluctuations. But, they provide higher returns as well, with three year returns up to 20 per cent.

Equities are ideal choice of investment for long term (3 years and above), with consistent inflation beating returns over the past years. Over the long term, the chances of incurring losses from equity funds reduces, thereby making them the optimal investment choice for long term goals such as child’s higher education and retirement corpus.

The decision to invest in equity or debt funds should depend upon your risk appetite, investment horizon and financial goals. For instance, moderate risk takers looking to invest for long term can opt for a mix of both equity and debt funds (balanced funds) to build portfolio, since it would reduce the overall risk and also provide stability of returns.

Decision 2: Closed or Open ended funds

The main difference between open and close ended mutual funds is the degree of flexibility and ease of sale and purchase of fund units. Open ended mutual funds are continuously available for sale and purchase, without any fixed maturity period. It offers great convenience to the new as well existing investors to buy and sell units at Net asset value (NAV), which changes on a day to day basis, based on market fluctuations.   

Whereas, close ended funds are open to subscription only during a set period post the new fund offer (NFO). These funds cannot be purchased once the NFO is over. New investors cannot exit till the scheme’s term lapses. However, existing investors still have a chance to exit, if the fund house has listed its close ended schemes on the stock exchange. However, since the trading volumes are usually quite low in these funds, existing investors often find it difficult to exit through this route.

While choosing between these two fund types, it’s vital to note that close ended funds lack past records and real time comparison, involve a higher expense ratio and concentrated portfolio, require market timing, are difficult to exit and do not offer the option of investment through SIP route.  

Decision 3: Direct or regular plans

When you buy a mutual fund through a distributor or some other intermediary, it implies purchase through regular plan route. Whereas, when you directly buy funds from the fund house, without the involvement of any intermediary, that’s referred to as direct plan. Even though the investment objectives of both are same, these two differ in terms of returns, NAV and expense ratio.

As direct plans do not involve financial advisory or distributors, they save on the expenses in the form of commissions, fees and brokerage. These savings translate into lower expense ratio, which is passed onto the investors in the form of higher returns and higher NAV.

Moreover, the problem of lack of financial advice and guidance in direct plans has been solved by online financial marketplaces. They are offering automated advisory services to each customer, while they visit their platform to purchase direct plans.

Decision 4: SIP v/s lump sum investment

Another decision that every investor needs to make while investing in mutual funds is whether to choose the SIP route or lump sum route. Systematic investment plans (SIP) regularly invest a fixed amount at preset date and fixed frequency, which is decided by the investor. With the presence of rupee cost averaging concept, investor doesn’t bear the risk of timing the market. Therefore, even new investors can opt for this route. Moreover, regular investment through SIPs helps inculcate the habit of disciplined investing, especially over the long term.

Lump sum investment involves one-time investment of a large amount, usually to build a huge corpus. Herein, investors need to time the market well in order to catch the market at a high point. As a result, investor would end up investing at a higher NAV, thereby reducing your gains when the market falls.

Decision 5: Growth v/s dividend option

Many investors often fall into this dilemma, whether to opt for dividend option or the growth option. When you choose the growth option, profit earned by the scheme is re-invested back into it. The growth of your investment is reflected in the form of higher NAV of that scheme. As far as dividend option is concerned, the company distributes a part of its profit as dividend. Many investors misconceive this dividend as an additional income. Actually, you are simply withdrawing a part of your profit from the fund, in the form of dividend.

Avoid opting for dividend option to withdraw your money (as dividend). Whenever you would require money, you can conveniently redeem a part of your investment in the growth option itself. Growth option works even more in the long term, as it grows your investment over the long period, to fulfill goals such as building corpus for retirement or child’s higher education.

As far as taxation is concerned, according to this year (2018)’s budget announcement, a dividend distribution tax (DDT) at 10 per cent has been proposed on equity oriented schemes. Also, equity funds would be involving a long term capital gains tax (LTCG) on gains exceeding Rs.1 lakh, taxed at 10 per cent.

Manish Kothari - Head of Mutual funds, Paisabazaar.com