Saturday, May 3, 2008

Mutual Funds: Part II

Last week I had written a post on mutual funds titled "Mutual Funds: What They Are?" Since that post had become very lengthy I had promised to add more to it. So, here I am.
Types of Mutual Funds

There are, essentially, and broadly, the following types of mutual funds:

1. Debt Funds
2. Equity Funds
3. Balanced Funds

Debt Funds: Debt Funds are those which invest a major portion of their corpus in government securities, bonds having varying durations, company fixed deposits and call and money markets. Between 90 to 95% of the total corpus is invested into such instruments. Since these are considered as safe instruments, therefore, the returns from such funds are also low but capital, in most cases, is protected, unless the investor stays invested in them for a very short period of time and there have been violent interest rate fluctuations in that period. One can expect a return of about 8-10% from such funds. One should stay invested in such funds for a minimum of 1 year for capital protection.

Equity Funds: Equity Funds invest a major portion (80% and above) in direct equities. Since the equity class is considered to be risky and returns are highly volatile, only those should invest who have the risk appetite to pass through volatile phases. There is a possibility that some investors may lose a part of their capital if they stay invested for a short period of time or if they invest in a bear market. To reap maximum benefits of an equity fund, one should plan to stay invested for a minimum of 4-5 years. One should expect a return of 18-20% from such funds.

Balanced Funds: As the name suggests, such funds invest about 50-60% of their total corpus in debt instruments and the remaining in equity instruments. This is done to reap advantages of both types of funds and to better the return as compared to debt funds and to reduce the risk which is there in classic equity funds. To lower the risk, one has to compromise on the returns, which are usually between 12-15% in such funds.

Loads

To run a Mutual Fund, there are costs and these costs are ultimately recovered from the investors in the form of loads. While most of the debt funds are no load funds, most equity funds have entry loads. In general, all equity funds charge an entry load of 2.25 to 2.5% while debt funds do not charge any. Both equity and debt funds are exit loaded on an early exit. While an equity fund charges 1% load on an exit within 6 months, a debt fund charges 0.5%. Debt funds are load free after 6 months whereas equity funds charge 0.5% if withdrawn between 6 and 12 months.

What Funds to Invest In?

Each investor has to see her own risk appetite. If you are the kind of person who would not like to take any risk whatsoever, then debt funds are the right choice. A person with a high risk appetite can go in for equity funds for higher returns while one can follow the ‘middle of the road’ approach by choosing balanced funds.

Equity funds come in different styles like thematic funds, sectoral funds, funds based on market capitalization etc. An investor should choose to invest a major portion of her portfolio in funds which are ‘evergreen’ like large cap funds or blue chip funds or well diversified funds. A part of the portfolio can go into other funds to take advantage of the ‘flavour of the season’. Keep your funds portfolio well diversified to reduce risk and get reasonable returns. Divide your money into 3-4 different funds but not so many that it becomes difficult to keep a track.

Today there are various funds like mid cap funds, small cap funds, power sector funds, media funds, banking funds, infrastructure funds and various others. All these concentrate on stocks of a particular sector or a particular capitalization and leave a lot to be desired from the power of diversification.

SIP is the Way to Go

Since timing the markets is a futile game (as one can never be right all the time), the best way to invest is to invest systematically. SIP is an acronym for Systematic Investment Plan. Under this plan, you set aside a particular amount (which could be as low as Rs.500/- with no upper limit) every month for investment in a fund. That amount is used by the fund to allot units to you based on the NAV of that day.

As an example, let us say you invest Rs.2000/- every month on the 15th. On 15th of last month, the NAV was Rs.20/- so you were allotted 100 units. On 15th of this month, with the improvement in the markets, the NAV increased to Rs.25/-, thus allotting you only 80 units. Then we witness a heavy crash and on 15th of next month the NAV falls to Rs.16/- which would then allot you 125 units. This means that you are buying lesser units when the price goes up and buying more when the price is low, thus decreasing the average price of holding. This way you acquire a total of 305 units for Rs.6000/- thus bringing your average to Rs.19.67/-. Alternatively, if you were buying 100 units each time, you would have spent Rs.6100/- and still bought only 300 units giving you an average cost of Rs.20.33 per unit. Thus, SIP helps you in bringing your average lower, which is also known as Rupee Cost Averaging.

Another advantage of SIPs is that you automatically save a small amount every month rather than a lumpsum every year. It will be easier for you to save Rs.5000/- every month rather than Rs.60000/- every year.

You can read more about SIPs on this page.

There is still a lot I need to talk about mutual funds but I guess I need one more post for that. Will upload it sometime next week.

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Happy Investing!!!