Amateur or an expert, every investor wants to know how mutual funds fit their overall investment strategy. Common questions that cross minds are regarding the benefits of mutual fund investment and the importance of mutual funds in the overall investment planning process.
To start with, let us first understand what a mutual fund is. And after that, we shall delve into the benefits and features of a mutual fund.
Meaning and types of mutual funds
A mutual fund is usually a large pool of money that invests in securities, bonds, money market instruments, and other assets. Professionals who manage that pool of funds are called Asset Managers. They attempt to generate income and appreciation in the investment value. Mutual funds can be of classified into three broad categories:
Equity funds – These invest in equity shares of listed companies. Equity funds are considered suitable for investors who have a long-term investment horizon. An equity asset class is ideal for investors who are willing to take moderate risk.
Debt funds – These invest in fixed income securities such as government bills or corporate deposits. Debt funds are less risky, and as a result, offer lower returns. A debt asset class is ideal for investors who wish to take a lower risk and are willing to compromise returns.
Hybrid funds – These invest in a mix of equity shares and fixed income securities. The idea is to maintain the right balance between risk and return. The fund managers operate within a specific ratio of equity and debt investment based on their market assessment.
There are other type of mutual funds as well like gold funds, international funds, etc.
Please also read Beginners guide to investing in mutual funds.
Here are ten most important benefits of investing in mutual funds:
1. Flexibility of investing
Mutual funds attract investors with the flexibility they offer. Amongst the several facets, below are essential features of mutual funds:
- Investor can start with minimal amounts
- Diversification across asset classes is possible irrespective of the quantum of the investment amount
- Systematic investment plan (SIP) habituates investors to save a fixed amount
- Investing in mutual funds do not require opening a Demat/Depository account
- Buying and selling is quite simple
2. Diversification is a significant benefit
Irrespective of the investment size, investing in mutual funds can provide well-rounded diversification. That allows the investor to manage risk and achieve long-term financial objectives.
Be aware of one common mistake investors make by investing in similar schemes across multiple fund houses. For example, buying large-cap mutual fund schemes of different fund houses is not diversification. Each of these funds would have invested in an almost similar set of companies, given their target is large-cap companies only. That is like holding the same security but through different brokerage houses.
Read more about this subject on Diversify your mutual fund portfolio.
3. Ease of investing
Aggregator websites (like www.moneycontrol.com) provide details of top-performing funds, top-ranked funds etc. Other metrics like recent & historical performance, fund return vs peers vs benchmark performance, growth in fund size are also available. All these facts immensely help investors to select the right mutual fund. Once decided, investment in mutual funds is straightforward and can be done either online or offline.
Purchase mutual funds directly from your bank account through net banking. Alternatively, buy from the mutual fund website or via third-party websites like www.moneycontrol.com.
One can hire an agent to help complete documentation and purchase formalities. Or visit the nearest branch of a specific asset management company.
4. Minimal costs to manage the portfolio
Mutual funds collect a fee when an investor joins the fund or exits, called entry load and exit load. The idea is that the entry load compensates the mutual fund for its selling and distribution expenses; the exit load covers transaction costs and acts as an exit barrier. Long back (in August 2009), the Securities and Exchange Board of India abolished entry load across mutual funds. The exit load exists and differs between fund houses.
As per SEBI (Mutual Funds) Regulations, funds are permitted to charge a portion of their operating expenses to manage the scheme. These include selling and marketing expenses, transaction costs, investment management fees and other administrative expenses. Total expense ratio (TER) is the cost charged to a specific mutual fund scheme related to its management as a percentage of the fund’s net assets. The general principle is – the lower the expense ratio, the better it is for investors. SEBI regulations provide guidelines on the maximum total expense ratio on funds for investors’ benefit.
Given the competitiveness and regulations, the cost to manage a mutual fund portfolio is reasonably low compared to the advantages of mutual fund investing.
Read How to choose the right mutual fund here.
5. Professionals manage the money
Asset managers are professionals who manage mutual fund investments. Their educational background, experience, and presence among people with knowledge of the financial market put them at an advantage. Although that does not guarantee performance or immunity from the downside, these asset managers are certainly in a much advantageous position that a typical investor.
Investors get varying returns across funds with very similar investment objectives. That is primarily because every asset manager has a different perspective and assessment of the market and securities.
Investor’s knowledge can also be enough, occasionally or over a period. But, the in-depth knowledge and understanding possessed by a fund manager combined with a fund house’s collective wisdom often score high. That is why people rely on mutual fund managers and allow them to manage their hard-earned money.
6. Systematic Investment Plan is an excellent feature
Systematic Investment Plan (SIP) means spreading investment into equal instalments over time. Here an investor contributes a (generally) fixed amount over time. Here are some of the essential features of SIP:
- An equal sum of money gets invested regularly on specific pre-defined dates
- SIPs work on the concept of cost averaging over a extended period
- Investment can happen in small sums
- Requires a long-term commitment
- Constant observation is neither required nor recommended
- Imposes discipline on savings and investing, especially for investors with irregular cash-flows
- Benefits of compounding available as interest/dividend gets reinvested in growth plans
- Highly liquid
7. Ample choices available based on criteria’s
Based on the criteria like below, investors can choose a mutual fund that suits their investment objectives.
- Duration – short term or long term horizon. Capital gains tax on income from the investment will also depend on the period of ownership
- Regularity of income – recurring current income required or accumulate gains through reinvesting
- Risk tolerance – swinging returns (high or low) or consistent returns (can be relatively moderate)
- Liquidity – if you expect any early requirement, always provide for such conditions as early withdrawal can be detrimental to overall returns
- Preference – an investor may have a specific fondness taste towards equity or debt (and their sub-classes)
8. Option to choose the investment style
Mutual funds, where the fund managers decide which assets to invest in, are actively managed funds. In this style, the fund managers do a great deal of research on assets, sectors, companies, macro and microeconomic factors before making an investment decision. The objective is to outperform its peer fund with similar goals and beat the benchmark index. These fund managers are usually well connected with companies in which they invest and with participants in financial markets to remain well informed in general. The expense ratio for actively managed funds can range from 0.5% to 1.5%.
Passively managed funds, on the other hand, seek to duplicate the performance of a benchmark index. The composition of these funds, also called Index funds, does not change unless there is a change in the benchmark index. Fewer changes in the fund composition lead to low share turnover and lower transaction-related expenses. Also, since the transactions are limited, the fund generates lower taxable income. All these factors lead to a relatively lower expense ratio.
9. Mutual funds offer income tax benefits
Equity Linked Savings Scheme (ELSS) is one category of mutual fund that offers income tax benefits. Investment into ELSS funds is deductible from taxable income under section 80C of India’s Income Tax Act. The maximum deduction is limited to Rs1.5 Lakhs in a financial year. This section covers several other options like PPF, NSC, etc. The exemption limit is cumulative for all these specified investments.
ELSS funds invest most of their corpus into equity & equity-related instruments. This equity investment happens across the sectors and the size of companies. Investment into ELSS comes with a mandatory lock-in period of three years from the date of purchase. There is, of course, no outer limit, and you may choose to remain invested for as long as you wish to continue. However, there is no possibility of any premature withdrawal from ELSS during the lock-in time.
Read more at Equity Linked Savings Scheme.
10. Selling a mutual fund is extremely simple
One of the essential features of a mutual fund investment is its ease of liquidation. The investor can sell its holding at any point in time. Unlike other asset classes, mutual funds investment is highly liquid. Be mindful of the below factors at the time of sale:
- Exit load – some mutual funds may apply this load, and it can impact the net amount received
- Tax on profits – if the sale value is higher than invested value, the difference (i.e. gains) may be subject to taxes as per the applicable rules
- Settlement lag – like shares, mutual fund redemption have a payment period, and you must consider that while planning an outflow based on the sale money
Mutual funds are simple to invest in, and there are multiple advantages of investing in mutual funds. Almost every investor can find out investments that suit their requirements aligned with their financial goals and risk tolerance levels.
The author is a senior finance professional with over fifteen years of work experience in corporate finance and has an affinity for personal finance and investment planning. Please leave your comment or share thoughts on this article via email at email@example.com. For more articles, please visit the website www.decodefinance.in.
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