Mutual Funds- What all you need to know (Do It Yourself)

  

Most of us shall buy products worth lakhs of rupees online every year from e-commerce websites but are not comfortable in investing one thousand rupees of our own in Mutual funds. We find it complex to invest online and shall prefer to pay hefty charges to financial advisors. Even after paying the charges one can’t be sure that the financial advisors are working in his/her best interest.

In today’s article, we shall be discussing a brief of everything you need to know to invest in mutual funds in simple terms. You may find various articles on specific terms if you want to learn more.

Type of Companies

When we talk about mutual funds it is like someone is buying stocks of listed companies on behalf of many investors who could not invest themselves due to any reason. The equity mutual fund primarily invests in the following type of companies

  • Large Cap Stocks: These are the top 100 listed companies in terms of market capitalization.
  • Mid Cap Stocks: These are the listed companies ranked from 101 to 250 in terms of market capitalization.
  • Small-Cap Stocks: These are the listed companies ranked after 251 in terms of market cap.

Many people confuse the market cap with the stock price of a company. They assume that the company having a share price of Rs. 100 is larger than the company having a share price of Rs. 50. But it is not the case. The market cap is the worth of a company as determined by the Stock market. It is calculated by multiplying the number of outstanding shares by the price of one share.

Let us understand the same with an example of two plots on sale:

  1. 200 square yard plot at an offer price of rupees 40000 per square yard. (offer price Rs. 80 lacs)
  2. 300 square yard plot at an offer price of rupees 30000 per square yard. (offer price Rs. 90 lacs)

In the plots consider the area in the square yard as the number of outstanding shares and price per square yard as price per share. Now plot 3 is larger than plot 2 even though the per square yard price of plot 2 is more than that of plot 3. Hence the price per share along with the number of outstanding shares determine the size of the company. 

In the plots consider the area in the square yard as the number of outstanding shares and price per square yard as price per share. Now plot 3 is larger than plot 2 even though the per square yard price of plot 2 is more than that of plot 3. Hence the price per share along with the number of outstanding shares determine the size of the company.

Type of Mutual Funds

The main mutual funds' categories are as detailed below

Sr. No

Fund Categorisation

Guidelines

1

Large Cap Fund

Minimum 80% investment in large-cap stocks

2

Large and Mid Cap Mutual Fund

Minimum 35% in large-cap companies and minimum 35% in midcap stocks.

3

Mid Cap Fund

Minimum 65% investment in mid-cap stocks

4

Small-Cap fund

Minimum 65% investment in small-cap stocks

5

Multicap fund

Minimum 25 % investment each in large-cap, mid-cap, and small-cap stocks

6

Flexi-Cap fund

Can invest across market capitalizations with a minimum 65% investment in equity and equity-related instruments

7

ELSS Funds

Tax Saving funds with a lock-in period of 3 years, The minimum investment in equities is 80%.

8

Sectoral Funds

These funds invest in a particular sector like Pharma, IT, banking, etc. The minimum investment in the sector is 80%.

9

Index Funds

These funds invests in particular index like Nifty 50, Nifty 100, Sensex etc


Risk Vs Return

Large companies are considered to be less risky in comparison to small companies. The large companies remained under the continuous scrutiny of investors, bankers, and governments, etc. As a general principle risk and return are in an inverse relationship. Hence the return expectations from investment in large companies are less than the return expectation from investment in small companies.

Now in light of the above, you need to know one of the most important aspects in the mutual fund investing i.e. “Risk Appetite”

Risk Appetite

Risk appetite in simple terms is one’s willingness to tolerate the loss in the investment. Since mutual funds are market-linked products returns shall be volatile in short term. The portfolio can be in losses at times (mostly in the initial period of the investment journey).

Hence before starting investments in mutual funds you need to know how much risk you are willing to take. An aggressive investor willing to take high risk may consider small-cap, mid-cap, sectoral funds, large & mid-cap funds, etc for higher returns. While a conservative investor may consider large-cap mutual funds at the cost of some returns.

(Note: We shall primarily be discussing equity mutual funds as we believe that equity is the best instrument to build wealth in long term for early retirement. If you want to invest for less than 5-7 years you should consider debt or hybrid mutual funds. For early retirement and to be financially independent you should be prepared to be invested for decades as only then you will experience the magic of compounding in long term only)

Expense Ratio

The expense ratio is the cost we have to pay for investment through mutual funds. It is indicated in the terms of annual percentage. A fund with a 1.00% expense ratio shall charge 1% of the investment as the cost of managing the fund.

Why it is important as it impacts the return on investment. Keeping all other things the same a fund with a higher expense ratio shall lead to a lower return.

Direct vs Regular mutual funds

This is one of the most important aspects to understand in mutual fund investing. You will observe that every mutual fund scheme (equity) has two plans – Regular and Direct. The only difference is that the Regular plan has a higher expense ratio and hence lower return than the Direct plan.

Understand it in a way that in the case of a direct mutual fund plan you invest directly with a mutual fund company while in the case of a regular plan you invest in the same scheme through an intermediary i.e. a broker, distributor, etc who charges a commission for their services.

The comparison of the expense ratio of the regular and direct plan of Parag Parikh Flexi cap fund is as under:

Scheme

Expense ratio

Parag Parikh Flexi Cap fund- regular Plan-Growth

1.89%

Parag Parikh Flexi Cap fund- Direct Plan-Growth

0.98%

There is a difference of approximately 90 basis points in the expense ratio of both plans. In monetary terms an investment of Rs. 10.00 lacs (assuming 15% annualized return) for 20 years shall earn Rs. 24.04 lacs less in the regular plan than in the direct plan. The difference in return shall be Rs. 1.40 Crores in 30 years. It signifies the importance of investing through Direct plans.

Fund house (Asset Management Company)


The fund house/AMCs are the financial institutions that invest the money in mutual funds etc. The major fund houses in India are SBI Mutual Fund, ICICI Prudential Mutual fund, Nippon India Mutual fund, HDFC Mutual fund, Axis Mutual Fund, Kotak Mahindra Mutual Fund, and IDFC mutual fund, etc.

 

Fund Manager


A fund manager is the professional appointed by the Mutual fund house to manage the mutual fund schemes. The fund manager makes the investment decisions based upon the research, market conditions keeping in view the broad investment strategy of the fund house.

 

Some mutual fund schemes are famous due to fund managers and many seasoned investors invest in these schemes only due to their fund managers. These investors are ready to undergo a period of under-performance in the scheme as they understood the broad investment strategy of the fund manager. These investors know that the short-term under-performance is not representative of the long-term returns. HDFC Flexi cap fund scheme managed by Sh. Prashant Jain is one such scheme. Many mutual fund investors who like the investment style of Sh. Prashant Jain has stuck with the scheme for many years despite the short-term performance. There are many such schemes of various mutual fund houses.

 

 

Debt Vs Growth Plans


While investing, you will mostly find four variants/plans of every mutual fund scheme. Let us understand the same with the example of Mirae asset emerging bluechip fund. The fund has four variants:

 

Mirae Asset Emerging Blue-chip fund- Regular–Growth

Mirae Asset Emerging Blue-chip Fund- Direct-Growth

Mirae Asset Emerging Blue-chip fund- Regular-Dividend

Mirae Asset Emerging Blue-chip Fund- Direct-Growth

 

We have already discussed the difference between Regular and Direct plans. Further, the difference between the Dividend and Growth plan is that in the dividend option the profits made by the scheme are distributed as a dividend to the investors at specific intervals while in the growth option the profits made by the scheme are reinvested in the same scheme. Considering that mutual fund investments are for long-term “Direct-Growth” variant of the scheme is the most obvious option.

 

Bottom line


We have discussed the basic concepts required to start investing in mutual funds. The basic knowledge is sufficient to start investing in mutual funds. Further, you can learn more by reading in detail about specific aspects (wherever required). We shall slowly be moving from theory to practice which shall further improve your knowledge of the concept.

 

So let us continue the journey to financial independence.


Best mutual funds for beginners


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