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:
- 200 square yard plot at an offer price of rupees 40000 per square yard. (offer price Rs. 80 lacs)
- 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.
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