Mutual funds are like a basket where your money gets divided into different things like stocks, loans, gold, and more. But, are they a good way to invest your money? Let’s dig into it by reading more!
The Context
Equity Mutual funds are the perfect solution for people who want to own stocks without doing their research — Peter Lynch
Indian investors who opt to hold their investments for a long time frequently use mutual funds as one of their investment vehicles.
Investing in mutual funds is a popular choice for novice investors looking to get started in the equity market due to their passive approach. The Indian sub-continent has seen tremendous growth in the mutual fund industry, with 44 AMFI registered fund houses offering over 2,500 mutual fund schemes.
According to recently published data by AMFI India, the Assets Under Management (AUM) of Indian mutual funds as of June 2021 stood at ₹34 trillion, and this is expected to grow to ₹92 trillion by 2029-30, representing an annual growth rate of 12.7% between FY21 and FY30.
Mutual funds are investment programs where shareholders pool their funds to invest in diversified holdings, professionally managed by a designated fund manager in return for salaries and commissions. The growth of mutual funds in India can be attributed to their convenience, diversification, and affordability, making them an ideal choice for retail investors looking to enter the equity market.
However, investors must conduct thorough research and select the mutual fund scheme that aligns with their financial goals, investment horizon, and risk tolerance to maximize returns.
Mutual funds are available in a variety of sizes and designs, catering to various investment philosophies that investors pursue. Some mutual funds are equity-focused, debt-focused, hybrid, solution-focused, or thematic for investors interested in a particular sector.
Investors often use the SIP mode or lump sum investments to maximize returns, but both have advantages and disadvantages. While SIP eliminates biases of fear and greed, it has the drawback of value-cost averaging, which can force investors to continue purchasing in a strong market that will eventually fall.
Timing the market during a downward trend can prove disastrous, as market bottoms cannot be assumed, and a 50% loss would require a 100% gain to return to the original investment.
Equity Mutual Funds
Mutual funds are professionally managed by fund managers who aim to outperform the market or benchmark indexes to justify their fees. On the other hand, investors aim to generate returns that are higher than the current market returns after factoring in fees, taxes, and commissions.
The conflicting motivations of investors and fund managers can be problematic when it comes to achieving investment goals.
For instance, even if a mutual fund returns 9% and a larger market index like NIFTY-50 returns 12%, a modest return of 8% after deductions may not justify costs and commissions.
As per research by the Economic Times, 57% of mutual funds have failed to beat benchmarks over the last two decades, indicating that a significant number of fund managers have not been able to outperform the market.
Moreover, data provided by Value Research in April 2020 shows that 90% of equity schemes that have existed for over a decade have given a return of less than 10%.
While fund managers may blame the complexity of markets or regulatory policies for their inability to win, ordinary investors remain concerned about the taxes, fees, and commissions associated with mutual fund investing.
Thankfully, SEBI (Securities and Exchange Board of India) oversees mutual fund investing, categorizing them according to clear objectives and return-risk ratings based on their exposure to different types of stocks. SEBI’s regulations help investors understand what they are getting into when investing in mutual funds.
Investors are advised to carefully read the offer papers that describe mutual fund categories and their investment objectives. It is important to look beneath the hood and understand the associated taxes, fees, and commissions to make informed investment decisions that will help you achieve your financial goals.
What’s the motivation behind promoter actions?
The primary reason why this instrument is so profitable for promoters is the charge and commissions.
Mutual fund sales and advertising are usually done by paid promoters who demand money.
Below are some of the charges attributed to Mutual Funds that you should be aware of-
1. Expense Ratio
The expense ratio of mutual funds in India can vary significantly, typically ranging from 0.1% to as high as 2.5% as per the regulations defined under Section 52 of the SEBI Mutual Fund Regulations. The expense ratio represents the fees that the fund house charges the investor for managing their investments, and it covers various costs such as administrative fees, advisory fees, marketing expenses, and other related expenses.
It is essential to understand that the expense ratio can significantly impact the investor’s net returns, as it reduces the overall returns earned by the fund. Therefore, investors must carefully evaluate the expense ratio of a mutual fund scheme before investing and compare it with similar schemes to ensure that they are getting the best value for their money.
Additionally, investors should also consider other factors such as the fund’s performance history, investment objectives, risk profile, and investment strategy before making any investment decisions.
2. Transactional Charges
A small amount has to be paid by investors as transaction fees. This is a fee that is charged only once during an investment.
A transaction fee of ₹150 for new investors and ₹100 for existing investors can be charged on investments worth ₹10,000 and above. For SIP investments, an amount of ₹100 may also be charged as a transaction fee.
This fee can be charged only if the SIP commitment is over ₹10,000 or above. For investments below ₹10,000, no transaction fee is levied. These transaction charges are paid to intermediaries or distributors selling that fund.
3. Exit Loads
When an investor exits from a certain mutual fund scheme within a short span of holding the same, an exit load has to be paid. This fee is levied to discourage investors from opting out of the scheme and to reduce the number of withdrawals.
Different fund houses charge different exit load fees, depending on a predetermined holding period.
4. Intermediary Charges
Mutual funds are typically classified into two categories: Direct Funds and Regular Funds. Direct Funds are those that you purchase directly from the fund house, while Regular Funds are usually purchased through intermediaries.
As we previously noted, the more valuable the asset you seek to acquire, the longer the line of hustlers waiting to get a piece of your investment. These intermediaries act as hawkers, offering you a variety of mutual fund options to further tailor your demands.
Of course, this level of customization comes at a cost. When they label a fund as “Regular,” you can expect to pay an additional expense ratio of around 1 percent. It’s important to note that this 1 percent is not a one-time expense, but rather applies to each investment made in the mutual fund.
To justify their 1% commission, many intermediaries also provide user-friendly apps, portals, SIP logistics, and withdrawal assistance.
5. Advisory Costs
Moreover, nowadays, there is a new type of financial advisor who can help you select the most exceptional fund from a vast array of outstanding funds available through an intermediary. These advisors charge a fixed fee for their services, and they aim to help you pick the best among the best (which may sound a bit confusing).
This is possible because there is a dedicated fund manager at the top of the hierarchy who is already diligently selecting the best stocks for that fund. With all parties working hard for your benefit, this may seem too good to be true at times.
However, you may be wondering why we seem so determined to refute the idea of mutual funds by this point. In reality, that is not the case. Keep reading to find out why!
A surprising turn of events
To determine the effects of these fees, let’s create a hypothetical fund called the “PlanB Sure-Shot Equity Fund” and perform some straightforward calculations.
- The expense ratio for our fund is 1.5 percent.
- You, the customer, are too sluggish to fill out digital forms or physical documentation and prefer to buy through our authorized intermediary, which adds another 1%.
- You decide to contact a fancy consultant who plays your choice for a seemingly harmless +0.2% cost because you are also too conservative.
That amounts to 1.5 + 1 + 0.2 percent; a total of 2.7 percent net upfront commission
Suppose our fund generates a 12 percent compound annual growth rate (CAGR) year-over-year. Your actual pre-inflation and pre-tax return for that year would hypothetically be 9.3 percent after a 2.7 percent upfront deduction.
However, due to the volatility of the equity market, the 12 percent yield of our fund cannot be guaranteed. Additionally, accounting for the annual inflation rate of 6 percent, your net year-over-year return would be +3.3 percent, and any short-term or long-term capital gains taxes due upon final withdrawal would not be included.
ELSS funds, on the other hand, may be an exception. By investing in large, medium, and small-cap stocks through an ELSS fund, you can receive a tax break under section 80C. Locking some money away for three years can potentially increase your overall returns.
Comparing debt instruments like fixed deposits, a bank fixed deposit’s effective post-tax yield would be around 3.72 percent (assuming you fall under the 30 percent tax slab), and a post office deposit would be approximately 4.61 percent.
However, taking 6 percent inflation into account, the post-tax yields would be minus 2.28 percent for FDs and minus 1.39 percent for post office deposits. These debt products offer guaranteed returns with minimal risk, but when inflation is factored in, they often decrease your investment, which can be painful.
Therefore, it appears that equity mutual funds are superior to conventional fixed-income vehicles. To properly balance your risk and returns, you should have a substantial portion of your investment portfolio diversified across debt instruments and other unrelated assets. For further information, please consult your financial adviser.
Conclusion
If you are currently focused on a lucrative job or profession, surpassing others in terms of active income streams, have no time to improve your equity analysis skills, are not interested in financial expertise, or have competing time constraints, mutual funds provide a compelling reason to hold off on investing until you are ready.
Our research demonstrates that mutual funds can yield greater inflation-adjusted returns than standard fixed-income and FD products but come with a higher level of risk. When investing in mutual funds, you can aim to boost your safety margin by avoiding commissions and fees wherever possible.
Alternatively, if you enjoy calculated risks to achieve higher returns, you can learn about investing directly in stocks. With the right skills, guidance, and vision, it is possible to create a portfolio resembling that of a mutual fund. DIY portfolios with higher stock concentrations, better liquidity, lower costs, and a reasonable chance of outperforming mutual funds in terms of returns can be smartly constructed.
If you’re interested in starting, click to enroll in our no-cost stock investing course. Additionally, if after reading this article you decide to invest in mutual funds, be sure to check back for our upcoming piece.
Frequently Asked Questions (FAQs)
1. What are mutual funds, and how do they work?
Mutual funds are investment programs where shareholders pool their funds to invest in diversified holdings managed by a designated fund manager. These holdings can include stocks, bonds, gold, and other assets. The fund manager’s goal is to generate returns for investors while adhering to the fund’s investment objectives and strategies.
2. What are the advantages of investing in mutual funds?
Mutual funds offer several advantages, including diversification, professional management, and affordability. By investing in a mutual fund, investors gain exposure to a diversified portfolio of assets without the need to individually select and manage securities. Additionally, mutual funds are accessible to retail investors with varying investment amounts.
3. What types of mutual funds are available, and how do they differ?
Mutual funds come in various sizes and designs, catering to different investment philosophies and objectives. Some common types include equity-focused, debt-focused, hybrid, solution-focused, and thematic funds. Each type of mutual fund has its own risk-return profile and investment strategy.
4. What charges are associated with mutual fund investing?
Investors should be aware of various charges associated with mutual fund investing, including expense ratios, transactional charges, exit loads, intermediary charges, and advisory costs. These fees can significantly impact the investor’s net returns and should be carefully evaluated before making investment decisions.
5. How can investors make informed decisions when investing in mutual funds?
Investors are advised to conduct thorough research and select mutual fund schemes that align with their financial goals, investment horizon, and risk tolerance. Reading offer documents, understanding charges, and comparing performance metrics are essential steps in making informed investment decisions. Additionally, consulting with a licensed financial advisor can provide personalized guidance based on individual circumstances.
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2 Comments
The problem see with mutual funds is that you can’t sell a stock from the portfolio that you already know is not going to perform well.
Hello Chhaya, yes this is indeed a problem and that’s why we promote direct Equity Investments. Check out our listed courses to gain a better perspective.