Mutual Funds: High returns, low risk

The term investment is used very loosely. People say they are investing in a house, even if they are going to live in the same house.

You cannot really unlock the property's real value unless it is sold. Similarly, most stock market investors gamble more than invest - buying huge quantities in the morning and selling them before afternoon.

None of these are truly investments. There are many good investment options though, mutual funds (MFs) being one.

Equity MF schemes have delivered a 20-plus per cent compounded annual growth rate (CAGR) over 10 years. This may not look impressive but see the difference between Rs 1 lakh invested at eight per cent and 20 per cent.

The former would grow to Rs 2.16 lakh or 2.15 times the amount invested. At 20 per cent, it becomes Rs 6.19 lakh in the same 10 years. This, when an investor needs to do nothing at all.

The several regulatory changes, however, have led to distributors all but abandoning MFs. This has created a problem for investors as investing in MFs involves numerous rules even for a simple thing like a change of bank account.

Despite the troubles, one should do so since it is one of the best ways to participate in equities.

Opting for mutual funds
Mutual funds come with lower risks due to diversification. Equity MF schemes invest in different companies, sectors and even across market capitalisation levels. Even if one or two sectors don't do well, others will compensate.

Take the case of DSP BR Equity Fund. Reliance Industries makes up 3.75 per cent of its portfolio.

The top 10 holdings make up 28 per cent only. Energy is their top sector at 14  per cent The second largest is financial services at 12.5 per cent .It is invested across some 15 such sectors.

By investing in MFs, a normal investor gets access to a fund manager who is a specialist and professional in deciding which stocks to invest in or switch. And this comes at a small cost. It ensures you do not have to worry about the market movements, follow economic trends and data and other news that can affect the market.

Good fund managers generate that alpha, which makes his role (and the charges) worthwhile. Fund managers differ in style of functioning. Some churn the portfolios aggressively, while others may swear by a buy and hold strategy.

Liquidity is another plus point for MFs. There are many who have invested in one of the hugely hyped initial public offerings (IPOs) or much-talked about shares that are no longer trading now.

When there are just no takers for these equity shares at any price, the investor faces a huge loss. That is where MFs score. If you want to sell, the fund will redeem the units for you. Illiquid shares or market conditions are their problem, not yours.

MFs schemes allow one to invest in amounts as low as Rs 5,000. Regular monthly investments can become a way of life if one adopts the systematic investment plans (SIP) that lets you invest as little as Rs 100 per month.

Since they are invested every month on a given day, the market timing risk is taken out of investing – we tend to invest when the market is going up and tend to hold the purse when the market is down.

With SIPs, since the same amount of money is getting invested every month, irrespective of market conditions, one averages out the buying price, over time. This is called the rupee cost averaging concept.

The array of products are suited for all kinds of investors. There are all kinds of funds, large-cap, small-cap, thematic, hybrid, sectoral and debt.

In the latter, there are ultra short-term funds, money manager funds, bond funds monthly income plans(MIPS), income funds and others.

Picking with care
But investors need to be cautious about the kind of funds that they invest in since their returns depend on the scope of investments for a fund.

For instance, investment by power sector specific funds may be restricted to the power sector which may or may not be doing too well at a particular time.

One could invest in sector funds only if there is high conviction about it. For instance, energy sector companies like those in crude oil production and marketing have not done well.

For instance, Sundaram Energy Opportunities Fund was a sector fund and has done badly, compared to broader market performance.

The icing on the cake is the tax benefit one can get. For equity MFs, the tax on short-term capital gains is 15 per cent.

Short-term is defined as less than 12 months. Anything sold beyond 12 months is classified as long-term. No tax applies on long-term capital gains of equity funds.  For debt funds, short term capital gains will be at one's slab rate.

Beyond a year, it is 10 per cent without indexation and 20 per cent with indexation. That makes the actual tax paid much less than comparable debt instruments.

Retail investors have yet to understand the benefits of investing through MFs. But given its unassailable relevance to investors, it is only a matter of time before they do.

The author is a certified financial planner.