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How To Invest in Mutual Funds: Choosing the Right Funds

Investing in mutual funds is a good idea because it gives you exposure to the financial markets without the risks associated with direct stocks. But getting started can sometimes be difficult, especially for those of us who aren't naturally inclined to think about things financially. In India, this problem can be compounded by the fact that technologicy in the world of mutual funds, while improving, is still not close to its zenith. In addition to facing a steep learning curve, investors also have to reckon with archaic (and sometimes non-responsive) user interfaces.

But if you have even spent five minutes on Quora or Reddit, you'll know that there are plenty of blog posts and commentary as there is a steady rise in the number of individual mutual fund investors. This can lead to information overload and a sense of overwhelment.

In this blog post, we break it down for you, simplifying the core principles of mutual fund investing so that you have a good, clear mind before setting off on your investment journey.


What are mutual funds?
Mutual funds are professionally managed funds that purchase a range of securities (tradable financial assets) with investors' money. Examples of securities include equities, bonds, debentures and bank notes. So when you put money in a mutual fund, the fund manager takes it and invests it in a variety of these securities, using her/his financial knowledge and best discretion to ensure good returns.

Mutual funds come in a few categories, based on the underlying security that they trade in. The two most important categories are Equity Funds and Debt Funds.

In India, Equity funds are funds that invest atleast 65% of their Asset Under Management (AUM) in equities such as direct stocks. Debt funds invest primarily in debt-based securities such as treasury bills, bonds and commercial paper.

Within these two categories, there are sub-categories as well. For instance, Equity funds consist of, among others, Small-, Mid-, and Large-cap funds, each name an indication of the value of the market capitalization of the underlying companies. The "smaller" the "cap," the higher the potential for return as well as risk.

Mutual funds are a good investment option for people who don't have the time or inclination to invest directly in stocks, and who are looking for higher rates of return than their banks' savings account or fixed deposits. The most important thing that mutual funds can do for you is help you beat inflation, so that you know that your money is not decreasing in value with each passing day. This means that you will be better prepared to take on future realities such as retirement.


How should I pick my mutual funds?
At any given time, you should ideally not have more than four to five funds in your portfolio. There are so many funds out there to pick from, but chances are, if you have two large-cap funds, they will probably have invested in similar underlying stocks, which means that they are essentially too similar to justify investing in two separate large-cap funds. For each category or sub-category, pick one fund based on your research, and give it a proper chance to succeed. If you're not happy with its performance, you can always move to another fund.

Picking the right mutual funds depends on what your financial goals, income and expense levels, and risk tolerance arer. If you are a young person starting out in your career, with no loans or large expenditures, you weight your portfolio towards long-term investments such as Equity funds. Equity funds are ideal for people who can afford to put away their money for more than five years, allowing their money to weather any short-term ups and downs of the stock market. It's important to keep your money in over a long time horizon because the last thing you want is to lose all your money in a stock market crash when you have a big expense coming up. Time and planning can help protect you from that fatalistic outcome.

If you know that you have a big expense coming up in less than five years (education, vehicle, real-estate purchase, Fall 2018 Prada Collection, etc.), start moving your money over from Equity to Debt funds. While your returns might be less in Debt funds, the risk is also less, and your money is protected against stock-market volatility.

Here is an easy way to categorize and think about your investments:
Emergency Funds: These funds should ideally contain up to six months of your monthly income, or the amount of money that you will need in the time required for you to find a new job should you lose your current one. Many people chose Liquid Funds to store their emergency fund because it gives them a higher rate of return than their banks' savings account, and has a lot more flexibility than Fixed Deposits. You can sell your funds and have the money within days.

Short Term Funds (upto three years): These funds should weigh more towards Debt funds and Hybrid funds which have a more equal split between different kinds of securities. These funds will protect you from short-term stock market volatility.

Long Term Funds: These are the funds where you will put away money that you know you won't need for the next five years. Retirement funds go into this bucket. In the beginning, you can invest in more risky, equity-based funds such as Small- and Mid-cap funds or Sectoral funds (where you are essentially hedging a bet on a particular sector to do well in the next few years). As you approach the time that you will need to start redeeming some or all of this money, you can begin to move some of these funds to more risk-averse options such as Debt funds.

Asset Allocation
Once you've picked your funds and looked at the amounts you want to invest in each one, take a look at the Equity:Debt ratio in your portfolio. Does it align with your financial goals? For instance, if all your investments are in Equities, but you plan to take a vacation next year with your investment money, your investment strategy isn't aligned with your goals. It's time to move some funds over to more liquid options.

Asset allocation is an important metric to monitor over time because it can change without you realizing it. How? If you invest 60:40 Debt:Equity and leave your portfolio unattended, you can come back to it after a year to discover that the ratio is now 30:70 Debt:Equity because the returns from your equities have far outweighed the returns from your debt funds, skewing your ratio. While the returns are great, this allocation might not work for you because you might not want 70% of your portfolio to be in equity funds. This is why portfolio review and asset allocation are very important.

Where do I find the best funds?
Currently, there are two websites in India that provide the most comprehensive review of mutual funds for individual investors. They are MoneyControl and Value Research. On these websites, you can filter the list of available funds to find the best options in each category, taking a look at their performance and rates of return over the past years to see if they would make a good fit for you.

A financial advisor can also help you pick the right funds based on their expertise and market knowledge. Today, there is also a host of mutual fund investment platforms that provide robo-advisory services - an algorithmic suggestion of funds based on information you input such as income, expenses and financial goals.

A few things to look out for when you pick a fund:

  • Assets Under Management (AUM): most often, bigger is better.
  • Rates of return over the past five years.
  • Benchmark Comparison: if it is an equity fund, how it has compared against the market (i.e. if you had invested the same money in the stock market in a similar-sized company as the ones the fund has invested in, would you have made more or less?). This information can be hard to find, but if it is accurately presented, it can be very useful.
  • Age of fund: old is gold (not always, but usually) as it indicates a good reputation.
  • General reputation of fund: a quick Google search will reveal if there has been any scandal associated with the fund that you should be worried about.

Next up: how to navigate the bureaucracy of being a first-time investor (KYC, registration, purchase of funds).

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