MF FAQ: 20 Basic Questions on mutual funds answered – part one

Following a suggestion by SEBI RIA Piyush Khatri, I would like to compile a set of 100(+) basic and elementary newbie questions on mutual funds (with answers!) This is the first batch of 20. Do share this with any of your contacts who would like to begin or have just started investing in mutual funds. Kindly note, this is not an FAQ that will inspire people to start investing in mutual funds. This FAQ represents the cold hard truth and financial literacy is the search for truth and not the search for inflation-beating returns.

1 What is a mutual fund? A mutual fund is an entity that collects money from investors and invests it in either stocks or bonds or gold as per a pre-determined strategy.

2 Do I need to invest in mutual funds? No. There is no need to. Among the available investment options, mutual funds are but one choice. You can choose them if they are suitable for your need.

3 When should I invest in mutual funds? This is contextual. If you do not wish to invest directly in stocks (because you have better things to do or just don’t feel like it), you can choose equity mutual funds (defined below). If you would like to lower your tax outgo compared to a fixed or recurring deposit and if possible with better returns, you can choose debt mutual funds (defined below). The clearer you are about your need, the faster and confident you will be in taking decisions regarding mutual funds – well, this applies to anything in life!

4 Who issues mutual funds? Asset management companies (or AMCs or fund houses) create mutual funds. All AMCs will have to be approved by the government body, Securities and Exchange Board of India (SEBI). All mutual funds have to be whetted by SEBI before it is open for the public to invest.

5 What does investing in mutual funds actually mean? Suppose a mutual fund invests in ten stocks and total current market value of these stocks is 1.1 Crore. Out of this, the AMC deducts say, 0.1 Crore for operating the fund (this is known as the expense ratio). So the net value is 1 crore. Now the AMC will divide this 1 Crore into say, 10,000 parts. These parts are known as units. The cost of one unit is 1Cr/10,000 = Rs. 1000. This is known as the Net Asset Value (NAV) of the mutual fund.

Suppose the AMC has set a minimum investment requirement of Rs. 500. Then if you pay Rs. 500, you will get 0.5 units of the fund. Remember that the cost of one unit is the cost when you made the purchase. Suppose after one year, the NAV has fallen to Rs. 700 per unit and you wish to exit the fund (also known as redemption), then you sell your 0.5 units back to the AMC and get 0.5 x Rs. 700 = Rs. 350 back.

Yes, you invested Rs. 500 and got back Rs. 350 – a loss of 150 over a year. The point is, that you buy units at current NAV and sell units (fully or partially) at current NAV. This is what investing in mutual fund actually means.

6 Do mutual fund guarantee returns? Well, sales guys would love to tell you that “over the long term” you will get good returns from mutual funds, but the truth is, there is no guarantee. As the above example shows, you buy at current market value and sell at the current market value. Anything, literally anything can happen in between spectacular returns or spectacular losses. Unless you are mentally ready to accept this and learn how to minimise this risk, do not invest in mutual funds.

7 Are mutual funds safe to invest in? That depends on what you mean by safe! If by safe you mean capital protection – that is, you invest Rs. 500 and even if returns are zero, your Rs. 500 is safe – then no mutual fund offers such protection. Your capital will always be at risk. Just a matter of how big or how small a risk. If by safe, you mean – will the AMC run away with my money? Then no, it is highly unlikely that the AMC will do that. There are enough safeguards implemented by SEBI. Want to read more? Are mutual funds safe? Can mutual funds run away with our money or become bankrupt?

8 If mutual funds do not offer guaranteed returns and are risky, why should I invest in mutual funds? Well, you don’t have to! If (IF) you want higher returns then you will need to take on higher risk. The risk is guaranteed but the returns are not. Life is tough! The question you should really be asking is: If I do not take on any risk (that is choose guaranteed return products) will I be able to invest enough money to achieve my goals? You will need a goal planning calculator to find out. See: Can I Plan My Retirement With Recurring Deposits and Fixed Deposits?

If your answer is yes, then you do not need mutual funds or any risky uncertain return product. If the answer is no, then you need to take on some risk to try and get higher returns. Whether you use mutual funds for this or not is up to you.

9 What are the types of mutual funds? From an investing perspective, there are three types of mutual funds

  • Equity mutual fund: A fund that invests at least 65% of its portfolio in Indian stocks
  • Debt mutual fund or fixed income mutual fund: A fund that invests predominantly in bonds (a tradeable fixed deposit)
  • Gold mutual fund: A fund that tracks the price of gold
  • Hybrid mutual fund: A fund that invests in a little bit of equity, a little bit of bonds, a little bit of gold. That little bit can be constant or vary from time to time

10 I have heard about “growth option”, “dividend option”, “regular plan” and “direct plan” What are these?

Every mutual fund has options and plans. So if ABC is an equity fund, you will have ABC growth option and ABC dividend option. In a growth option, the fund manager (the person in charge of handling investments) will stay invests in stocks/bonds/gold at all times as per the investment strategy.

In a dividend option, the fund manager can, from time to time, sell some equity or bonds and distribute the profits to all unitholders (the investors) equally. This is known as a dividend option. Stay away from the dividend option. Growth option is all you need when you start.

Every mutual also has a regular plan and a direct plan. In a regular plan, commissions for the salesperson will be deducted from the NAV every day before it is published in addition to expenses for running the fund. In a direct plan, no such commissions will be deducted. So you can save significant amounts of money by choosing a direct plan. More importantly, you can avoid biased advice by choosing direct plans.

So our ABC fund will be available in the following flavours:

  1. ABC Fund Growth Option Regular Plan
  2. ABC Fund Growth Option Direct Plan <=== Pick this!
  3. ABC Fund Dividend Option Regular Plan
  4. ABC Fund Dividend Option Direct Plan

11 From where can I buy mutual funds? That depends on where you want the regular plan (why would you?!) or the direct plan. You can buy regular mutual funds from any place that does not talk about direct plans! Eg. Banks, All popular mutual fund news and star rating portals etc.

You can buy direct plans directly from the fund house (hence the name direct!) or via MF Utility an entity created jointly by fund houses. There are other methods, but I do not recommend those!

12 How do I start investing in mutual funds? You start by not being in a hurry to invest!

13 What do I need to start investing in mutual funds?

You first need to provide proof of your identity and proof of address to the fund house. This is known as “Know your customer” (KYC) process. You can complete the KYC process in two ways:

A: Select a fund that you would like to start investing in, then go to the website of the AMC and search for an office near to you. Download KYC form, fill it, take id proof and address proof (all standard ones will be good enough), take photocopies of these, download an investment form, fill it and submit it along with a cancelled bank cheque. You will be sent a folio no (this is an id for your account) by email. You can go to the AMC site register yourself and check your investment details. Further investments can be done online

B: You can go through the KYC process online (search for e-KYC and any fund house name) but the limitation is that you can only invest Rs. 50,000 a year in all funds combined.

14 How much should I first invest?

Most mutual funds have an Rs. 5000 initial investment limit. Then you can invest any amount above Rs 500 or Rs. 1000. So if you do not have Rs. 5000, save up and then complete the process in 13.

15 What is a SIP? How is it different from a lump sum investment?

A SIP or systematic investment plan is where you ask the mutual fund to deduct a certain amount from your bank on say the 5th or 15th or 25th of each month. You will be allotted units in your folio as per the NAV on the purchase date. In a lump sum investment, you buy units on any given day.

There is no difference between a SIP and lump sum investment. Do not get confused. A lump sum is occasionally buying of units. A SIP is periodic buying of units. Read more:

16 Do SIPs offer any benefits? None. They will not make you disciplined. They will not lower risk. So if you want to invest each month, do so once a month on your own. Read more: Don’t Be Fooled: SIP is NOT systematic investing! Also Beware of Misinformation: Mutual Fund SIPs Do Not Reduce Risk!

17 I am not disciplined. Should I not start a SIP? If you are not disciplined you will get nothing in life. A SIP will not help you. Go jump.

18 Why are you asking people to invest Rs. 5000 first? Should they not start a SIP? Start with Rs. 5000 and observe how the value of the investment fluctuates day to day for a few months. Then start investing more. What is the hurry?

19 How do I get my money back from a mutual fund? You cannot! You buy units at current NAV value and you sell back the units at current NAV. There is no such thing as getting money. Remember at all times that mutual funds are market-linked instruments.

20 Can I save tax with mutual funds? There are equity funds knowns as Equity Linked Saving Schemes (ELSS). Your investments up to Rs. 1.5 lakh a financial year will be exempt from tax (section 80C). Each unit you purchase will be locked up for 3 years though.

So that is the first set of questions and my stupid answers. To be continued. I am sure many of you do not agree with some of my suggestions, but I think it is better for a newbie to start slowly instead of opening a SIP from day one.

 

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8 thoughts on “MF FAQ: 20 Basic Questions on mutual funds answered – part one

  1. I do have to take issues with FAQ 17. For people used to other financial products in India – so called insurance plans, RD, etc – SIPs have a ring of familiarity. They do increase the chances that people would keep investing every period instead of trying to time entry points.
    I do believe that automation of important decisions is useful for many people. Automation is one key benefit of SIP.

    1. Automation has only one benefit – automation and several disadvantages like forgetting risk management, assuming thigs will be okay if we keep SIPping. A sense of hands-on investing and risk management is essential from day one.

      1. Agree with sir.. SIP may give a false sense of security. I think monthly lumpsum purchase is good enough. Here do you suggest any sort of timing ? Say you see markets falling on a given day so you invest on that day on your large cap blue chip fund ? I have a faint recollection that one of your previous post mentioned that this type of timing does not give any significant benefit in long term

  2. When this expense ratio is deducted? Monthly in SIP or at the end when i withdraw.
    And the previous years returns shown by funds, includes the expense ratio or those return % are without the expense ratio?

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