Part 3 of MF FAQ: 20 Basic Questions on mutual funds answered

I am trying to create an e-book with 100+ basic questions and answered for new mutual fund investors and publishing them in parts first as individual articles so that they can be compiled easily later on. The aim here is to make the questions connected so that any new investor who reads in sequence will be able to understand when and how to use mutual funds (when and how not to as well). This is the third part in the series.

Did not read the last couple of posts? You can always catch now!

The questions will start from number 46 as 1-20 were covered in part one, 21 to 45 in part two. This time we consider some of the most common questions that arise when a person starts investing in mutual funds. If you have not read the first two parts, please take some time to read them as well. Do consider sharing this with your contacts who may be newbies. If you have questions that you should be addressed, please post them as comments. The freefincal youtube channel has 23 videos in the MF FAQ playlist. Do have a look.

Part 3 of MF FAQ: 20 Basic Questions on mutual funds answered

46: I was told that if we invest in mutual funds we can enjoy the power of compounding. How does it work? You have been fooled! There is no such thing as compounding in a mutual fund or a stock or anything related to the market. You buy at the current price and sell at the current price after a while. The selling price may be higher or lower than the buying price. We use the mathematics of compounding to understand how much the investment has grown (or fallen). That is all. Other than that, there is no magic of compounding or magic of compounding. Do not take the nonsense peddled by sales guys seriously. If you want to enjoy the power of compounding, get a fixed deposit, recurring deposit, PPF etc.

Compounding means, you invest Rs. 100 in a product that gives you a fixed return of 10% say. After one year, you will get 100 x (1+ 10%) =110. After one more year, 110 x (1+10%). That is the original amount plus the interest grows at the fixed interest rate. After one more year, 110 x (1+10%) x (1+10%) and so on. Thus compounding means an amount plus its interest receives an interest then the total amount receives an interest and so on. Since there is no concept of an interest in mutual funds, there is no compounding too.

47: I just saw an ad that said a mutual fund scheme has given an annualized return of 21.35% since inception. Does this mean the return each year was 21.35%?! No. Read what you asked again. You said, annualized return and that is not the same an “annual return”. To understand the difference and find out how annualized returns are calculated, try the most basic question about mutual fund returns.

48: Okay, how about: How are mutual fund returns calculated? Sounds good. Let us start with the SEBI rules and the universally followed convention of calculating returns. Returns for a duration less than one year are absolute. For example, you buy at a NAV of Rs. 15 per unit in January 2018. The current NAV is Rs. 11 per unit. What is the return?

Since the duration is less than a year, we calculate the absolute return as (11 – 15)/15 = -0.267 or = -26.7%. The main problem with the absolute return is that time does not feature in the calculation. So the absolute return does not really mean anything.

Above one year, the annualized return has to be calculated. This is easy to do when you make only one purchase. Suppose you buy at a NAV of Rs. 15 on 1st Jan 2018 and you want to know the return as on March 31st 2022. The first thing to do is compute the time elapsed in years. So (Mar 31st 2022 – 1st Jan 2018)/365 = 4.24 years.

Then we use the standard compounding formula: Final amount = purchase price x (1+ R)^n

Here, final amount = Nav on Mar 31st 2022= Rs. 11 per unit (say)

Purchase price = Rs. 15 per unit.

n = duration = 4.24 years.

R = annualized return.

^ means to the power of. For eg. 2^3 means you multiply 2 3 times = 2 x 2 x 2 = 8.

So here you multiply (1+R) by n times. Suppose n =3 for example,

Then to find the final amount we multiply the purchase by (1+R) x (1+R) x (1+R). This means that IF (repeat IF) the mutual fund grew as if it compounded as Q46, then R would the annualized return. Recognise that we are trying to understand the growth of a fund by assuming the same return applies to all years. This is very very far from true but this is necessary to compare the fund returns with an FD return where there is actual compounding. Remember there is no such thing as a fixed annual return in mutual funds. We are trying to measure growth assume there is one ONLY for the purpose of comparing it with a risk-free instrument.

Now, for the numbers given above, 11 = 15 x (1+R)^4.24. This has to be turned around to get R.

R = (11/15)^(1/4.24) -1 = -7%

49: I have heard of the term CAGR, what does it stand for?

CAGR is the compounded annualized growth rate and is the same as the annualized return mentioned above. You can see an example here:

50: I have a mutual fund SIP running, how does one compute annualized return for that? This is done by an approximation technique that you studied in 11th or 12th standard math. Since there are multiple investments involved, we try and find a single annualized return number that will fit each of them. This is known as the internal rate of return (IRR). When the investment dates are random, the math is modified a bit and the method is then known as extended IRR or the XIRR. Read more: What is XIRR: A simple introduction

51: What kind of returns can I expect from mutual funds? This depends on several factors. What type of fund that you are invested in. What category within that type you are invested in. When you started investing in it. In question 9 (part 1), we covered the types of mutual funds: Equity funds, debt funds and gold funds. So you need to ask a basic question first. Please note that, even if we are clear about these, all we can do is only expect. Reality can be very different, especially from the past.

52: When should I use equity funds? When should I use debt funds? When should I use gold funds? Is that basic enough for you? It sure is. Again this depends on your need. If you need money within the next:

5 years: Use no equity fund. Stick to only debt funds or better still, stick to bank deposits.

5-10 years: You can have a small exposure to equity funds and rest to debt funds or bank deposits.

10-15 years: Reasonable exposure to equity funds (40-50%) and rest in debt funds

15 years and above): Reasonable exposure to equity funds (50-60%) and rest in debt funds or PPF or EPF.

Stay away from gold funds as gold is riskier than stocks!

53: How to select a mutual fund? To be able to select a mutual fund, you need to be clear about two things. What is your need? (see part 1 for this and above) What type of fund is suitable for your need? Once you are clear about your need, the next question is, which category of mutual funds is suitable for that need? We just look at how to select fund types. From within a type, a category has to be selected next.

54: How do I select a mutual fund category? So now, we know whether we need to use an equity fund or a debt fund or both for our need. How do we find the suitable equity fund category? How do we find the suitable debt fund category? This is what your question actually means. In order to select fund categories, you must be able to judge how much returns can fluctuate. That is you need to be able to measure risk (like we looked at measuring return above). So you need to ask me, how do I measure risk in mutual funds?

55: STOP! What is wrong with you? Why are you making it so complicated? Why can’t you just tell me in which fund I should invest in? Okay lazybones, if you do not care about your money, why should I? If you want readymade solutions, download the Freefincal Robo Advisory Software Template, punch in your numbers and then find suitable funds from my Handpicked Mutual Funds September 2018 (PlumbLine). However, if you invest without understanding, then your losses are your own.

56: This sounds complicated and unnecessary. Can I just pay someone to help me select the right fund? Yeah, effort always seems unnecessary (at first). Okay, if that is the way you want to roll, ask me first, who should I not get mutual fund investment advice from?

57: You are a sadist! Okay, who should I NOT get mutual fund investment advice from?

  • Banks, especially relationship managers. Better not visit banks or take calls from them, unless they want to verify your credentials
  • Sales guys. That is people who will offer investment advice for “free” but will get commissions from your investment daily (from the NAV) and claim as if the commissions come from somewhere else. If you choose “direct plans”, you can get rid both these issues.
  • Quora. These are filled with sales guys looking for business
  • Facebook groups like Asan Ideas for Wealth. Using it for finding the best bread toaster, not best mutual fund
  • People like me, who have no responsibility towards you. So what should your next question be?

58: Sigh! Who should I get mutual fund investment advice from? From a fiduciary. Say that with me: fi-du-ci-a-ry. A fiduciary is someone who is responsible for the well-being of your money. Someone who is expected to always act in your best interests. Of course, that is a definition on paper. In real life, you got to be careful. So you can safely get investment advice from a SEBI registered investment advisor who functions as a fee-only financial planner. These are professionals who will create a full financial plan for you in exchange for a fee and will suggest products that will not get them commissions or profit directly or indirectly.

59: Oh god! Finding a fiduciary seems harder than finding the right mutual fund! Can you help me find one? Yes, it is pretty hard, but I can help in two ways. Choose a fiduciary who:

  • Charges a flat fee and not a fee linked to your income or assets. This is a proxy for commissions.
  • Recommends only direct mutual fund plans. Make sure they do before you sign up. A lot of rule breakers out there.
  • is experienced and qualified, in addition to the mandatory SEBI registration as an investment advisor.
  • can answer these tough questions satisfactorily

60: You said, you can help in two ways, what is the other way? Thank you for paying attention. For the last five years, I have been maintaining a list of such fee-only fiduciaries. Use this as a short-list, apply the above criterion and get going! Hundreds of readers from all over the world are working with them to become better investors.

61: I want to be a DIY investor, so tell me how do I measure risk in mutual funds? Come to my arms friend! The first thing to recognise is, mutual funds are classified in two ways: (a) by how they invest and (b) the associated risk. So if we know how risk is measured, we quickly understand how to classify mutual funds. Then we will know which category to choose when and then finally pick a mutual fund. No, this is not hard, this is common sense and it is often the first casualty.

There are many ways to measure risk, but we will start with the simplest as you can find this number in popular investment portals. This is known as the standard deviation. Suppose I go to my class of 50 and give them a coin and a measuring device and ask each of them to measure the thickness of the coin in turns. When they finish, I will get 50 answers for the thickness.

Suppose the instrument that I gave (remember a screw gauge from school or college?) is pretty accurate, I will get results that are not too different from each other: 1 mm, 1.1 mm., 0.98 mm, 0.99 mm, 1.2 mm etc. I can now calculate the average thickness of the coin measured. I now ask, how much did each individual measurement deviate from the average? Since the instrument is accurate, the individual deviations will be small. The standard deviation is a measure of such individual deviations from the average.

If the instrument was faulty and/or the students were lazy in measuring, the spread in the results will be large. Hence deviations from the average will be large. Hence the standard deviation will be large. Now, let us head to mutual funds. Over the past 3 year periods, let us compute the monthly return. So we will have 36 data points. We can get an average monthly return.

We then ask, how much did each monthly return deviate from the average. This is again the standard deviation and is the simplest measure of mutual fund risk. The higher the standard deviation, the higher the monthly returns fluctuate and higher the risk. Obviously, debt mutual fund that invests in bonds will have a much lower standard deviation than equity mutual funds. Gold mutual funds will have a standard deviation that is comparable or even higher than equity mutual funds. We can study the standard deviation within a fund type and understand which are riskier than the other. Let us do this for equity mutual funds first. So now please ask, what are the major equity mutual fund categories?

62: I am supposed to be asking the questions here! Why are you tell me what to ask? It is annoying! Because if you do not ask the right questions, you have no way of finding the right answers. Now get on with it!

63: Sigh! What are the major equity mutual fund categories?

  • Diversified equity mutual funds: These funds invest in stocks from different sectors at all times with vary market capitalization (see below for what that means)
  • Thematic equity funds: These invest either in particular way or invest in a particular type of stocks only
  • Hybrid equity funds: In addition to stocks, they can also invest in bonds or gold, but they ensure that the annual average of the equity exposure is at least 65% to be classified as equity funds

64: What is market capitalization? The definition is current market price times the number of available shares. This is also known as full market capitalization. Another definition is the free float market capitalization where only the shares that can be freely traded is used. That is shares held by the promoter or the government are excluded. Market cap is an important risk measure. Typically well-established companies with several shares available for trading have a high market cap. This means that one can buy or sell a lot of those shares without affecting the price too much. So higher market cap means lower price volatility.

65: This means there should be a way to classify market cap so that risk can also be classified? You are catching on! Yes indeed, there is a large market cap or large cap, mid-market cap or mid cap and a small cap. What is large, middle or small is arbitrary but SEBI now has come up with a definition.

Large Cap: 1 st to the 100th company in terms of full market capitalization
Mid Cap: 101st -to the 250th company in terms of full market capitalization
Small-cap: 251st company onwards.
Risk classification in terms of increasing risk: large-cap —> mid-cap —-> small-cap
66: Can you similarly classify the major equity fund categories? Sure!
Hybrid funds —> Diversified equity funds —-> Thematic funds (increasing risk)
67: What are the sub-categories under each major category? How are they classified in terms of risk?
Hang on, this post is now 2772 words long! We will continue in the next part.
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