Major advantage of investing via Mutual funds is you get broad diversification with very little capital requirement.

There are few people who enjoy spectacular returns by owing individual stocks but that portion consist of a small section of people, it is not as easy to earn high returns consistently. Re-read the word consistently. Majority of people, around 90%, will be better off investing consistently via Mutual Funds.

The very first decision you have to make is about asset allocation. Every financial asset can be broadly classified into one of these two groups, Equity or Bonds.

Equity, think stocks, you will make or lose money based on the performance of the company. There are no fixed guaranteed returns here. Whereas in bonds you get a certain fixed return on investment. For Example, FDs, Government Bonds, etc. Generally, returns on equity investments are higher than bonds but fluctuation in prices are also high.

Equities are more volatile its price fluctuates in shorter duration but over a long duration it tends to go up. Historically over long periods, equities have almost always outperformed bonds.

What should be your equity/bond ratio?

There is no right answer to it, it depends on lot of factors including your investment objective, income requirements, risk tolerance, financial situation, age.

Benjamin Graham suggests a ratio of 50/50 in his book The Intelligent Investor,

John C Bogle suggests a ratio of 70/30 to 60/40 equity/bond portfolio.

In your investment journey you will have two phases, phase one (accumulation phase) when you start investing money and you have your income to manage your expenses. Phase two (distribution phase) when you start using your accumulated money for expenses. When you are in Phase one and you have extra cash, you can have more exposure into equity and as you move towards phase two you can gradually adjust equity/bond ratio on an annual or bi-annual basis.

The advantages of investing money via Mutual funds are:

1. Broad diversification
2. Professional management
3. Liquidity
4. Simplicity & Convenience

Broad diversification – For many of us, investment corpus and cost alone prevent us to achieve adequate diversification without using mutual funds.

Ex, you have 50,000 to invest, you can achieve diversification by purchasing 15 different stocks. However, the transaction costs incurred in buying and selling will be high since you have to do many transactions.

In bond funds the diversification offered by mutual funds is much more beneficial, since here you have minimum investment amount in individual bonds, if you have to achieve a diversification you need a big corpus.

If you are a young investor with limited finances, planning to accumulate capital, the ability to diversify among stocks & bonds via mutual funds is a significant advantage.

Professional management – Investment professional who manages the fund does it strictly in accordance with the fund’s basic investment objective and policy. Therefore, it is very essential that you read the investment objective of MF that you want to invest in.

Liquidity – You can liquidate (sell) MF holdings anytime you want. The benefit over individual stock is you can liquidate at a lower cost than you would incur in selling individual securities since you have to engage in multiple transactions. You can also effectively switch among different investment options.

Simplicity & Convenience – Convenience of online buying, automatic reinvestment of dividends, reporting profits for tax, distributing gains, SIP, etc are big advantages.

1. It depersonalizes relationship between client and adviser.
2. It comes with range of costs, some direct (expense ratio) and mostly indirect (portfolio transaction cost).
3. You lose control over realization of capital gains to optimize your taxes.
4. Selecting the most appropriate funds that meet your investment objective is an awesome challenge.

• Based on Market Capitalization
  1. Large Cap Funds
  2. Mid Cap
  3. Small Cap
  4. Large & Mid Cap
  5. Multi Cap
  6. Flexi Cap

Market cap is the total value of a company’s shares in the stock market. It is calculated by multiplying the share price by the number of shares outstanding.

There are lot of funds available based on Market Capitalization, they only invest in the stocks which satisfy their Market Cap criteria. Currently the large cap companies are the 1st-100th, mid cap companies are 101st -250th and small cap companies are 251st company onwards in terms of full market capitalisation.

• Tax Saving Funds (ELSS)

These funds primarily invest in equities with options to save tax under section 80C. Each instalment comes with a lock-in period of 3 years which is lowest among other tax saving instruments.

• Value Funds

Invest in companies which are trading at discount to their intrinsic value. It seeks a combination of growth and income funds, often focusing on stocks with above average yield and below average Price-to-Earnings ratio.

• Dividend Yield Funds

Invest in high dividend-yield stocks with the objective of regular income. This is suitable for people who want regular income from their investments.

• Focused/ Sectoral/ Thematic Funds

Invests in stocks of single industry like Pharma, healthcare, etc which fund believes can perform better in the coming years. Since they are not diversified across sectors there are more risky than other funds.

• Contra Funds

Invests in stocks which are not performing well, but fund manager believes can perform better in future.

While investing in bond terms, an investor must choose a fund that aligns with investor time horizon. For example, if you are saving for a goal two year ahead investing in Low Duration Fund is advisable and if you are investing for a goal 5 years ahead investing in medium duration fund is advisable. Investor time horizon and bond duration should be aligned to minimize interest rate risk.

• Based on Maturity
  1. Overnight Fund
  2. Liquid Fund
  3. Ultra Short fund
  4. Money Market Fund
  5. Low Duration Fund
  6. Short Duration Fund
  7. Medium Duration Fund
  8. Long Duration Fund

With the increase in maturity the rate of return also increases.

• Corporate Bond Fund

These funds invest majorly in corporate bonds with a minimum credit rating of AA+, returns are proportional to the credit rating. High rating translates to low risk, which in turn translates to lower returns. As a general rule, it doesn’t make much sense to invest in low grade bonds in lieu of higher returns.

• Floater

Bonds are also volatile like stocks. As the general interest rate increases the bonds which are available in market issued when the interest rates were lower declines in value hence there is a capital risk. Floater bonds aims to minimize capital risk by investing in floating rate bonds. Here the interest rates are not fixed they go up and down by changing interest rates in economy. It can be beneficial in rising interest rates and not beneficial in decreasing interest rates scenario.

• Banking & PSU

Invests primarily in bonds issued by banks, PSUs. Generally, these institutes are backed by government in India, hence they are more secure from credit default.

• Credit Risk

Invests majority in corporate bonds funds with a rating of AA or below. Investor should be aware about taking extra risks in lieu of higher returns.

• Dynamic Bond

As discussed, changing interest rates affects the prices of bonds. Dynamic bond funds aim to take advantage of fluctuating interest rates by changing allocation to short-term and long-term bonds under rising or falling interest rate environment.

• Gilt

These are nearest to risk free investments that primarily invests in Central or state government bonds. Hence these are less risky, the returns are also lower. Gilt bonds come in different time horizons from short to long terms.

One common mistake is to invest based on funds past returns rather than the appropriateness of fund’s investment objective. You should always read the fund’s investment objective.

Fund Characteristics

This section contains some technical stuff. If something is not clear, please do reach out to us.

Too many investors select a common stock fund based solely on its past performance record. You should look at the past performance but only after a review of the fund’s basic characteristics.

• Size of fund –

As a general rule you should probably avoid the funds with assets less than 100 crores (bottom 10%). There are two reasons, one, relatively higher expenses associated with small funds. Second, fund may not survive or may change its investment objective to get more traction. If you are seeking high returns, you should also exclude funds with more than 15000 crore (top 5%). It is not because larger funds will fall short of returns than smaller fund. But because of Regression to Mean principle.

• Age of fund-

For a fund to prove its merit, it should be in market from at least 5 years.

• Tenure of Portfolio Manager –

Generally, funds are run by a team of managers and performance depends on lot of factors especially, market conditions. If a fund manager’s investment style contributed to the past growth, then a recent change in manager may also be a factor to consider.

• Cost of Ownership –

The conclusion is not that you should always select the lowest-cost fund, but other things being equal lower costs would translate to higher returns. Generally, people look into exit load and expense ratio only, there is also an invisible transaction cost which is a result of Portfolio Turnover, make sure you take that into account as well. We will cover costs in detail in a separate article.

• Portfolio Characteristics –

Here the most important factors to look for are Portfolio concentration, Market capitalization, Portfolio turnover, cash position.

Portfolio concentration – One good measure to check for funds concentration is checking the funds 10 largest holdings. In most concentrated funds it might comprise upto 50% of the portfolio, in less concentrated funds it might comprise upto 15% of portfolio.

As a general rule, the greater the concentration, the greater is opportunity to provide for differentiated performance. (The differentiation can be positive or negative)

It is also important to check the industry concentration in a fund’s portfolio as a further measure of its level of diversification.

Market Capitalization – It tells whether the fund emphasizes on the stocks of blue-chip companies with large market capitalization, emerging companies with small market capitalization or something in between. There is no right or wrong average market capitalization but knowing this gives you a sense of investment philosophy of the fund.

Portfolio Turnover – The purchase and sale of stocks in a fund’s portfolio is often too ignored by investors. But it is an important indicator of funds’ fundamental investment strategy. Low turnover tends to indicate a longer-term investment orientation, high turnover indicates a short-term investment horizon of fund manager.

Impacts of turnover

• Cost of managing the fund – higher the fund turnover, higher the transaction costs
• Realization of capital gains – higher the turnover, higher portion of total return is realized and thus taxable for capital gains, if distributed.

• Portfolio Statistics

To compare various funds that are similar in their investment approaches, you need to understand three measures.

R squared – this indicates the relationship between a fund’s return and the benchmark market index.

In a typical mainstream equity fund R squared is something around 80-90%, meaning 90% of the overall returns are explained by the performance of overall stock market. Only the remaining 10-20% is explained by some combination of fund investment strategy, tactics, stock selections, etc.

A R-squared of less than 80% indicates less predictability of relative performance. A R-squared of 95% or more indicates the fund is similar to index, but charging high fees with little opportunity to add value over benchmark market’s return.

Beta– Beta is a measure of risk. It indicates a fund’s past price volatility relative to a benchmark. Most mainstream equity funds have beta in the range of 0.85 to 1.05. If beta is 0.75, it means for a -10% market decline, fund values might be expected to fall -7.5%.

Beta gives you an idea of general volatility in fund asset values.

Gross Dividend yield – Gross yield is the profit percentage before taxes and expenses are taken into account. Clearly, gross yield is a more reliable differentiator of fund’s investment philosophy.

Taken these R squared, Beta and gross dividend yield together will help you compare the funds in similar category. Remember different categories like Growth fund or Value funds, or small cap fund will have different characteristics, so when you compare just make sure to compare funds in the similar category. Fare comparison will require you to compare funds where investment policies characteristics are more or less similar.

These three statistics taken together should substantially narrow the parameters with which to evaluate a fund’s relative performance. But statistics are no substitute for judgement. Most of this data regarding fund size, age, management tenure, costs, portfolio statistics are available in fund’s Key Information Memorandum (KIM) & SID (Scheme Information Document).

• Fund Returns

 When you are done with above factors than evaluating past performance makes sense. As you observe the performance of fund over longer duration also check the year over year returns to check for consistency in returns. Be aware of attributing too much attention to past returns in which top performance is concentrated in just few short periods.

Great, you also got insight on how to select fund for Equity portion of your portfolio.

Let’s understand how to select the Bond Mutual Fund for your portfolio.

For maximizing risk-reward ratio in bond fund, you must describe your quality & maturity requirements based on your investment objective.

Before taking any bond fund position you should think about, why I want to buy a bond fund in the first place?

·        Are you saving for your retirement? Then you might want to consider long term bond funds.

·        Are you moving out of FD to attain higher yield offered by bond fund? Short term bond fund may be the best choice

Important elements in Bond fund

• Quality – (AAA, AA, A, etc) It represents credit worthiness of bonds, higher rated bonds have less chances of default.
• Maturity – (Short term, intermediate term, long term) It represents when will the bond mature and investor gets their principal and interests payment.
• Cost – Expense ratio, the expenses incurred on owning a bond fund.

Basic Characteristics

• Age & Size of Fund – Since bonds have explicitly stated investment policies and objective, there is a little reason not to invest in fund with limited track record as long as it has reasonable assets for economies of scale advantage. However, if you have the option of choosing an established firm with established track record then the fund with similar objective in untested environment, former would be a prudent choice.

• Tenure of Portfolio Manager – Skill & tenure of fund manager are important considerations in selecting a stock funds, but may be less important in evaluating bond funds. The more important things to consider are: investment objectives & policies (Quality & Maturity standards), Operating costs

• Relative Yields – Looking at relative yields in vacuum is wrong. There are two ways of calculating yields; current yields, Yield to maturity.

Income returns and capital returns, offset each other in bonds.

Current yield is the annual interest received divided by its current price of bond.

Yield to maturity is the total rate of return that an investor expects to earn from a bond if it is held until it matures. It is the internal rate of return that makes the present value of all future cash flows from the bond equal to its current price

• Cost of Ownership – While some stock funds have provided premium performance despite prodigious cost, most bond funds, most of the time, have failed to do so. The reason is that, within the major sectors, bond funds operate under comparable quality and average maturity standards.

• Portfolio characteristics

Quality – 

Carefully consider the average quality of bond’s portfolio and its distribution across security as well. BBB is the lowest investment grade rating. Since each drop in quality entails an increase in yield, gaining extra yields is easy at the cost of higher credit risk.

There is no point in purchasing a lower-quality bond fund that incurs a higher expense ratio than a higher quality bond fund with comparable maturity.

Average maturity –

Average maturity is a two street. You can gain higher yields by investing in long term bonds but because of changing interest rate environment it can be as volatile as stock investments (aka Capital risk). If you focus more on short term bonds, then you will not get higher yields. (aka Income risk). Therefore, it is important to select a fund based on your desired maturity to balance income risk and capital risk.

• Tax Implications – Consider you post tax returns.

After being clear on Quality & Maturity you must decide which category of bond should be hold.

Selecting the right duration is important in bond funds since in bonds if interest rate increases, the capital returns become negative and if interest rate declines the capital returns become positive. You might want to consider a portfolio of short, mid and long-term bonds to achieve desired objective.

It is important to understand taxes before you make your mind to invest in Mutual Funds. Let’s explore:

• Understanding taxes on Mutual Funds
• Optimizing the taxes

 Mutual funds pass all the interests, dividends earned to investors each year. There are options where you can choose the dividends to be pay-out to you (IDCW Plan – Income Distribution Cum Withdrawal plan) or automatic reinvestment of the dividends (Growth Plan). Either way dividends are taxable. Funds themselves are not subject to taxes but when you receive the payments you will have to pay capital gains taxes like you hold the bonds or stocks directly with the fund just assisting you. Capital gains are taxed as:

Since different people fall into different tax brackets you have to consider the impact of taxes for yourself. You can optimize taxes by choosing a suitable investment horizon & product.

Capital gains are taxed only when stocks are sold by investors. But there is one exception where capital gains can arise without you selling anything, it happens when mutual funds declare capital gains. This is a tricky position, if interested, you can read about it here. Avoiding the Unpleasant Surprise of a Mutual Fund Capital Gain Distribution – Rodgers & Associates (rodgers-associates.com)

It is important to recognize three simple facts:

• Mutual funds are generally managed without regard to tax considerations.
• Taxes reduce, to a greater or lesser extent, the post-tax returns earned by investors.
• A fund with low appreciation and fund with low turnover will realize less tax or realize it later in time than other fund, in case where Funds can declare capital gains.

First of all, you should reap maximum benefit of programs that offer pre-tax investments. In regular investments, you earn, you pay tax and then invest the remaining whereas in some tax benefit programs you earn, invest (upto certain limits) and pay tax on remaining. The only possible drawback here is that such instruments come with a lock-in period. You should consider factors like costs, your investment horizon and penalties on premature withdrawals for evaluating such instruments.

Always consider your post tax returns. You should give special attention to the holding period of your investment since every time you sell you are taxed on capital gains. If you prefer buy-and-hold strategy you can defer capital gain taxes for long durations.

There are various tax saving investment programs, when it comes to Mutual Funds, ELSS funds can help you get some tax benefits.

In the past 3-5 years, we have spent lot of time in understanding how we can build wealth by investing. During our journey we learnt, unlearnt, relearnt lot of things. We are still learning!!!

We were so impressed with our learning, we launched My Invest Buddy, with the mission

“Empowering Individuals to take Prudent Investment Decisions”

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