A large portion of household savings today is parked in a variety of mutual funds. Thanks to AMFI’s Mutual Funds Sahi Hai campaign, launched in March 2017, which focused on educating investors around market-linked wealth creation and demystifying common myths about mutual funds. Systematic Investment Plans or SIPs, in particular, have become a popular mode of investing today, enabling investors to save and invest systematically, in a disciplined manner, to plan for their envisioned financial goals – for the down payment of the dream home, children’s education needs, wedding expenses, and even one’s retirement.
The data from AMFI shows that even in volatile market conditions, most investors – retail and high-net-worth individuals (HNIs) – have continued their SIP investments, wisely recognising the inherent rupee-cost averaging feature of SIPs (which mitigates risk) and their wealth-creation potential over the long run.
However, mutual fund investors often buy recommendations from mutual fund distributors/agents/brokers or follow unqualified advice from family, friends, and relatives, rather than carefully reading the scheme information document and evaluating whether the scheme is the most suitable for them. You see, investing is an individualistic exercise. Each person’s risk profile, financial circumstances, broader investment objective, financial goal (s), and investment horizon are different. There is no one-size-fits-all approach. You need to add schemes to your portfolio that align with your needs.
Before investing in any mutual fund scheme, it is important to recognise the scheme type and sub-type, the risk involved, its investment objective, the strategy it will pursue to achieve that objective, and the expense ratio, among other factors. All of this can be understood well by taking some extra effort to read the Scheme Information Document (SID).
Here are the key aspects to read in a mutual fund SID:
Highlights of the Scheme
‘Part I’ of the SID provides an overview of the mutual fund scheme. It provides an outline of the scheme – the type of scheme, sub-type, whether open-ended or close-ended, actively managed or passively managed, the investment objective, the benchmark it tracks, the plans and options available, the expense ratio, minimum investment, etc.
Thereafter, in ‘Part II’, more specific and detailed information about the scheme is mentioned. The facets you need to consider are explained below.
Asset Allocation
This indicates how the fund plans to distribute its assets across various asset classes – equity, debt, and gold. Further, much also depends on the sub-category. For example, among equity funds, a large-cap fund, as the name suggests, invests 80-100% of its total assets in equity & equity-related instruments of large-cap companies.
Likewise, a mid-cap fund and a small-cap fund have the mandate to predominantly invest in companies ranked 101st to 250th on a full market capitalisation basis, and those ranked beyond the 251st on a full market capitalisation basis. Similarly, a flexi cap fund invests its assets dynamically across largecaps, midcaps, and small caps with no upper or lower limits. Whereas a multi-cap fund is required to invest 25% each in large caps, midcaps, and small caps.
In the same way, there are equity funds pursuing a certain style. For instance, a value fund aims to invest predominantly (at least 65% of total assets) in fundamentally sound stocks trading below their intrinsic/fair value and hold them until their value/potential is realised. On the other hand, funds pursuing growth and/or momentum investing predominantly invest in high-PE stocks and/or those with positive momentum to benefit from.
Correspondingly, there are sector & thematic funds aiming to capitalise on the opportunities arising from the sectors and themes they follow. Also, there are international funds that allow you to gain investment exposure beyond a country’s borders. In the case of debt funds too, although they largely invest in debt & money market instruments, each has a different investment mandate, and accordingly, the investments are made in money market funds, short-duration debt, long-duration debt, Government securities (G-secs), corporate bonds, public sector debt instruments and so on.
In the case of gold funds – gold ETFs and gold savings funds – they predominantly invest in gold and aim to deliver returns that correspond to it. There is a plethora of mutual fund schemes available, and it is important to recognise where your hard-earned money will be invested (the types of instruments) so you can make a prudent choice.
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Investment Strategy
In addition to knowing the asset allocation and investment instruments, assess the investment strategy the fund will follow to achieve its investment objective.
This helps understand how the fund builds its portfolio. The approach followed to pick stocks (bottom-up, top-down, or a blend of the two), the investment style (growth, growth at a reasonable price, value, blend), and broadly the facets it looks at when investing in companies, the stock selection process, macroeconomic factors, and the investment ideology, among a host of other aspects.
This helps understand whether the fund house is process-driven in its approach, or leaves portfolio construction to the whims, fancies, and personal convictions of the fund manager. If the fund house is process-driven – and the process itself is robust – it could benefit you, the investor, in the long run.
Investment Objective
The asset allocation and investment objective of every scheme are designed to achieve a specific objective. In the case of equity funds, the investment objective is primarily capital appreciation, i.e., the goal is to grow the principal over the long term with high risk. For the debt funds, it is mainly regular income and capital preservation with low to moderate risk. For hybrid funds, the investment objective depends on the asset class in which it predominantly invests.
It is important to choose schemes that align with your investment objectives, financial goals, and time horizon, rather than doing so arbitrarily.
The Benchmark of the Scheme
While the investment objective and the strategy to achieve it are laid out, know how the scheme would benchmark its performance. Knowing the benchmark of a mutual fund scheme will help you understand the range of stock selection. The benchmark for the scheme is often selected based on its mandate. For example, in the case of large-cap funds, most fund houses use the Nifty 100 – Total Return Index (TRI) as the benchmark.
Regardless of the benchmark the fund follows, an active fund is supposed to outperform the respective benchmark index. If it is a passively managed fund, it is expected to deliver returns almost in line with the index.
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Who Manages the Scheme
The fund manager’s credentials – his/her educational qualifications, experience, number of schemes he/she manages, and the track record of schemes under his/her watch – are vital factors that potentially have bearing on the fund’s performance. The fund manager’s expertise is vital to the scheme’s long-term performance.
That said, avoid buying a scheme solely because a star fund manager is handling it. This is because, tomorrow, when he/she leaves the organisation, it may affect the performance of those schemes. It is critical that the fund follow a process-driven approach rather than rely solely on the discretion of the fund manager (s).
How Has the Scheme Performed
For existing mutual fund schemes, fund houses are mandated to disclose the scheme’s performance and its benchmark for a particular month in the SID. This helps evaluate how the scheme has fared vis-à-vis the benchmark and if the stated investment objective is achieved. But keep in mind, past performance is not an indicator of future returns. Hence, do not make the mistake of zeroing in on schemes based on their historical performance.
Risk Factors
Along with performance, you also need to know the risks associated. This is because, for every level of return you seek, there is also a certain level of risk (which depends on the scheme’s mandate).
‘The essence of investment management is the management of risks, not the management of returns.’ – Benjamin Graham.
Hence, you need to be aware of the risk factor involved, whether you are investing in an equity fund, a debt fund, a commodity fund, or a hybrid fund. Remember, returns in mutual fund schemes are not guaranteed; they are market-linked.
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Expense Ratio
A fund incurs several costs to run a mutual fund scheme, including management fees, brokerage/transaction costs, administrative expenses, sales & marketing expenses, registrar fees, custodian fees, audit fees, etc.
These are subsumed under the Total Expense Ratio (TER). The TER is charged as a percentage of the scheme’s net asset value (NAV) and differs between equity and debt funds, as well as active funds and passive funds.
Also, as the fund’s assets under management (AUM) increase, fund houses usually charge a lower expense ratio.
If the fund charges a higher expense ratio than some of its peers, it can affect potential returns. Usually, the expense ratio for the direct plan is lower than the regular plan, and even a difference of 0.5% can make a huge difference in the returns you could make over the long-term. That said, note that TER is one of the important parameters to select funds, but not the most important factor.
To conclude
Avoid following the herd when investing in mutual funds. Read and understand the scheme information document carefully before investing and select the ones that align well with your needs and risk profile, rather than getting carried away by the historical returns presented to you by the mutual fund distributors/ agents/brokers/relationship managers.
If you are not sure how to go about it or lack confidence, seek the services of a SEBI-registered investment adviser.
Invest sensibly. Be a thoughtful investor.
Happy investing!
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