A beginner's guide to Investing in Indian Mutual Funds - Part 1

This is the first part of a 3-part guide to investing in Indian Mutual Funds. The other parts are linked at the bottom of this post.

Let's assume you already know about what a mutual fund is. Let's also assume I don't know much :) , and, in fact, I mix up things a lot, but yet I might want to share whatever I mix up. Let's also assume you read disclaimers diligently, even if they are not there and fully understand the implications of asking the half-baked guys about your hard-baked money. Now if thats some average behaviour you come across in life and average information is quite okay with you, join hands, let's get in.

Mutual Fund companies (also called Asset Management Companies or AMC) run different schemes. Investors invest money in one or more of these schemes belonging to the AMC. Ex: HDFC Mutual Fund is an AMC that has schemes like HDFC Top 200, HDFC Tax Saver and so on. Sundaram Mutual Fund, for example, has its own tax-saving scheme called Sundaram Tax Saver.

There are many kinds of Mutual Fund schemes. Let's focus on a few major categories, assuming we intend to generate a substantially higher return, in the long run, than we do from, say, bank deposits.

1. Equity funds - that invest all of their money in stocks of companies - considered relatively higher risk than the other two.
2. Debt funds - that invest in other types of investment instruments, for example, in bonds and fixed income instruments. Considered relatively lower risk among the three. Of course, return potential will accordingly be lower.
3. Balanced funds - A kind of hybrid, investing a portion of the money in equity and the rest in debt. The proportion varies from scheme to scheme. Considered medium risk compared to the other two.

There are such organisms called gilt funds, liquid funds, monthly income plans etc. We'll skip those and reserve for a later lesson.

Among the three, we'll mainly handle equity funds of different subcategories. Why only equity funds, are they not high risk ? Okay, thats relative to the other types of funds. Also, among the three, equity funds are the only ones capable of generating higher returns in the long run, than all other forms of investment. As this rediff page says:

If you look at the market over 25-30 years, the average annual return would be around 15-18 per cent. Data on global markets will indicate that equity will deliver around 12 per cent.

These categories are based on the objectives, restrictions and approach of the scheme as stated in the scheme's prospectus. For example, we have this Banking Sector Fund, which announces that it would be investing only in bank stocks. Are you someone, who believes that the financial services is poised for a growth run in the next 3 to 5 years ? Then thats for you.

Equity Funds

1a. Sectoral Funds : Funds that proclaim to invest in companies in a particular sector, for example, the power sector, the financial services sector or the Oil-Gas-Petrol sector. Among the subcategories of equity funds, considered high risk. Why ? Because, it seeks to put all eggs in a single basket, that is from a single sector. If that sector goes phut, you know what. Of course, if that sector booms, it can outperform other categories. High risk, high potential for return. You have to be like Mark Twain, keep all your eggs in one basket, but keep a watch on it.

1b. Diversified Equity Funds : These are 'Go Anywhere' funds. Means their prospectus doesn't restrict them from buying or selling X or Y types of companies of A or B size. They can buy the stocks of small companies or blue-chip companies or somewhere in the middle. They can buy stocks from different sectors in whichever proportion they want. Discretion is left to the fund manager. Relatively low risk. Why ? Because the investment is spread across different sectors and different companies. Some may do well at some times and others at different times. So the risk is said to be "diversified".

BTW, Diversification would indeed be one of the basic lessons in Personal Finance. Even within a person's money bag of investments, ideally, one should have, some in Fixed Deposits, some in property, some in gold, some in debt funds, some in equity funds and so on.

1c. Size-based funds : You typically come across names like Midcap funds, Smallcap funds, Blue-chip or Large-cap funds and so on. Cap here means market capitalisation, not as in 'Topi Daalna' :). It roughly indicates the size of the company. You can see the exact definition here. So companies like Tata Consultancy Services, Infosys and Airtel and considered huge, some like Lakshmi Machine Works and Balaram Chini Mills are considered Mid-cap and Bachcha companies like Balaji Telefilms and Gitanjali Gems are considered small-cap.

Again, large-cap companies are considered low-risk, mid-cap companies are of slightly higher risk and small-cap companies are considered high-risk. Why ? Because of a word called "Liquidity". Liquidity roughly means 'en-cash-ability' : If you suddenly want cash and want to sell a company's stock, will many people be available to bid and buy ? Large-cap company stocks are traded all the time, there are more buyers and sellers, so their liquidity is higher. We'll leave it at that for the moment. If we have the knack to spot that potential small-cap company of today, which has got the performance drive to become the giant large-cap company of tomorrow, you have just spotted the next Google or the next Infosys. If you had invested just Rs.10000 in Infosys in the year 1994, that Rs.10000 would have been worth Rs.1.5 crore in 2007. Juicy, no ? Have some pickle to contrast the fascination , mitigate the enthusiasm and understand the risk and patience involved.

1d. Lifesytle-based or Thematic Funds : Some like Sundaram Rural India Fund, Kotak LIfestyle fund etc. come up with unique differentiating objectives and seek to find good performance in such investing styles.

1e. Index funds : My latest fad. These are funds that invest according to a particular index. For example, Birla Sunlife Index fund, invests, in all the X number of stocks comprising the sensex, in the same proportion in which they comprise the sensex. So sensex goes up, your money goes up that much, sensex comes down, it comes down as much. Considered low-risk for three reasons : 1. Unlikely a fund manager will mess it up for you, because his is a passive role. Also the fund management fees are lower. 2. These indices usually comprise of large-cap or liquid stocks and are automatically diversified across sectors. 3. For a small investor, if you put Rs.5000, you get to invest in all those big companies (somewhat like that) and mirror their collective performance.

1f. Tax-saving funds: These are funds that are similar to diversified equity funds in terms of investing style. But they have a 3-year lock-in period. Means, you can't take your money out for three years. The merit is, if you are looking to save tax, this is one of the avenues to do so.

Balanced Funds:

For a beginner, these are a nice place to start. They invest only a portion of funds in equity and the rest in debt instruments, so they have a mix of low risk and slightly higher risk. Their returns are also slightly reduced than that of equity, but as a beginner, if you want to start small with something, you can choose one of these. My first investment was for Rs.1000 in SBI Magnum Balanced Fund in December 2005. It has given an average annual return of 12% till now. Even 1000 rupees can cause a lot of pride, you see. I don't want to take it out for atleast 10 years, just want to see what on earth would happen. It can't go into minus and they can't fine me for investing, right ? :)

Do you get similar ideas ? Then read on for the next part, Part 2 that covers :
How to choose a mutual fund without having to revise your lessons on standard deviation.

If you still haven't given up on me and decided to part with your dough, I won't stop you from going on to Part 3 : on How to buy and how to sell.