After having spent more than 18 years investing in the markets & one and a half decade in the Mutual Fund Industry and having seen the way Mutual Funds are sold and bought I thought that it was important for me to now educate existing and potential investors about investing in Mutual Funds, what kind of Mutual Funds suit what kind of investors, the returns that you should expect from mutual funds, what are the pitfalls that should be avoided and how over the long run you can create wealth from Mutual Fund investing. Now I will be trying to start off by keeping things simple and over a period of time as the number of articles go one I will try to address issues that are deeper and might be pertinent to investors who have been investing into Mutual Funds over long periods of time.
I started off my career in SBI Mutual Fund in the year 1995. At that time the Mutual Fund industry was in a very nascent stage with the majority of the market lying with UTI. Besides UTI very few public and private sector funds were in existence. At that time the understanding of Mutual Funds was extremely poor and the return expectations were unrealistic. There was hardly any regulation and SEBI that was incorporated in the year 1992 was just in the process of formulating operating rules and parameters for Mutual Funds. A lot of Mutual Fund units were sold as if they were units of shares and a lot of investors thought that they will make money by investing in Mutual Fund IPO’s as they would by investing in IPO’s of company share offerings. The process of learning for mutual fund investors has been a long haul and still the financial literacy of mutual funds in India leaves a lot to be desired.
Now before investing for the first time you need to do a Know Your Client procedure. However over the last three years this process has been made very good. If a KYC is done for any form of securities investment then it does not have to be repeated. The process is very simple and the forms can be downloaded from the websites of amfi, amfiindia.com or of any mutual fund company. You just need your PAN card, address and identity proof documents to complete this formality in case you have not done it already.
Now when we look at mutual funds we can demarcate the funds into two broad categories. Equity and Debt funds. Then there are funds that are a combination of these two which fall into the Hybrid category.
Now Equity Funds are those where the investment is into the shares of companies listed on the stock markets. Here the fund manager invests in accordance with the mandate of the fund. Now the mandate of the fund is defined in its offer document and is also reinforced in the scheme information documents that are updated by the mutual fund companies every years. These are in the form of Statement of Additional Instrument which are easily available on the websites of all mutual funds. In the case of equity schemes there is a requirement that the scheme should remain invested into equity shares to the extent of atleast 65% at all points of time. This requirement is there so that the scheme can be treated the same as listed equity shares where there is no long term capital gains tax i.e that there will be no tax on profits if the scheme is held for a period exceeding one year. Below a holding period of one year the tax will be 15%. Dividends received from equity mutual funds is tax free in the hands of investors. Equity Mutual Funds typically have charges of around 2% every year which are used to cover the operating costs of the management of the funds. Over the last two years SEBI has come out with norms on Direct investments into MF schemes where you do not have to go through a distributor and as such the yearly charges are lower by around 1%. This increases the return potential over longer periods of time substantially. For example if a scheme gives a return of 15% every year for 5 years then at the end of 5 years an investment of Rs 100 will become Rs 200. However in a direct plan the return will be 16% and the total value of the investment at the end of 5 years will be 210, a difference of 10%. As such if you know where you want to invest then go Direct. Expected returns from Equity Schemes over long periods of times should be 15-20%. However they can be very negative, 2008 (-40to -60%) or very positive 2003(100-120%) also, but this should not be the expectation.
Now coming to Debt Funds. Debt Funds typically invest in money market instruments, securities issued by the government and by different companies in the country. There are a large categories of Debt mutual funds which are suitable for investors according to the time duration of the investment to me made. There are funds that are suitable for investment for a few days to as long as required. The one thing that investors need to keep in mind is that debt mutual fund schemes are not bank deposits where the amount invested is totally safe. In the case of debt mutual fund schemes although the safety of the principal amount is generally there the interest rate risk as well as credit risk is there in these investments. I will elaborate about these in my later episodes. However broadly, for higher tax bracket instruments the debt mutual fund schemes are more tax efficient than bank deposits as the tax rate varies between 20-30%. Dividends are charged at the rate of 25% in the case of debt mutual fund schemes. Growth options of debt funds also offer the benefit of the returns being charged as capital gains tax. Short term capital gains is as per the income tax slab of the investor, however long term capital gains tax is just 10% without taking advantage of indexation and 20% if the benefit of indexation is taken. As such for investors who do not want regular income but are willing to get returns over a period of one year or more the taxation can be very low and after tax returns very healthy. The returns of debt mutual fund schemes depends on the interest rates in the economy and the direction of interest rate movement and cannot be generalized.
In the next article I will talk more about various kinds of equity and debt equity fund schemes.