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Why mutual funds are the best investment asset class

Mar 30, 2017 / Dwaipayan Bose | 240 Downloaded | 7009 Viewed | |
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People who have invested in mutual funds for a long period of time know that they are the best investment options to achieve financial goals. Despite rising popularity of mutual funds in India, there are many investors, who are not aware of the benefits of mutual funds. There are also several misconceptions regarding mutual funds in our country. For example, lot of people associate mutual funds with share market only. Mutual fund investment is not limited to investing in share market only; through mutual funds you can also invest in debt market, money market, gold etc. We, in Advisorkhoj, believe that, if people’s awareness of mutual funds increases, then more and more people will use mutual funds as the most important asset in their financial planning armoury. Let us discuss the major benefits of investing in mutual funds.

Asset Allocation

The most important success factor in financial goals is asset allocation. Asset allocation is linked to your risk profile and financial objectives. For example, for young investors, equity is the best asset class. As per a common asset allocation heuristic, a 30 year old investor should have 70% allocation to equity and 30% allocation to debt. A 50 year old investor should have 50% allocation to equity and 50% debt.

There are various asset types like equity, debt, gold, real estate etc. Within each asset category, there are several sub-categories. Mutual fund products span the entire spectrum of almost all asset categories and sub-categories. With mutual funds, you can manage your asset allocation with the passage of time in the most efficient way.

Let us understand this with the help of an example. Let us suppose that, the most optimal asset allocation requires you to have 60% of your assets in equity. By investing in mutual funds, you will not have to research stocks for investments, opening demat and trading accounts, giving buy order to your stock-broker to buy stocks at particular price; all you have to do is to invest in some equity mutual funds with good track record. You can check the track record of a fund on a number of websites like moneycontrol.com, Morningstar.in, valueresearchonline.com, advisorkhoj.com etc. The track record of a fund is far easier to check than identifying individual stocks for investment.

Let us discuss another example of how mutual fund investment is most efficient way of managing asset allocation. Let us suppose that, you want a certain percentage of your assets in gold for your child’s wedding. One way of investing in gold will involve going to a jeweller(s), check the purity of the material, deciding whether to buy it in form of jewellery (which will involve making charges) or in form of bars, figuring out where to store the physical gold etc. The other way, through mutual funds, is to simply buy paper gold (e.g. gold ETFs, gold funds etc.). There is no need to check the purity of the substance, no making charges and no storage charges.

Mutual funds can also help you rebalance your asset allocation in an efficient manner. Over the passage of time the optimal asset allocation profile of the investor changes. With mutual funds, you can switch from equity fund to debt fund or vice versa with a simple transaction, as opposed to more complex transactions where you have to sell stocks and buy bonds or vice versa. Mutual funds also offer investors the flexibility of investing in small weekly/ monthly/ quarterly instalments (popularly known as SIP) out of their regular savings, with only a one time effort. Mutual funds also offer investors to switch between asset types in a systematic way (weekly, monthly, quarterly etc.) through Systematic Transfer Plans (STP), without having investors to worry about price levels, timings etc.

Professional Management

Investing in stocks may be more glamorous than investing in mutual funds, but for most retail investors, investing in mutual funds gives better results. This is because mutual funds are managed by professional fund managers who have much more experience and knowledge of investing than average retail investors. A user once commented in our posts that, if the investor is able to do fundamental analysis, then investing in stocks is better than investing in mutual funds. This is easier said than done.

Firstly, understanding balance sheets, income statements and cash-flow statements requires finance and accounting skills which most retail investors do not possess. Secondly, fundamental analysis requires the investor to have a deep understanding of the sector and the competitive forces within the sector; so that, the investor can project future cash-flows of the company. A deep knowledge of the sector and competitive forces operating within it comes from experience and a network of professional relationships, which retail investors are not likely to have.

Thirdly, crunching numbers on a spread-sheet is not enough; fund managers attend Annual General Meetings (AGMs), conference calls, and meet with company managements on a regular basis. Reading the research report of a company, is nowhere as effective as hearing directly from the management and asking questions. Most retail investors will not have the time to attend AGMs, conference calls etc., because they have jobs and businesses to take care of. Moreover, as individual shareholders, the equity stake of an average retail investor in a company is, practically speaking, too small for the management to grant them an audience.

Mutual funds incur a cost to manage a scheme which is charged as fee to investors (in form of expense ratios). However, since mutual fund works on the concept of a pool of money from many investors, the cost is spread out over a large investor base and so the average cost to an individual investor is quite small. Good mutual fund schemes have been able to generate excellent returns for investors over a sufficiently long time horizon.

Diversification

There are two kinds of risk in equity investments, Systematic Risk and Unsystematic Risk. Let us understand both types of risks, with the help of an example.

Let us assume that, you invest in a bank stock. If the bank makes a quarterly loss, for whatever reason, then the share price of the bank will go down. This is a company specific risk. Even during the quarter, if the RBI, hikes interest rates, for whatever reason, the share price of banks (including the one, you have invested in) are likely to go down. This is a sector specific risk. Both types of risks, company risk or sector risk, are unsystematic risks.

Let us now assume that the Nifty, the index of the largest market cap stocks in India, of which your bank stock is also a part of, goes up or down by 3% in a day. If Nifty goes down by 3%, your bank stock, is also likely to go down in price. This is because your bank stock is part of the stock market, and therefore subject to market sentiments and risk. This is known as systematic risks or market risk.

We have no control over systematic risk and hence they are called uncontrollable risks. But we can reduce unsystematic risks; how? Let us assume, in addition to investing in the bank stock, you also invest in a pharmaceutical stock. If the pharmaceutical company that, you invested in, makes a profit in the quarter in which your bank stock made a loss, then the share price of the pharmaceutical company will rise, which may fully or partially, cancel out the loss made in the banking stock. Also, the pharmaceutical sector is unrelated to banking sector and therefore, even if the entire banking sector is affected due to an event, the pharmaceutical sector may not be affected. Therefore, by adding, a pharmaceutical stock to your portfolio, you will be able to reduce your overall portfolio risks.

Mutual funds pool the money of different people and invest them in different stocks, in the right proportion, to create a diversified portfolio. The Assets under Management (AUM) of a mutual fund scheme is much larger than the investible capital of an individual retail investor. Each investor in a mutual fund owns units of the fund, which represents a fraction of the holdings of the mutual fund. Therefore, by owning mutual fund units, the investors have the beneficial ownership of a diversified investment portfolio. By investing, just Rs 5,000 in a diversified equity mutual fund, you can get diversification benefits that may have required at least few lakhs if you had invested directly in equity shares.

Suitability for a variety of financial goals

Mutual funds are suitable for a wide variety of financial goals and risk profiles. Equity funds are ideal for long term financial goals. Balanced funds are great long term investment options for investors having moderate risk profiles. Long term debt funds are good investment options for medium term financial goals, while short term debt funds are good investment options for short term financial goals.

Mutual funds provide great solutions for even very short term (few days, weeks or months) financial goals. Liquid funds are much better vehicle for parking your short term funds for a few days to few weeks or even months, compared to your savings bank account. Liquid fund returns, which are based on money market rates, are much higher than your savings bank interest rate. Ultra-short term debt funds offer investing solutions for periods ranging from a few months up to a year. The returns of ultra-short term debt funds are usually higher than liquid funds. One can also consider arbitrage funds for parking short term funds. Arbitrage funds, on an historical basis, have matched liquid fund returns, but are more tax efficient than liquid and ultra-short term debt funds.

Tax Advantages

While the benefits of mutual funds discussed thus far, make it one of the best, if not the best, investment option for retail investors, in our country, the additional benefit of tax advantage enjoyed by mutual funds puts this investment asset class above all other asset classes. Long term capital gains (investments held for over 12 months) of equity mutual fund schemes are entirely tax free. Dividends paid by equity mutual fund schemes are also tax free. Investors should note that, balanced funds (where debt exposure can be as high as 35%), equity savings fund (where un-hedged equity exposure can be only around 30 – 40%) and arbitrage funds (which by definition are risk-free since the equity exposure is hedged) are all treated as equity mutual fund schemes from a tax perspective.

For fixed income investors with a long investment horizon (more than 3 years), debt mutual funds are more tax efficient than many other traditional savings schemes like fixed deposits, MIS, NSC etc. Long term capital gains from debt mutual funds are taxed at 20%, after allowing for indexation benefits. Indexation benefits reduce the tax obligation of investors considerably. Investors should also note that, for resident Indian mutual fund investors are not subject to tax deducted at source (TDS), unlike in bank FDs and other products.

In addition to tax advantage at the time of redemption, investments in certain mutual fund products like Equity Linked Savings Schemes (ELSS, also known as tax saver funds) and select retirement funds can save you tax upto Rs 1.50 lakhs under Section 80C of Income Tax Act 1961. The maturity proceeds of these funds are also totally tax free.

We have stated a number of times in our blog that, investors must pay attention to the tax consequences of their investment decisions, because taxes can take out a substantial portion of the profits. In equity mutual funds, you get to keep your entire profit for investments made for a period of one year or more. Even in debt mutual funds, you get to keep a substantial portion of your profit for investments made for a period of three years or more.

Need for a MUTUAL FUND DAY and conclusion

We have discussed why mutual funds are the best investment options for your financial goals (short term, medium term or long term). As such, mutual funds should form the core investment solutions of retail investors.

Most households have a fixed day for most things they need for their regular needs. Households have a fixed day (usually Saturday or Sunday) for grocery shopping. They have a fixed day every month to pay the milkman, the newspaper delivery boy, school fees for their kids, credit card bills, utility bills (electricity, broadband, cable / satellite etc.), rent / maintenance, salaries for household staff, drivers etc. Some households also have fixed days for eating out, going to movies etc.

Reliance Mutual Fund has proposed, why not have a Mutual Fund Day? This is the day of the month, when you will make sure that your mutual fund investments are on track. You can even automate the regular mutual fund investment process, by investing through SIPs, but having a Mutual Fund Day on your calendar will ensure that, you are aware when the SIP is debited from your bank and also remind you to check the performance of your portfolio from time to time. You should work with your financial advisor on a regular basis to make sure that your mutual fund investment is on track to meet your financial goals.

Disclaimer

The information herein below is meant only for general reading purposes and the views being expressed only constitute opinions and therefore cannot be considered as guidelines, recommendations or as a professional guide for the readers. Certain factual and statistical information (historical as well as projected) pertaining to Industry and markets have been obtained from independent third-party sources, which are deemed to be reliable.

This information is not intended to be an offer or solicitation for the purchase or sale of any financial product or instrument. Recipients of this information should rely on information/data arising out of their own investigations. Before making any investments, the readers are advised to seek independent professional advice, verify the contents in order to arrive at an informed investment decision.

Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.

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The information being provided under this section 'Investor Education' is for the sole purpose of creating awareness about Mutual Funds and for their understanding, in general. The views being expressed only constitute opinions and therefore cannot be considered as guidelines, recommendations or as a professional guide for the readers. Before making any investments, the readers are advised to seek independent professional advice, verify the contents in order to arrive at an informed investment decision.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

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