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In the previous episode, we spoke about using equity shares to create long term wealth. Phew! All that research and due diligence in stock selection is a lot of work, especially if you are not acquainted with the nuances of equity shares.

At this point, it’s important to introduce you to managed funds like mutual funds, portfolio management service (PMS) and alternate investmentAn investment is made to give you a return. You make an investment if you use your money to buy either physical assets like property or financial assets like bonds and equity with an aim to receive income or gains... funds (AIF)

Think of managed funds like a basket of fruits. You need different kinds of fruits to give you different nutrients and that’s why you will add different fruits in your basket. Also, quantities will vary, you will not pick the same weight for all fruits. Similarly, a managed fund is a basket of equity stocks issued by companies of different sizes from various industries and these are included in the basket in different amounts; one equity stock might get a lot more space than another.

In fact, managed funds are available for other assets too like bonds, gold and even real estate. PMS and AIFs required are managed funds structured to offer access not just to listed stocks and bonds but also real estate linked securities and other unlisted opportunities in equity and debt through private equity and venture capital. However, investments in these begin at a minimum of ₹50 lakh and ₹1 crore respectively.

This brings us back to mutual funds which are a lot more accessible, flexible and transparent for the individual investor.

Advantage Mutual Funds

In terms of the kind of risk or return, you can expect the same profile as the underlying asset. An equity mutual fund will behave like equity shares. This means you will have to remain invested for at least 7-10 years for equity linked volatility to smoothen out.

However, there are other advantages which make investing in equity through mutual funds a desirable option.

1. Access to professional managers.

 Mutual fund managers are individuals you are qualified and experienced professionals with a mandate to deliver benchmark beating returns on the funds they manage. Every fund is a customised basket of stocks and the performance of this basket is compared to its benchmark to measure whether it has done well or not.

A benchmark is a standardised basket of stocks with a published value or an index like the Nifty 50 or BSE Sensex, among others.

Fund managers pick and choose stocks from different industries and sectors and put them together in a basket in a manner that the combination helps them deliver an annual return greater than the benchmark.

Performance is not always measured on an annual basis and it’s, in fact, most efficient when measured over the period of your investmentAn investment is made to give you a return. You make an investment if you use your money to buy either physical assets like property or financial assets like bonds and equity with an aim to receive income or gains... which could be 7 or 10 years or more.

2. Transparency

With mutual funds you know exactly what you are investing in thanks to the monthly fact sheet which is accessible online on the fund house website. You can see the basket of stocks you hold, the quantities and the names of the underlying companies, the cost of the scheme, the risk parameters, fund manager details and so on.

All this information is available to investors without any questions. Not only that, on websites like Moneycontrol.com and Valueresearchonline.com, you can compare the performance and other criteria of the scheme you have invested in with other similar schemes.

This helps in understanding your scheme’s relative performance too.

3. Flexibility

When you talk about flexibility in investing, it means that you should be able to invest whatever amount you want, whenever you want and also sell when you want. This is all possible with mutual fund schemes.

You can invest as little as ₹500 or as much as ₹5 lakh a month.

You can buy any day of the week and sell any day of the week as long as the capital markets are functioning on that day.

4. Tax efficiency

If you are going to go the managed fund route, then mutual funds are also more tax efficient than picking other options like PMS. While capital gains tax remains at 15% for the short term (if you sell before a year is up) and 10% for the long term (holding your fund or stock for more than a year), its in the fund structure that you get the advantage. Firstly, dividends received by a mutual fund are not taxed, however, if you own stocks through a PMS, dividends will be taxed in the hands of the investor at the marginal income tax rate. Secondly, your mutual fund scheme will attract capital gains tax only when you sell your fund units and not when the fund manager is selling within the scheme portfolio. This is not what happens in a PMS, where each time your fund manager sells a stock, if its at a profit, there is a capital gain incidence to deal with. AIF taxation is still more complicated, plus the minimum investmentAn investment is made to give you a return. You make an investment if you use your money to buy either physical assets like property or financial assets like bonds and equity with an aim to receive income or gains... threshold is anyway too high at Rs 1 crore.

What to watch out for

One can’t ignore the ease of transaction when it comes to mutual funds, right from account opening to buying, selling or registering SIPs everything can be done online with minimum issues.

Like with all kinds of financial securities there are caveats when it comes to managed funds like MFs too.

These are not caveats as much as they are things to watch out for.

Cost

There is a fee or cost or expense ratio attached to mutual funds. You don’t see it outright but it is embedded in the daily price of your mutual fund scheme. The charge is shown as an annual expense but in practice, your daily mutual fund NAV is adjusted for the cost (per day as per the annual expense ratio).

For equity-oriented funds the annual expense ratio is anywhere between 1% and 3% depending on the specific scheme and the plan you opt for.

Every mutual fund scheme no matter how similar it is to others or not will have a unique expense ratio. There is a prescribed upper limit however, within that the expense ratio can differ for each scheme. Also, you have a choice to opt for either the direct plan in a scheme or a regular plan. The regular plan assumes you are investing through a third person and not entirely yourself – and hence, budgets for the compensation of this person in helping you buy a fund. As a result, the expense ratio of a regular plan is higher than a direct plan.

Being cheaper doesn’t make the direct plan better. It is meant for individuals who are very well versed with mutual funds and the nuances involved in selecting a scheme. For everyone else, there is a need for some advisor or distributor who can guide you.

The direct plan can be up to 1% lower on cost than the regular plan.

Be aware of cost when comparing two similar schemes.

Risk

Managed funds also come with risks. You have the benefit of a professional manager however; the risk of the underlying asset remains the same.

This means that if you are investing in an equity scheme, there will be daily up and down or change in price. Ideally, just like a stock, you will have to hold on to the equity fund for at least 7-10 years to benefit from compoundingCompounding is the concept of earning return on both your principle investment and your profit. It is a way of calculating return that assumes you pull back your return till yesterday and remain invested so that any change in value... returns. Similarly, in a debt fund too, there is the risk of being a fund which has low coupon securities in a rising interest rate environment.

Then there is the risk of the portfolio quality, whether the underlying stocks and bonds are issued by companies which are high grade or not.

Lastly, there is the risk that your fund manager is sub-par and unable to deliver the returns that are expected from the fund. To understand this risk, each fund is measured against a stated benchmark index with the objective that the fund returns should be better than this index on a consistent basis.

While that can happen, if the fund manager is consistently under delivering compared to its peer group, then too you have to question it. Hence, there is always a risk that your fund manager will under deliver on the implied returns despite qualification and experience.

There is no easy way to overcome this risk, it just requires in-depth analysis of the fund manager, the asset manager’s investmentAn investment is made to give you a return. You make an investment if you use your money to buy either physical assets like property or financial assets like bonds and equity with an aim to receive income or gains... process and the portfolio itself.

Quality

Finally, you have to watch out for quality. Not just the quality of the portfolio, but the quality of the entire asset management team you are handing over your money to. The quality of the fund manager in terms of being able to deliver consistent returns and stick with the objective of the scheme. Is the asset manager of good quality and able to retain its talent within the investmentAn investment is made to give you a return. You make an investment if you use your money to buy either physical assets like property or financial assets like bonds and equity with an aim to receive income or gains... team in order to ensure the best result for the investor?

It is not easy to judge the quality and perhaps requires years of familiarity with the funds and schemes to arrive at a reasonable filter for this.

Nevertheless, as a thumb rule, you should know that

                       Quality is not equal to Brand

In financial services, there are many brands which have multiple businesses running simultaneously. You may recognise the brand as a successful bank, for example, but that does not mean it has a reliable asset management franchise and good quality mutual fund schemes.

                       Quality is not equal to high returns

Just because a scheme is currently delivering high returns doesn’t mean it’s a good quality scheme. There are several reasons why the immediate returns or last 6-12-month returns can look relatively higher. This in itself does not speak for the long-term quality of the scheme or its ability to consistently deliver benchmark beating returns. Also, remember high return comes thanks to higher risk, you have to ensure that it is not reckless risk that’s leading to this high return.

What should you do?

Are you feeling completely overwhelmed after reading this material and not sure about what to do?

Honestly, don’t put too much stress on yourself to excel at choosing a mutual fund scheme that works for your wealth creation. There are many advisors out there who are already proficient at this and can help you figure it out.

Spend your time picking an advisor if you find all the above too much to take in.

If you are unable to find that advisor who suits you and who you can trust, then there is something called passive funds or funds which don’t need a human fund manager.

Passive funds simply mirror an existing market index and what you get when you buy one is basically exposure to the underlying market index. An index is like the Nifty 50 or BSE Sensex.

There is no manual intervention in this portfolio. This continues to be a basket of stocks but without the active knowledge of a human being to pick and choose which stocks are part of this basket and in what proportion.

Indices are usually constructed on the basis of market capitalisation, in Nifty 50 for example, you have the top 50 stocks in the market by size. If you buy a passive fund with this index underlying it, you will basically hold all these 50 stocks in the proportion they are present in the Nifty 50.

There are many choices in this segment as well, all based on different underlying indices.

These also cost lower than actively managed funds.

Summary

Managed funds help you get access to a portfolio of equity stocks with the benefit of professional management and flexibility. But even here, you have to be aware of the caveats and ensure you consider quality before buying. If you have no concrete way of doing this, get an advisor is what I would advise!