Getting started as a Mutual Fund Investor
Getting relevant information and selecting a proper mutual fund can be a tedious and intimidating task because of the extensive and segregated data available. Usually, to avoid this process and to reduce the risk because of incomplete or improper information, individuals turn to financial advisors for choosing an investment portfolio.
Even in this case, I believe it is necessary for the investor to have some basic knowledge of what mutual funds are, how they work, their advantages and disadvantages.
Mutual Fund is made up of pool of money collected from many investors to invest in stocks, bonds, money market instruments and other assets. They are managed by professional fund managers. A mutual fund’s portfolio is structured and maintained to match the investment objective of that fund.
Mutual fund provides small and individual investors access to professionally managed portfolios.
What makes mutual fund investment comparatively safer?
In any type of mutual fund, the amount invested is diversified in various sectors. So, out of $100 invested, $30 would be in the financial sector, $20 in pharma, $15 in energy, $15 in automobile and so on. As it diversifies the amount in different categories of companies, they reduce the risk on investment. Investment in various sectors increases the probability of making a profit.
Returns of Mutual Funds:
One of the important factors considered while investing in mutual funds is the historical returns offered by that fund.
Unfortunately, calculating mutual fund returns over a longer duration of time can be confusing and may lead to incorrect selection of fund. To avoid this, it is necessary to understand how the returns are calculated.
The majorly used types of returns calculation are,
- Absolute Return
- Annualized Return
- XIRR and
- CAGR
How do we calculate these different returns?
Let us consider that we have invested $1000 in a fund on 1st January 2010.
On 1st January 2020, the invested amount has increased to $2000.
- Absolute Returns
To calculate Absolute returns,
Absolute Returns = [ (Current amount — Invested amount)/ Invested Amount]*100
=[ (2000–1000) / 1000]*100
= 100%
2. Annualized Returns
These are the returns that provide information regarding the annual rate of return on investment. It analyzes the gain or loss in the given time period with the consideration of compounding.
This return also takes into consideration the interdependency of return rate of a year over previous years’ return rate.
Annualized Returns = [(1 + Absolute Returns) ^ (1 / Duration)] — 1
= [(1+10)^(1/10)] — 1
= 1.27–1
= 27%
3. Extended Internal Rate of return (XIRR)
In case of SIP, there are multiple investments across a different time period, hence calculating returns is different. Here, along with the investment amount, the time of investment plays an important role, hence returns are calculated by taking into consideration the time of investment.
XIRR is used to calculate when the cash flow is spread out over a period of time.
XIRR is calculated using excel function
4. Compounded Annual Growth Rate (CAGR)
CAGR is the best formula to understand how an investment has performed over a period of time. It is simple and easy to calculate. However, it does not take into consideration the market volatility.
CAGR = [(Current Value/Investment Value)^(1/duration)]-1 OR
CAGR = Absolute Return/tenure
CAGR = 100/10
CAGR = 10%
Types of Mutual Funds
To understand the benefit offered by Mutual funds, it is necessary to understand where the fund invests it. To get an idea about this, it is essential to understand different categories of mutual funds.
- Equity Mutual Fund
These mutual funds invest in the equity market, i.e. it invests the money in the companies listed on NASDAQ, NSE, BSE, etc.
2. Debt Mutual Fund
These mutual funds invest in bonds, debentures, government bonds, etc.
3. Hybrid Mutual Fund
These mutual funds invest in a combination of equity market and debt instruments.
4. ELSS Fund
This fund is specifically in India. The only difference in this fund and other funds is that this mutual fund has a lock-in period of 3 years i.e. when any amount is invested in this fund, it cannot be redeemed before 3 years. These funds are used to get tax benefit under section 80C.
Classification of Mutual Funds based on Risk
- Low Risk
These are the funds which have low risk compared to other options. The investments in low risk fund are made in debt market due to which they tend to be long-term investments. As the risk of investment is low, the returns are also low in these type of funds.
2. Medium Risk
These funds have a medium risk for the investment. These tend to offer comparatively higher returns with some risk. They can be used to build wealth over a longer period of time.
3. High Risk
These funds have the highest risk due to their choice of investment instruments. As the risks associated with these funds are high, the returns offered too are higher.
Important terminologies used in Mutual fund details
- NAV — Net Asset Value
The Net Asset Value represents the market value of per share of a Mutual Fund.
2. Portfolio
Portfolio is a collection of financial investments like stocks, bonds, commodities, cash, cash equivalents, closed ended funds, exchange-traded funds.
Different investment options
- Lumpsum Investment
Like the name suggests, we invest whatever amount we desire at the same time. When we use lumpsum investment, we need to take into consideration the CAGR.
2. Systematic Investment Plan (SIP)
Those of us who do not have a substantial amount to invest and would rather prefer a systematic method of investments go for SIP i.e. Systematic Investment Plan. When we invest using SIP, a pre-defined amount is invested after a specific amount of time.
As the investment duration for each investment is different, to get a proper sense of the % return on our investment we should take into consideration the XIRR.
Factors to consider while selecting a mutual fund
The two major factors to consider while selecting any investment solution are,
- Risk appetite
Every mutual fund has a certain level of risk associated with it. Depending on the ability of investor to take risks with his investment, he can choose a fund.
Example : If the investor is comfortable with high risk investment, he can opt for high risk investment funds. The advantage of this is that he has a higher possibility of higher returns. Whereas if an investor is not comfortable with high risk, he can go for low or moderate risk funds.
2. Duration for which the amount will be invested
The returns offered by mutual funds are dependent on the tenure of investment. Thus, investor needs to take into consideration the duration of the investment.
In general, the investment horizons for different types of mutual funds are;
- Equity Fund : 5+ years
- Debt fund : A few days to few years
- Hybrid funds : Over 3 years
Any given mutual fund provides information about the risk level that is associated with it. Along with it, it also provides an investment horizon.
This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any financial decisions
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