A beginner's guide to mutual funds

Mutual funds are a well-diversified, low-cost and tax-efficient way of growing your savings. They are an ideal investment option for those who do not have the expertise for stock investing. You simply invest in a fund, and the fund manager will do the job of picking the stocks that they think will yield good returns.

Despite their simplicity and suitability for small investors, they are not the preferred investment option for the vast majority of Indian investors. They are either not aware of them or find them too complex to understand.

If you happen to be one of them, here is a primer that should help you start investing in mutual funds with ease. It summarises the key steps in your journey and explains all you need to know to get started.

1. Getting ready:

There are a few one-time prerequisites to start investing in mutual funds. You need to have a bank account and you must be KYC (know your customer) compliant. KYC is the process of verifying the identity of an investor. It's free and just requires your passport-sized photograph, PAN and Aadhaar Card. Also, you can check your KYC status.

If you haven't yet registered for KYC, you can apply for it in two ways - offline and online. An offline KYC can be done by filling out a form which is available on the websites of Registrar and Transfer agent (CAMS/Karvy) and all the mutual fund houses (AMCs).

You can also get your KYC done in just five minutes by filling out an online form on the website of AMCs or RTAs. You need to provide your registered mobile number and Aadhaar number for verification via OTP. Your in-person verification (IPV) is done via video call, where you have to show your original identity and address proof. Once the verification is done, you are all set to invest.

2. Choosing mutual funds:

Mutual funds are meant to simplify the job of investing for you. But ironically, the task of choosing the right funds can become overwhelming, given that you are faced with more than 2,500 fund schemes to choose from. Here are the decision points you'll be confronted with and here's how you can make the right choices with ease.

a. Debt or equity funds

Referred to as the asset allocation decision, this is basically where you decide whether and how much you should invest in fixed-income securities and in equity shares. Both are meant to fulfil different needs.

Debt funds offer steadier but offer lower returns. Given their low-risk, low-return profile, they are a suitable choice to meet short-term goals where capital preservation assumes precedence over return potential.

On the other hand, as the name suggests,equity funds invest in shares which can earn far higher returns but can also fluctuate much more in the short term. They are suitable for time horizons of five years or more. The chances of incurring losses from equity investments fall drastically over longer investment horizons. And coupled with their superior return potential, they are an ideal choice for building meaningful wealth over the long term.

If you are a first-time investor looking to invest in equity,aggressive hybrid funds could be a suitable option for you. These mutual fund schemes invest between 65% to 80% of your money in equity and the rest in debt. With this combination, you get the flavour of equity investing and the debt portion brings a bit of stability.

In summary, a debt fund is a suitable choice to invest the money you have earmarked to buy a car next year. On the other hand, equity and balanced funds will be a good option for your retirement plan.

b. Which mutual funds

Once you have decided on your asset allocation, the next step is to pick the specific fund(s) within the debt or equity categories. Do not randomly pick mutual fund schemes or blindly rely on the advice of a relative or a friend. You should opt for funds that have performed well consistently over the long term instead of the season's chartbusters.

The list of four or five-star rated funds by Value Research can greatly simplify your job. These ratings are based on funds' long-term risk-adjusted returns and therefore reward funds that have a proven track record of performance. Also, you can check out our list of top-rated funds.

c. How many

Even by investing in a single fund, your portfolio gets diversified across 30-40 stocks. So, two or three funds from different fund houses are quite enough to provide adequate diversification. With a larger number of funds than this, you may just end up replicating your existing holdings.

d. Direct plan or Regular plan

Every mutual fund scheme now offers a direct plan and a regular plan. They are the same except that a direct plan charges lower annual expenses (lower by around 0.75 - 1 per cent per annum in the case of equity funds) because it does not have to pay a distributor fee or commission.

This is because, in the case of direct plans, you invest the money yourself, without the mediation of a broker or agent. Whilst direct plans will save you money, you'll have to do everything yourself, and being a DIY investor requires active tracking, rebalancing, switching funds, etc., which can be daunting for a beginner.

You may instead want to go through a distributor initially and invest in regular plans. Later on, once you've become more knowledgeable and confident, you can think of switching to direct plans. But the only word of caution here is to stick to your investment plan and not get persuaded by any other investment option they may offer you as they have their own interests attached to it.

e. Growth option or IDCW

Within both regular and direct variants of each mutual fund scheme, you may also get to choose between two options - Growth and IDCW (Income Distribution cum Capital Withdrawal) plans. In IDCW plans, fund houses pay out some portion of the gains made to the unitholders. The quantum of payout and timing is as per the choice of the AMC. Also, the amount paid out is subject to income tax, as financially, it's exactly as if you have withdrawn that money from the fund.

In the Growth option, there are no periodic payouts made at the behest of the AMC. Your money remains fully invested until you decide to redeem it, in part or in full.

So which one is better?

We suggest you keep it simple and always opt for the Growth option. It is more tax-efficient and gives you more control over when and how much you redeem.

3. Buying mutual funds:

Now that we are past the stage of choosing a mutual fund, we are ready to go ahead and buy them. You can either buy funds directly from a fund house or through an intermediary.To invest directly, you'll have to submit filled forms, cheques, etc. at investor service centres of the mutual fund houses or registrars, who have their branch networks across many cities. Or more conveniently, you also have the option of investing online via the websites of mutual fund houses or various online platforms that facilitate buying and selling of funds. There are a host of platforms to choose from, making it easier to embark on your investment journey. In fact, you can get started with Value Research Fund Advisor. It makes your life simpler by offering expert fund recommendations and then helping you instantly invest in those funds.

Payments can be made online by using net banking or UPI to complete the transaction.In case you prefer to invest through an intermediary, there is a wide variety of them available, including banks, individual financial advisors, distribution companies, online portals, and brokerages.

At this stage, you'll need to ponder over how much to invest and at what frequency. Here, you broadly have two options - lump sum investment or Systematic Investment Plans (SIP).

Lump sum investing simply means you invest all the money that you want to invest at one go. SIP on the other hand involves investing a fixed amount at a fixed frequency (generally monthly). For instance, if you have Rs 1 lakh to invest, you may invest the entire amount in a lump sum or you may create a monthly SIP with each instalment of Rs 10,000 over a 10-month period.

So, which one is better?

Well, for debt funds, you may invest a lump sum, but for equity or balanced funds, we strongly recommend you create an SIP spread across a certain number of months.

4. Monitoring your investments:

You should keep track of how well your investments are performing. But don't overdo it. Given the ubiquity of modern technology, you will constantly get updates about the ups and downs of the market. Do not be swayed by this. Reviewing your investments once in a while is all you need to do.

Use the My Investments feature on Value Research to analyse every detail of your portfolio.

5. How and when to sell:

There are broadly two reasons why you should consider selling your fund: 1) It has become a poor performer, or 2) You need the money to meet the financial goal(s) for which you were investing in the first place. Let's look at both of them one by one.

a. Poor performance: If the fund's performance has been consistently dipping compared to the peer group and benchmark, you should carefully consider whether or not it should be part of your portfolio. However, don't let a single month of bad performance change your mind. You need to take a longer-term view on this. A quick and convenient way is to keep an eye on the fund's rating. In case its rating drops to one or two and remains there for a few months, you can consider selling it and look for a better option.

b. Meeting your financial goal: In the case of equity funds, you should withdraw systematically. Therefore, as your planned goal nears, exit your equity investment over a period of two to three years and move your money into debt funds. This gradual withdrawal is important to avoid getting adversely impacted by any sharp declines in equity markets right at the last minute. In the case of debt funds, however, it is fine to withdraw your money in one go. Lastly, you should keep tax implications in mind while selling your funds.