Chapter 7 Things to know before investing in Mutual Funds

Investing in Equity or Debt Mutual Fund can result in losses. In fact, even liquid funds, in exceptional circumstances, can result in minor losses. Past performance of a mutual fund is no indicator of its future performance.

Funds with similar investment objective could deliver different returns

Each fund is run by a different fund manager and the securities in the portfolio could be very different from those of another fund manager who has a similar investment objective.

Using Portfolio Turnover Ratio

This ratio shows how frequently a fund manager enters and exits stocks. If churning is excessive, expense rises, and reduces returns. Funds also fail to make the most of investment opportunities because of early exits.

Lower NAV is not cheaper

A fund with NAV of Rs. 10 that returns 20% in one year is exactly similar to a fund with NAV of Rs. 100 that returns the same 20% over the one year. Returns differentiate the fund, not the NAV.

Debt Funds are not Risk-free investments

Debt funds face the risk of rising interest rates on their fixed rate portfolio which lowers the value of the underlying securities. They also face the risk that the company may not be able to repay the principal to whom they lent funds. These events could result to losses in a debt fund.

Not All debt funds of similar Duration Are the Same

Some debt funds invest only in AAA rated (highest quality bonds), while others invest across the credit spectrum (lower rated bonds), referred as credit opportunity funds. Though these funds may provide the additional kicker in returns, the risk of default in the portfolio, i.e. bond failing to make interest payments and/or principal is higher than in the fund with highest quality bonds.

Size of the fund is important

Size matters to an extent, especially, in case of debt oriented funds, where there are institutional investors. If a few large investors decide to exit, it can disturb the portfolio and impact returns. However, very large funds are best avoided as they may become hard to manage. In India, however, fund size is not a key factor in the equity space, as less than 5% of market cap is mutual fund-owned.

Loan Against MF units

Loan against Mutual Fund units are available with some of the banks / NBFCs, but can have an associated cost which could be higher than the returns on the Mutual Fund investments.

Key Takeaways

• Funds with similar investment objective could deliver different returns.

• Lower NAV does not mean the fund is cheap.

• Debt funds face the risk of rising interest rates on their fixed rate portfolio which lowers the value of the underlying securities.