The Equity Fund Blueprint

Mutual funds have become one of the most popular vehicles for investments all over the world. This is especially true for equity investments. Today mutual funds form a significant portion of almost every investor's equity portfolio. But quite often equity mutual funds are included merely based on popularity and past performance. This is because these are two aspects which are clearly apparent. Information on these aspects is also readily available. But in truth both these parameters should have very little say in our decision making process as regards whether or not to add a particular fund in our portfolios.

Investing in equity mutual funds needs to involve a lot more forethought and analysis at various levels. We must develop a clear process and structure before we make decisions and act on them. Therefore today I will be talking about the fundamental aspects of developing an investment process with regard to investing in equity mutual funds. This would make our equity fund investing a lot more purposeful than simply picking funds with the catchiest names or the highest returns in the recent past.

Any investment process developed around equity mutual funds must begin with investors educating themselves on the basic essence of mutual funds. A mutual fund simply pools small amounts of savings from a number of investors. This money is then given to a mutual fund house who are represented by a qualified professional known as a fund manager. The fund manager then invests the money in a single asset class or a variety of asset classes. In the case of equity mutual funds, the money is mainly invested in stocks of various companies. The profits or losses from the money invested are then shared proportionately among those who contributed their savings to the mutual fund.

This is a very basic explanation of the working of a mutual fund. Those who wish to gain an in depth understanding of other aspects with regard to mutual funds may refer the investor handbooks available on the websites of SEBI and AMFI (Association of Mutual Funds of India). These handbooks provide details on aspects such as historical performance, goal based selection and risk factors associated with mutual funds. The SEBI investor handbook can be found here, and the AMFI investor handbook can be found here.

Our mutual fund choices must always be aligned to our financial goals. Therefore, once we have a basic understanding of mutual funds as a product, we must then gain a clear understanding of what our major financial goals are. Investing in equity mutual funds would only make sense only for those goals which have at least 5-7 years before falling due. We must also have a clear idea of the asset allocation strategy for each such goal. This would act as a guideline as to what portion of the portfolio for each goal should go into equities.

For all long term goals, equity exposure in the portfolio must ideally be at least 60% but not more than 70%. There are a number of categories available to investors within the equity mutual fund universe. While mid cap and small cap funds are popular and provide higher returns, drawdowns in such funds can be sharp and long lasting (sometimes lasting as long as a number of years). This can be emotionally stressful for investors. And the most likely outcome of this is that they don't stick with their funds for long enough. So, for most investors, large cap funds would represent the most viable option.

Among large cap funds, index funds would be the best option. Index funds must replicate the portfolio of the benchmark indices that they track, leaving very little room for the fund manager's discretion. They therefore eliminate the element of human error on part of the fund manager which is common with actively managed funds. As a result, costs associated with such funds are lower translating into higher long term returns for investors.

There are index funds available that are benchmarked to mid cap and small cap indices. But most such funds do not track their benchmark indices effectively. Such funds are hence best avoided.

The fact sheet of any mutual fund is the best place for investors to learn about a mutual fund. The fact sheet gives information about aspects such as the investment objectives, portfolio and risk profile of the particular fund. We must first go through the fact sheet of any equity fund that we wish to invest in and see if the investment objectives and the risk profile of the fund matches the needs and risk profiles of their own. They must also analyse the portfolio of the fund to understand the quality of stocks held in the fund. Only then must they finalise their choices and begin their investments.

Most mutual fund schemes are offered under a regular plan and a direct plan. Under a regular plan, a qualified mutual fund distributor assists investors in terms of recommending funds, educating them about their choices and helping them execute their transactions. But distributors charge a commission for their services which is collected from investors as a part of the cost of each purchase transaction. This reduces the overall return investors enjoy from the fund over the long term.

Under a direct plan on the other hand, investors interact and carry out their transactions directly with the fund house (also called an Asset Management Company or AMC). This means that distributors are not a part of the equation. And so investors save on the money that they would otherwise have paid out in commissions, resulting in higher net returns.

Therefore it would be prudent for investors to educate themselves about their fund choices through fact sheets or help from professional advisors. This would then allow them to invest through direct plans without needing to depend on distributors and bear the associated commissions.
There are two major options offered by most mutual fund schemes. These are the Dividend Payout and Growth options. The way in which these options work and their respective tax treatments are explained in the graphic that follows.

There is also another option known as the Dividend Reinvestment option. Here, the dividend amount left after the charge of 10% Dividend Distribution Tax is reinvested back into the fund. All things considered, the growth option would be the ideal choice for most investors, given the benefits of uninterrupted compounding and tax deferral that it offers over the other two options.

Ultimately, there is no standard formula that guarantees success with regard to equity mutual fund investing. But, bringing all the elements discussed until now into a clear framework instead of blindly buying funds based on past performance and popularity would give us a clear blueprint which would greatly improve our chances of ultimate success. And this represents the best case scenario for any equity mutual fund investor.

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Akshay Nayak

SEBI Registered Investment Advisor and Fee Only Financial Planner based in Bangalore, India. My stories ≠ advice. Email ID : akshayadv93@gmail.com