Mutual funds are a way for savers to put their money to work in asset classes of their choice
Any person who is in in employment or a business or profession has a steady source of income even if that income is moderate to start with and would be expected to grow as one progresses. As Indians we have always had a strong saving culture as part of our DNA, and the individual starts saving part of that income, traditionally in bank deposits or other relatively safe avenues which one is comfortable with.
However, besides deposits, there are many other assets or instruments where one can put one’s savings like equity shares of companies, government debt, corporate debt, shares of global companies and so on. A saver who looks only at traditional instruments like deposits to put his money is like a diner who goes to a buffet and sticks only to soup, and ignores all other dishes on the menu.
Just as a combination of different dishes on the menu go to make a balanced diet, a combination of different asset classes makes a balanced portfolio while adding to the overall returns (or experience, in the diner analogy). This is true especially as each asset class brings its own strengths to the table. As an example, equity has given good returns over the long term (the BSE Sensex has given CAGR returns of 14.6 percent pa over the past 27 years as on 15th June 2017 , debt has given decent returns with limited volatility in the past 15-20 years. While these different asset classes bring their own strengths to the table, it is often not possible for the average individual to choose and invest in these assets directly.
Mutual funds are a way for savers to put their money to work in asset classes of their choice. Mutual funds are pass through vehicles, and as such there can be as many types of mutual funds as there are asset types. While the advantages of mutual funds are well known, it is worth repeating them which are: access to professional managers at a low cost, liquidity (they can be redeemed any time), a high degree of scrutiny from regulators ensuring investors’ interest is protected, transparency (full portfolio disclosure, all costs etc.), ease of use, low minimum investment and flexibility in terms of the wide variety of options available. The wide choices enable the investor to build a portfolio to meet a financial goal that he/ she might have.
A young investor with a stable income and many years to invest may feel comfortable taking risk to achieve greater return investing primarily in equity funds. This can be a wealth creation goal as sustained investing has the potential to build a substantial corpus over the long term. A mid-career investor trying to balance risk and return more moderately can invest in a mix of equity and debt, or in a balanced fund. This mix will also lead to wealth creation but with lower risk and correspondingly lower return.
A good product that is available for investors with moderate risk appetite is the dynamic equity fund which varies its equity exposure depending on how expensive or cheap the market is. This enables the fund to buy low and sell high which preserves returns when the markets are high and reduces the volatility of the portfolio while giving returns which may be broadly aligned to the equity market returns. This product is a good fit for mid-career investors who want to have some growth in their portfolio while controlling the risk.
However, one aspect that is most important and which investors often ignore is asset allocation. As an example, suppose the best equity fund grows 20 percent in a year while the average fund grows say 15 percent. Also, assume the best debt fund grows 9 percent while the average fund grows say 7.5 percent.
A young investor who had an equity: debt allocation of 20:80 in the portfolio and had the best performing funds in his portfolio would get return of 11.2 percent for the year while another young investor who had an exposure of 60:40 for equity: debt and only had the average funds in his portfolio would get returns of 12 percent for the year. It is hence important to get advice from an investment adviser and focus on asset allocation which can be a big determinant of returns for an investor.
Author is Chief Investment Officer, Principal Pnb Asset Management Company
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