Why Mutual Funds?

Indian investors are typically well diversified when it comes to asset classes. A normal person can be found willing to invest in gold or fixed income or small saving instruments for his/her financial needs. He/she can now also be found trying his luck investing in direct equities. So can we say that the investor is doing the right thing here by investing directly into such different asset classes?

The answer is No. Traditional investment avenues are sub-optimal choices plagued by many drawbacks and challenges. Let us explore these traditional ways to hold assets more closely:

Gold: The traditional method is holding it in form of physical gold. The physical gold is typically in form of jewellery. Another way of holding it is through Gold bonds although it is still not a popular way to hold gold. Here are the drawbacks of holding gold in traditional /sub-optimal ways…

• The first drawback of holding gold is first of purity. We are really not sure if we are getting the right quality of gold we are buying and often have to rely on the brand and/or the certification given/quoted by the seller.
• Next drawback is the cost of making or making charges charged on jewellery. This cost is like a sunk cost and would not be realised when gold is resold back.
• Physical gold has the drawback of liquidity, both at the time of buying and selling. High initial purchase cost makes it difficult for everyone to buy gold. Selling also is not easy, especially with Gold bonds where there is a five year lock-in period.
• The last and the most important drawback is of security with the risk of theft, loss always looming over you.

Debt: Indian investors have a great love for holding debt or fixed income products in their portfolio. This is typically in the form of bank fixed deposits or bonds or the popular small saving schemes of the government. Here are the general drawbacks of holding such assets, the traditional way...

• The traditional debt products are not very liquid. Bank fixed deposits are locked away for at least few years of your choice. Small saving schemes of government, like PPF, KVP, NSC, etc, have high maturity years.
• The next drawback is of penalty levied when a pre-mature withdrawal or closure is made. This penalty frankly does not make any sense and is like punishing the investor for any sudden requirement which cropped up.
• The most important drawback is related to inefficient taxation, especially in the case of fixed deposits. Returns from bank fixed deposits are interest income and as such have to be added to your normal income every year and taxed at your income slab – which normally would be 30%. Banks also deduct TDS on interest income from fixed deposits.

Equity: With rising markets and growing awareness, investors are attracted towards investing in equities. Most investors typically are lured towards investing in direct equities through share brokers. Investing equities though is full of challenges and not an easy thing to do as a retail investor. Here are the drawbacks of directly investing in equities...

• Stock selection is not easy. It requires lots of expertise and knowledge about the company and the industry. To develop this expertise and knowledge, one may need to put in years of time and effort.
• Monitoring your stocks and other opportunities in the market requires a lot of time and effort. It requires dedicated effort on your part.
• Direct equity investing is highly risky as your portfolio would be concentrated in few stocks.
• The last drawback is in form of emotional challenge you would face on a daily basis while making the decision to hold, sell or buy with the increased volatility. This would add to your stress levels too.

As we clearly understand now, traditional ways of investing in some our popular asset classes is really not appealing and has a lot of drawbacks. The real question now is - what would is the ideal /right way to invest?

While there is no right way for everyone, surely there is one option that removes the drawbacks as discussed above. And the answer is Mutual Funds.

How can Mutual Funds remove the drawbacks?

Mutual funds can be understood as an investment vehicle which pools money from many investors and invests into asset classes of choice. A fund manager and his team then manage the assets professionally as per the fund /scheme objectives. It is important to note that a mutual fund is not an asset class in itself as the underlying can be any asset class or product like gold, debt or equity. As an investment vehicle, we can see mutual funds offering many advantages or benefits to its' investors. These are...

• Professional Management: There underlying investments of a mutual fund is managed by a qualified, experienced and skilled professional fund manager and team with lots of resources and information at their disposal.
• Diversification: The investments in a mutual fund is spread across different issuers (for debt) and stocks (for equity). This reduces risk as the relative weight of any bad investment is small.
• No buying limits: One can effectively start making investment in any asset class with as low as Rs.500. There are no upper limits though.
• High liquidity: Most schemes (open-ended) are available to buy or sell on a daily basis to its' investors. You can effectively sell anything and receive money in couple of days.
• No Lock-in: Mutual funds typically do not have any lock-in periods and you can invest for any duration and withdraw at any time.
• Choices: Mutual funds offer a huge choice of products and underlying asset classes. You can choose your scheme as per your risk appetite and investment horizon. A person can choose to invest in say liquid debt funds for a few days or equity funds for long term horizon.
• Tax efficient: Compared to fixed deposits, debt funds are much more tax efficient. First, there is no interest income but capital gains. If you hold the investment for least three years, you will benefit from long term capital gains of 20% with indexation benefit. There is no TDS as well.

Having known the advantages of mutual funds over traditional investment routes, you should at least explore mutual funds further. Please note that mutuals are not risk-free and are subject to market volatility. On the other hand, they also have the potential to add deliver higher returns. We would recommend that you consult a mutual fund distributor or advisor for proper guidance for your investments.