What is a mutual fund?

What is a mutual fund?

It is a pool of money collected from a large number of investors by a professional entity with an aim to invest in different avenues for a variety of purposes. These avenues could be equity, debt, gold, commodities, real estate and so on.

Presently in India, Mutual Funds are not allowed to invest in real estate directly, though they can invest in equity shares or bonds of real estate companies. Equity markets, debt markets and gold are the most popular asset classes that Indian MFs invest in.

The purpose of investment will vary according to the asset class chosen. Equity is usually a vehicle for long-term wealth creation; debt for some regular income and an attempt to protect your capital; and gold as an inflation hedge.

When do mutual funds work…

Unlike bank fixed deposits—where, whichever deposit you choose, you get a fixed rate of return—Mutual Funds don’t assure returns. The degree of risk varies from scheme to scheme. So, be mindful of which one you select. The good news is that risk is not a bad word; it means volatility and volatility can be managed.

…and when do mutual funds not work

MFs are not the right choice if you want guaranteed returns.Mutual Funds never guarantee returns; regulations prohibit them from doing so. Since they invest in equity and fixed-income markets, your money is subject to the volatility that these markets bring.

But since you end up taking risks, the chances that you earn returns higher than a typical assured-return instrument are also high. If you are certain that you need assured returns, avoid Mutual Funds.

Types of mutual funds

Broadly, there are four types of Mutual Fund schemes.

Equity

These funds invest in equity markets. They could either invest in large and well-established companies or medium- and small-sized companies. Some include a healthy proportion of both segments and are called multi-cap funds. There are thematic and sector funds as well, which invest in a few sectors or just a single sector, and are meant for those who have timely and informed views about the fortunes of select sectors.

Among the four categories of funds, equity funds are the most volatile. Use equity funds if your financial goal is at least five to seven years away.

Debt

These funds invest in fixed-income instruments such as bonds, government securities and short-term instruments such as certificates of deposit and commercial paper. Although they do not assure returns, they are less volatile than equity funds and are, therefore, used to earn regular income.

While liquid funds are least volatile (since they cater to investments of up to three months), bond funds rank high on the risk ladder since their underlying instruments mature after 3-5 years. Debt funds make money by managing credit risk and interest rate risk.

A credit risk is managed by investing in low-rated companies with the view that if credit ratings improve, their scrip prices would also go up. Interest rate risk is managed by managing the maturity of the underlying securities, depending on where the fund manager believes interest rates would go.

Hybrid funds

These funds invest in equity and debt markets at the same time. Here, too, risk profiles differ depending on how much they invest in equity markets. Balanced funds typically invest 50-70% in equity markets.

Monthly income plans (MIPs) invest between nil and 20% in equity markets and the rest gets invested in fixed-income markets. Therefore, balanced funds are meant for long-term goals. Whereas, MIPs are more conservative and are used for goals that need to be reached within 5 years with measured risks.

Gold funds

These funds invest in gold. They have passively managed funds and they track the price of gold. Instead of buying physical gold and then having to store it—which will require adequate safety and space—investing in gold funds is a good alternative to buying physical gold.

If you have a demat account, you can invest in a gold exchange-traded fund (ETF), which is a passively managed fund that gets listed on the stock exchanges. Or, if you don’t have a demat account, you can invest in a gold MF scheme, like any other scheme, which then invests your entire sum in a gold ETF.

So which category of mutual fund will suit you

Ascertain your investment time horizon

Ask yourself for how long would you need to stay invested, at the minimum? This depends on how distant is your financial goal. Say, you want to buy a house after 5 years, or you want to send your kids to a good college after 10 years. Or, you want to retire after 20 years and need to build yourself a retirement kitty.

Ascertaining the tenure is important because you need to choose an appropriate fund that matches it. That’s because different MFs cater to different tenures. For example, liquid funds are meant for short-term (parking) needs. Equity funds are meant for long-term goals, but you need to wait out for at least 5 to 7 years, sometimes even longer.

Mistakes to avoid in equity investment

Mistakes to avoid in equity investment

Equity investment makes a compelling argument for being included in long-term growth portfolios. This is due to the higher inflation-adjusted returns equity investment generates. Here are a few practices that you should avoid since these practices increase the risk in your portfolio.

Timing entry, exit

Unless you are an expert at interpreting technical indicators, you will not be able to call the market’s highs and lows with too much success.

Most common investors would not have an in-depth understanding of all the events. Frequent entries and exits from any investment instrument lead to additional costs, which eat into your returns.

During the time that you wait for signals to indicate the right time to invest, your money will be lying idle.

Similarly, trying to time your exit according to a market peak has disadvantages too. First, you may not have the money when you need it. Second, the market may decline before you are able to monetize your investment.

Leveraged funds

It is important not to use borrowed funds to invest in volatile assets. Returns from such investments have to go towards servicing the loan. And while returns can be high in best-case scenarios, if such investment tanks the losses will be more with long-lasting impacts on your life.

Leveraging magnifies losses as much as it does the gains and is, therefore, a risky strategy to adopt for volatile instruments.

Short-term investing

Growth assets with high long-term average returns need a long investment horizon.

Higher returns from such investments can be had by giving them time to ride out turbulent markets or economic downturns.

If an investment is made after adequate evaluation of the fundamental factors and it periodically monitored, then it should be held in the portfolio for as long as the goals require.

It is important to tune out the noise of short-term market responses to events and focus on the long-term prospects of the investment.

A high return on long-term investment does not guarantee the same level of returns over a shorter holding period.

Investing funds earmarked for immediate goals in volatile investments, to earn higher returns, may not always be successful. A fall in market values during that period will depreciate the capital invested.

Booking quick profits

Trying to exploit an upward momentum in an investment, to make a quick profit, is a risky strategy unless you have the tools and information required to time and execute such trades.

Inexperienced retail investors are likely to enter into a trade when the momentum has petered out and the prices are retracting.

Sometimes such investors are unwilling to cut their losses and exit. This may happen even as the prices continue to sink further. At other times, greed may make them ignore the signals to book profits and they stay invested in the hope of higher prices.

The availability and regular updates on prices, and ease of making transactions make it tempting to use such strategies to make a quick profit.

But given the hits and misses, as well as the costs and taxes, the cumulative outcome may not be all rosy.

Chasing past performers

Chasing last year’s best-performing asset class, industry, strategy, or product category can put your goals at risk. The risk is that the previous year’s best performers need not be the same this year.

Chasing performance necessitates moving funds from one investment to the next, which implies costs and taxes that affect net returns. It may result also in buying products that are not aligned with the needs of the investor.

The portfolio has to reflect your goals and the ability to take risks. A diversified portfolio that is aligned with the goals will take care of having exposure to multiple asset classes.

Monitor the investment performance and consider a rebalancing only if there is consistent underperformance relative to valid benchmarks and peer groups.

Investments that have the potential to generate higher returns come with greater fluctuations in their returns. Keep the focus away from the volatility and instead focus on your investment plan.

Having a plan that reflects your risk and returns preferences will help ride out the troughs and get you to your financial goals.

Risk of not knowing your investment risk

Risk of not knowing your investment risk

‘Keeping money in a fixed deposit is safe and investing in equity is risky’. ‘Real estate investing is less risky than equity investing’. ‘Will I lose my capital ?’. And the list goes on. These are not the right concerns to address when you plan your investments.

Let’s reflect on how investment text books define risk. Volatility or the movement in value is usually shown as a proxy of risk. More volatile the asset value is, riskier the asset becomes. Warren Buffet, legendary investor defines risk as “Risk of not knowing”. Most of the people are not aware what they are investing into.

The only investment product categorized as the lowest risk in a country is a ‘government bond’. It is the lowest risk because these bonds are backed by the ‘government’.

India’s credit rating is BBB-, which is the lowest investment grade rating. If the rating goes below BBB- then the bond is categorized as non-investment grade and the likelihood of default increases. So even our government bond can default and hence risky.

So what do you do?

Do you expect your capital to go down? Do you just park your money in a government bond? No, you educate yourself and know what you are investing into. Majority of investors think in three ways about their investments: Short-term, long-term, don’t care.

Knowing your time-horizon

Short-term

These investments are done to meet short-term needs, say less than five years. You can invest your money in fixed deposit. To increase the post-tax return you can also evaluate investing in ultra-short-term and short-term bond funds.

Long-term

These are the objectives that you plan to achieve post five years. A combination of equity and real estate can help you grow your assets over long-term.

Since most of the investors are over-invested in real-estate so that leaves only equity. A combination of mutual funds, equity exchange-traded funds and PMS is recommended.

Don’t care

Please note the category is ‘don’t care’ and not ‘don’t know’. If you have additional cash that you don’t care, you should invest in equity. Sure, there are other categories such as private equity, startup investing etc. but these alternative categories are even riskier.

Rather than knowing which product, one way to address risk is ‘what for’ or defining the objective. If you have clarity of the objective, you will be a lot comfortable handling the short-term fluctuation.

Additionally, you need to also reflect on your behaviour or psychology.

Do you get disturbed when you see a lot of fluctuation in your portfolio? If yes, you should not expose yourself to equity or real estate asset category.

Reflect on your needs and decide the allocation, you will feel a lot better managing your wealth.

How can NRIs in Canada and USA invest in India

How can NRIs in Canada and USA invest in India

It is quite difficult to ignore India’s growth. Until the late 2000s, most of the NRI money was flowing in real estate. However, over the last few years, the trend is changing. Investors are moving away from physical assets and into financial assets.

Simply speaking financial assets can be broken down into debt and equity.

Fixed deposits

Most of the NRIs prefer fixed deposits because it is simple and easy.

NRI needs to open one of the three banks accounts-non-resident external rupee (NRE) account, non-resident ordinary rupee (NRO) account or foreign currency non-resident account (FCNR) with an Indian bank.

NRE Account is best suitable for those who need to make payments in Indian rupees or want to make investments in India from his/her overseas earnings and at the same time want rupee savings to be freely repatriable.

NRO account is suitable for those who want to deposit his/her income in India from sources such as rent, dividends etc. and want the investments in India to give higher returns.

FCNR Accounts are best suitable for people who wish to keep his overseas savings in India but do not want to convert them in Indian rupees.

Debt mutual fund

There are 7-8 fund houses in India that are offered to the investors in the US and Canada. Investing in ultra-short-term and short-term debt is preferred since you don’t know where the $ to INR would move over long-term.

The benefit of debt mutual fund over a fixed deposit is the indexation benefit if the investment stays for more than three years.

At the time of redemption, TDS is applicable.

Equity mutual fund

The fund houses that offer debt mutual funds also offer equity mutual funds to the investors in the US and Canada. You can make investments through an NRO or NRE account.

Redemption proceeds are either paid through cheques or directly credited to the investor’s bank account. All earnings are payable in rupees. Investments made through inward remittances or from NRE/FCNR accounts are fully repatriable. Hence, earnings made by redeeming the units or through dividends are fully repatriable. However, in case of investments made through NRO accounts, only the capital appreciation is repatriable, not the principal amount.

 

Equity Mutual Funds

Debt Funds

 Short-term Capital Gains Tax

Investments held for less than 12 months:

15% + surcharge 12%+ education cess 3% = 17.3% (total)

Investments held for less than 36 months:

As per tax slab

 Long-term Capital Gains Tax       

10% + surcharge 12%+ education cess 3% = 11.65% (total)

20% with indexation

 Dividend Distribution Tax

Nil

29.12%

While tax liabilities of an NRI investing in India are the same as that of a resident investor, the tax is deducted at source in case of the former. Whether an NRI is subject to double taxation-once in India and again in the country of their residence depends on the country of residence. If the Indian government has an avoidance of double taxation treaty (ADTT) with that country, the NRI will be spared from paying tax twice.

Stock investing

In the United States, IRS guideline on PFIC (Passive Fund Investment Company) applies. The guideline explains that as a US tax filer you need to disclose all your investments globally and pay taxes. These taxes also apply to unrealized gains on mutual funds, infrastructure fund and exchange-traded fund. 

One way to avoid paying taxes on unrealized gains is to invest directly. If you invest through a discretionary PMS, PFIC guideline does not apply. A financial advisor can help in facilitating PMS investment in India. There are more than 275 PMS, therefore financial advisor should be able to evaluate the top PMS and create a portfolio.

US and Canada based NRIs must deal with a qualified and SEBI registered financial advisor. This will take care of the compliance and reporting.

How much should be your emergency fund

How much should be your emergency fund?

An emergency fund is used to efficiently meet anticipated and unanticipated demands for cash distributions. Significant liquidity requirements constrain the ability to bear the risk. Liquidity requirements can arise for any number of reasons but generally fall into one of the following categories:

Ongoing Expenses

The ongoing costs of daily living create a predictable need for cash and constitute one of the investment portfolio’s highest priorities. Because of their high predictability and short time horizon, anticipated expenses must be met using a high degree of liquidity in some portion of the investment portfolio.

Emergency Reserves

As a precaution against unanticipated events such as sudden unemployment or uninsured losses, keeping an emergency reserve is highly advisable. The reserve’s size ranges from three months to more than one year of your anticipated expenses. Individuals working in a cyclical or litigious environment may require a larger reserve than those in more stable settings. Although the timing of emergencies is by definition uncertain, the need for cash when such events do occur is immediate.

Negative Liquidity Events

Liquidity events involve discrete future cash flows or major changes in ongoing expenses. Examples might include a significant charitable gift, anticipated home repairs, or a change in cash needs brought on by retirement. As the time horizon to a major liquidity event decreases, the need for portfolio liquidity rises.

The funds to meet liquidity needs may be invested in either a fixed deposit with one-year maturity or in ultra-short-term bond funds. Both these instruments are taxable, however, an ultra-short-term bond fund will usually earn 1-1.5% more than FD. Additionally, if you continue to hold the ultra-short-term bond fund for over three years, you also get indexation benefit, thereby saving taxes as well.