A Guide to Mutual Fund Investment

By August 30, 2016Literature


Some of the investment options that we recommend in mutual funds are briefly described below. Depending upon your risk appetite, you can choose the option/s you are comfortable with.  We are unapologetically conservative in our investment advice. Our focus is on safety, diversification, asset allocation and optimum returns.  In the long term (10 years and above), we seek to achieve results well described by an old investment saying: “The ultimate objective of good investment is to obtain above average returns at below average risk.”

Option 1:  Debt Mutual Funds:

For investments of uncertain duration and investments of up to 3 months’ duration, money market accounts and liquid plans of mutual funds are excellent investments. In our opinion, they would be attractive alternatives to savings accounts of banks, without compromising on either liquidity or safety. For investment horizons of more than 3 months and less than a year, ‘liquid plus’ plans and short-term floating rate mutual funds (also called ‘floaters’) offer liquid investment avenues with a high degree of safety.

If the period of investment exceeds a year, the best options would be short-term funds.  For time horizons of more than 3 years, Fixed Maturity Plans (FMPs) would be ideal. FMPs of over 3 years are more tax-efficient than comparable cumulative bank fixed deposits, especially for investors in the higher tax brackets. Let us explain.

If any of the categories of debt funds mentioned above is liquidated after three years, the resulting appreciation will be taxed at the long-term capital gains tax rate of (presently) 20.6% with cost inflation indexation. To that extent, these funds are tax-efficient, especially for investors in the higher income-tax brackets of 20.6% and 30.9%.

An important feature of floating rate funds is that in the event of a rise in the general interest rates, the returns on these funds will also rise automatically, because they basically invest in floating rate securities. A fall in general interest rates will result in lower yields from floaters.  Short-term floaters are very liquid.

On the other hand, short-term funds will do better when interest rates fall and worse when interest rates rise.  A mix of liquid funds and floaters on the one hand, and short-term funds on the other, could be a good way of parking funds or investing for short and intermediate time horizons.

Dividends on all mutual funds are tax-free. However, for investments of more than three years, the growth option is better, because non-equity mutual fund plans, including debt fund plans have to deduct a dividend distribution tax in case of dividends paid out or reinvested, which is presently higher than the long-term capital gains tax payable on growth options.

NRIs can invest in debt funds both on a repatriable and non-repatriable basis.  Investment in these funds carries low risk, provided an investor exercises some caution and diversification in the choice of funds.

Option 2: Debt Mutual Fund to Diversified Equity Mutual Fund Systematic Transfer Plan:

This strategy requires a minimum investment of Rs 50,000/-, even though starting with Rs 1,00,000/- is better. The strategy can best be understood by the example of how a basic investment of Rs 1,00,000/- would be made. This initial corpus is placed in a liquid or short-term or short-term floating rate fund. From here, 2% of the principal (Rs 2,000/- for a Rs 1,00,000/- lump sum) is systematically transferred to a diversified equity fund.

Our experience with this type of investment for investors in India shows that attractive and tax-efficient returns can be earned in a period of five years or more, with relatively low risk to principal. Invest in this strategy only if you are reasonably confident that you do not need to withdraw funds for at least five years.

Option 3: Highly Conservative Systematic Transfer Plans:

Here the objective is to preserve the principal invested even in a bad stock market.  The simplest way to do this is to invest the lump sum in a liquid or liquid plus or short-term floating rate or short-term fund and then register a monthly or quarterly transfer of only the capital appreciation to an index fund or diversified equity fund. This is the closest you can come to fashioning a zero-risk mutual fund strategy on your own, allocating assets between debt and equity.

You could also try a variation of Option 2. Instead of two percent, only one percent of the principal is transferred every month from the debt fund to the equity fund in this strategy.  The minimum investment advised here is Rs 1,00,000/-.  We have not seen a risk to capital in this strategy even during the global financial crisis that started in the latter half of 2007.  That does not mean risk cannot occur. There is no such thing as a risk-free strategy.  But the probability of a risk to principal here is remote.

There can be value additions to the above strategies. After you have begun any of the two investment strategies mentioned in the two paragraphs appearing immediately above this one, if the stock market index falls by at least 25% from its last peak and remains at this lower level for at least a month, you would do well to double the monthly systematic transfer of Rs 1,000/- to Rs 2,000/-.  Similarly, in case the index falls by 50% from its last peak, we would recommend transferring the entire balance in the debt fund to the equity fund/s.

These strategies are recommended for investors who wouldn’t mind an exposure to the stock market, but want to be shielded from the risks associated with equity investment. These strategies are also ideal for investors with no previous experience in stock market investment.

Investors who opt for this would be following Warren Buffett’s famous dictum: “The first rule of investing is, do not lose. And the second rule is, do not forget the first rule.  And that’s all the rules there are.”

Option 4:  For regular fund flows – Systematic Investment Plans (SIPs):

SIPs into a mix of debt, balanced, asset allocation, diversified equity, equity index and (when they are available) real estate mutual funds are probably the best way of building wealth in the long term.  SIPs into any mutual funds that have an element of equity must be continued without interruption for a period of at least five years, and preferably for much longer.

Wealth can also be built by direct investment in a diversified portfolio of blue chip stocks.  Our advice on direct equity investment is contained in a separate paper entitled ‘A GUIDE TO EQUITY INVESTMENT.’


Mr. Gerard Colaco
Partner, Colaco & Aranha, Mangalore.

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