Let's Talk Mutual Funds: A Systematic, Smart Way to Make Them Work for You

by Monika Halan

There are five things that need to be changed in the way middle-class India thinks about its money.

One, stop thinking about money as a one-time decision. It is a recurring decision throughout your life.

Two, investing long term is not your first goal at all. The goal is to have a financial plan that covers all the contours of an average money-life, such as having liquidity when you need it, having money when you want to buy a house, having buffer cash for when things go wrong.

Three, you just have to stop killing your money in toxic insurance-plus-investment plans. These plans give neither a good life cover nor good returns.

Four, rethink the idea that real estate is your best long-term investment. This is an illiquid asset—you can’t sell a loo when you need some money, you need to sell the whole three BHK.

Five, you have no option but to give your money an equity exposure, or an allocation to stocks. Equity allocation must not be misunderstood to mean only buying shares yourself or trading them through the day.

You have to stop thinking of the stock market as if it is a gambling den. It can be for people who like to punt. But it is also a place for taking structured risk with products, such as index funds (explained on page 72, Chapter 4), that help you build a corpus at a very low cost.

You are doing okay if you understand that

investing is not just about returns;

investing is also about ...

investing is about divers...

investing is abou...

investing is about ease of tran...

investing is about having the money whe...

mutual fund is just a pipe that connects your savings to various asset classes (equity, debt, gold) and their combinations. Now if this pipe is in the hands of somebody who will divert the money to himself or do something with it that you don’t want, there is a problem. It is over decades that the rules of the mutual fund market have been crafted with the aim of reducing various risks for average investors who may not be experts in finance, law and economics.

the Indian mutual fund has a three-tier structure—sponsor, trust and asset management company (AMC). India has chosen the trust structure so that neither the sponsor nor the AMC can divert the money and vanish.

The investor money is held by a trustee company or a board of trustees. This is true as of 2023, but SEBI can change these rules along the way. The trust rules in India are very strict—if found guilty of fraud or misuse of investor funds, the trustees stand to lose their personal assets and can be jailed.

Large-cap stocks are the first 100 stocks listed on the stock exchanges in India. Mid-cap stocks lie between the 101st stock and the 250th stock. Small-caps are 251st stock onwards in terms of market cap.

From these eleven categories, six are useful for you: large-cap, mid-cap, small-cap, large- and mid-cap, ELSS and multi-cap funds. Just ignore the rest.

Remember that I am including index funds on the Sensex and Nifty within the category of large-cap funds. Large-cap funds have mostly stopped generating a return that is higher than the benchmark and for most portfolios, instead of an active large-cap, a Sensex or Nifty 50 index fund is a better choice.

will repeat this again and again: a good investment is not just about the highest return, but also about low costs, liquidity and having access to the money when needed.

We do not use liquid fund to target large returns. We use liquid funds to have money available in the next three months. We need to fully discard this harvest-the-highest-return mindset and work with matching our money needs with the debt categories.

I often hear the argument that India has regulatory overreach and SEBI gets into micro-managing the industry. What you, as an investor with no lobby working for you, need to know is that the job of a good regulator is to look after your interest since market forces, especially in finance, do not. The expense ratio story is a great example of this.

you are in an active fund, ensure that the fund manager is earning the extra cost you will pay by giving you a return that is at least 4 per cent to 5 per cent higher than the benchmark return, else stay with a very cheap index fund.

We will use a combination of trailing returns, with some risk metrics and expense ratios to finally select funds in Chapter 10. An additional check can be done using a rolling return calculator (an internet search is your friend for this!) for those who want to be extra sure and want to do some more work.

Who makes the benchmarks? There are now firms such as NSE Indices (owned by the National Stock Exchange) and Asia Index Pvt. Ltd (joint venture of BSE and S&P Dow Jones index) that specialize in constructing, maintaining and selling the use of these indices. Mutual funds need to buy the license to use the index they want to use.

Remember that each extra benchmark the fund house is using, it is adding to the expense ratio in the license fee it pays to the index providers. I like to keep it simple. I look at the Sensex and Nifty 50 return, then the category benchmark return, and then the average category return to evaluate the performance of the scheme.

We need to understand two key things about risk. One, there is never going to be high return without higher risk. Those who promise risk-free high returns are lying.

Nominal return is what you get in rupees in your hand. Real return is what that money can actually buy after you take into account the price rise over the holding period. If the return is 5 per cent and inflation is at 6 per cent, you have lost around a percentage point of purchasing power. Add the tax on interest that you pay on slab level

A good investment is one that keeps the purchasing power of your money, post tax, ahead of inflation.

A change in interest rates causes a change in bond prices in the secondary market where bond trading takes place. If the central bank raises rates, then bond prices will fall as investors rush to buy the new bonds that offer a higher interest. If the central bank reduces rates, then buyers rush to buy the older bonds that have a now-higher interest than the new bonds.

This relationship between interest rates and bond prices is measured by a concept called duration. Very simply, duration measures by how much will bond prices change (rise or fall) for a 1 percentage point change (fall or rise) in interest rates. A duration of three years, for example, means that a 1 per cent fall in interest rates will cause a 3 per cent rise in bond prices.

What you need to know is that the longer the holding period of the bond or bond portfolio, the greater is the duration and hence the greater is the risk of changes in intere...

Again, SEBI has done a deep clean of the debt part of the market in the late 2010s and early 2020s, so that if you match your holding period to the correct category, your interest rate risk is well managed. Do not buy a long-term bond if you need the money short term, and the reverse is also true.

get this question all the time: should I sell my equity funds; the markets are very high? Apart from being flummoxed at the same question by the same people over the years, I don’t get why they don’t understand this counter question: what will you do with the money if you sell? Where will you reinvest?

unless there is a need of money or you need to rebalance your portfolio, there is no need to sell a winning asset class just because you have made a profit today.

We want to reduce the risk per unit of return we earn. Finance uses the concept of risk-adjusted return to measure this. If two funds give the same return, we want to see which fund took lesser risk to achieve it.

First, we need to measure risk. This is done by a metric called standard deviation.

When we measure returns, the standard deviation tells us how far away from the average return our return expectation should be. For example, if a fund’s average return is 10 per cent with a standard deviation of 2, then 68 per cent of the times (called 1 standard deviation), the fund’s returns will lie in the range of 8 per cent and 12 per cent. And 95 per cent of the times (called 2 standard deviations), the returns will lie between 6 per cent and 14 per cent.

If the standard deviation is 3, the range of returns you can expect goes up. A 1 standard deviation will point to a return range of between 7 per cent and 13 per cent. A 2 standard deviation will point to a return range of 4 per cent and 16 per cent. Do you see how the downside risk is going up as the standard deviation is rising?

We don’t mind the upside return when standard deviation is high, but we don’t...

Another way to understand this is to see that the standard deviation of a liquid fund will be much lower than a credit risk fund. And that of a large-cap fun...

just remember that a lower standard deviation is less risky than a higher standard deviation. When you compare a set of schemes, with other attributes like return, cost and consistency the same, a lower standard de...

Next, we want to see whether the scheme is giving passive fund returns or if there is outperformance. We want to invest in active funds only if they outperform the benchmark, right? If you don’t know why, go back to the costs part and understand this again.

The average return we know is measured by the relevant benchmark. Now we want to measure how far from the benchmark are the returns of the scheme. We use beta as a metric to measure this.

A beta of 1 means that the fund is giving benchmark returns. A beta less than 1 means the fund is less volatile than the benchmark and a beta greater than 1 means more volatile than the benchmark.

A beta of 0.65 means that for a 1 percentage point change in the benchmark, the fund will change by 0.65 per cent. If the benchmark moved up 1 per cent, then the fund will rise by 0.65 per cent. But if the index fell by 1 per cent, the fund will fall by only 0.65 per cent.

So, a lower beta is less risky than a higher beta. But we also don’t want a beta of 1 for our active funds—that means there is no fund manager performance, we are just getting index return—better to be in a low-cost passive fund.

Ideally, we want our scheme to outperform the index or benchmark, but we also want to measure the risk-adjusted return—or to find out if the return came at the cost of too much risk. One measure for this is Sharpe ratio.

It considers the risk-free return (for example, your bank FD rate or a government bond price) and calculates the excess return given by the scheme, and then uses standard deviation to divide this to give us a number. The Sharpe ratio tells us if returns are due to excessive risk or smart fund management.