Planning to invest in mutual funds? Here is how people having different risk appetites can take exposure to this asset class.
A mutual fund is a professionally-managed investment vehicle that pools money to purchase various securities such as equities, corporate bonds, G-Sec, CP, and CD, among others. Mutual funds can be open or closed ended; indexed or thematic; pure equity or debt instrument. A key advantage to a mutual fund is that the investment is in a basket and hence it avoids specific risk. Let’s look at 4 ways in which an individual can take exposure to this particular asset class, beginning from a risk-averse strategy to the riskiest one.
Systematic Investment Plan (SIP)
The Association of Mutual Funds in India (AMFI), which is a self-regulatory organisation (SRO), advertises an SIP as good EMI. Just like any EMI, individuals can make contributions every month to achieve a planned goal. An SIP has the advantage of market participation by muting market timing, which can result in low volatility of returns.
Many individuals either invest directly or through an intermediary. They invest periodically in lump sum amounts from the savings accumulated. This results in market timing since the periodicity is at discretion. Subject to market timing and investment weighing, the individual can have above average or below average returns. This should only be practiced by individuals who have skill and expertise or depend upon advisors who have the same for participation in the financial markets.
Purchase and sale in bands
Some individuals like to ride bubbles and bursts in indices. They enter at predetermined levels of a benchmark. An entry may be defined as a correction from the peak, which may be quantified by an individual at 20-30%. They also exit at predetermined levels such as 30-40% above the trough. This is a risky strategy and is predominantly relying on timing and irrationality in the market which inflates or deflates the valuations. This strategy shall not work well when the markets are unidirectional for large periods of time. Any structural changes can lead to an extremely poor performance of this strategy. Such a strategy is advised to individuals for just a portion of the investable surplus.
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Mutual funds as an investment do not provide leverage. Leverage can only be induced from a portfolio perspective and apportion the leverage to mutual funds given that money is fungible. Let’s look at the process here. An individual will try and figure out which is the cheapest way of fund raising for that individual. For most, it will be a home loan. For some if that option is not viable, then LAP could be a mechanism. The funding cost typically could be sub 10%. Further, any long-term investment in equity mutual funds does yield 12-14% return. Hence the individual is earning a spread of 2-4% by the financial jugglery.
Though this might seem simple, this requires discipline, long-term commitment and being richly cashflow positive. This strategy works well only from a long-term perspective and hence these funds should be such that the individual may not require for a long time. Another caveat here is that the fund-raising leads to debt and interest repayment obligation. Hence, such a strategy can only be exercised by individuals who are having sizeable surplus cashflows.
(By Shreekant Daga, Associate Director, CAIA Foundation)