Author: sandhya dubey
HOW TO INVEST IN MUTUAL FUNDS?
Millions of investors have come to rely on mutual funds as their primary investments. The growth of funds has been explosive, with individuals, retirement plans and others putting well over $1 trillion in the funds in the 90's. If you are thinking of investing in a mutual fund, you should remember that they are only one of the many types of investments and that, as with any investment, you should know and understand the nature and risks of mutual funds and options available to you before you invest any of your money.
You can earn money out of a fund in basically three ways. First, a fund may receive income in the form of dividends and interest on the securities it owns which it pays to its shareholders in the form of dividends. Second, the price of the securities a fund owns may increase. When a fund sells a security that has increased in price, the fund has a capital gain. At the end of the year, most funds distribute these capital gains (minus any capital losses) to investors. Third, if a fund does not sell but holds on to securities that have increased in price, the value of its shares (NAV) increases.
The higher NAV reflects the higher value of your investment. If you sell your shares, you make a profit (this also is a capital gain). Today there is a bewildering array of funds on offer. So how does one choose a well performing fund. There is one golden rule of Mutual fund investing- When small stocks do better than big ones, funds will beat the market. When big ones do better, the market will outperform the funds. If you think small stocks are due for a run, then you would expect actively managed funds to beat the indexes.
But before you invest it is better to do some background work: KNOW YOURSELF. Before you invest, decide whether the goals and risks of any fund you are considering are a good fit for you. You take risks when you invest in any mutual fund. You may lose some or all of the money you invest (your principal), because the securities held by a fund go up and down in value. What you earn on your investment also may go up or down.
A portfolio's asset allocation or 'mix of funds' should represent one's tolerance for risk and time horizon. An investor should establish what percentage to invest in stocks, bonds, cash, etc. before choosing a portfolio of worthy funds. In fact, searching for funds without considering asset allocation may lead to a portfolio of funds that are all invested in the same thing. A good portfolio diversifies into different assets to hedge against unforeseen market declines. Which kind of fund is a good investment for you is trickier; the best answer is, a fund whose manager is doing something you understand and are comfortable with as a long-term investment. Read some annual reports; get a feel for the people who run the fund; see if they think the way you do. Or buy an index fund, which is run on autopilot.
ESTABLISH YOUR BENCHMARKS: Be clear in how you will measure the performance of the fund. If it is a dedicated fund like say pharmacy, FMCG etc. then its performance can be measured only against those particular indices. A small cap fund's performance cannot be measured against the BSE Sensex performance. So be clear what is the profile of the fund and what will its performance be compared to. Post that, how much you want the fund to out performs that index is dependant on your risk profile and market conditions.
DO YOUR HOME WORK: There are sources of information that you should consult before you invest in mutual funds. The most important of these is the prospectus of the fund you are considering. The prospectus is the fund's selling document and contains information about costs, risks, past performance, and the fund's investment goals. Request a prospectus from a fund, or from a financial professional if you are using one. Read the prospectus before you invest.
The Annual Report of the fund is another source of information. Look at "fee table," where the fund shows what it's charging you. Any waivers or temporary fee reductions have to be disclosed--but, of course, they're in the fine print, where you'll have to squint to read them. Read all official fund disclosure documents from back to front. All the stuff that can hurt you is buried in the back, where the people who run the fund hope you'll never see it. So read the stuff at the back first, so you get the bad news on the table at the start.
Also once you invest in a fund track it. If you have not recently examined the prospectus for a fund you own, you should monitor your investment by obtaining and reading the most recent prospectus, SAI and financial statements--these may contain important changes. Careful reading of quarterly and annual reports is also necessary to keep up with changes in your investment.
DON'T GET TAKEN IN BY PAST PERFORMANCE: A fund's past performance is not as important as you might think. Advertisements, rankings, and ratings tell you how well a fund has performed in the past. But studies show that the future is often different. This year's "number one" fund can easily become next year's below average fund. Although past performance is not a reliable indicator of future performance, volatility of past returns is a good indicator of a fund's future volatility.
COMPARE THE FUNDS ON TOTAL RETURN: Check the fund's total return. Included in the computation are distributions paid to investors, capital gains distributions and unrealized capital gains and losses. Since all fund activity which has an effect on net asset value is represented, this measure provides a picture of performance which is more complete than yield. You will find it in the Financial Highlights, near the front of the prospectus. Total return measures increases and decreases in the value of your investment over time, after subtracting costs. See how total return has varied over the years. The Financial Highlights in the prospectus show yearly total return for the most recent 10-year period. An impressive 10-year total return may be based on one spectacular year followed by many average years. Looking at year-to-year changes in total return is a good way to see how stable the fund's returns have been.
YIELD: Yield is the income generated over a specified time period divided by the fund's current price per share. This is a measure of mutual fund performance, which is figured by dividing the income generated (dividends, capital gains distribution, etc.) per share for a specific time period by the fund's current price per share. For example if, during a year, a single share of a fund had paid income totaling Re.1 and its share price was Re.10, the annual yield for that year would be figured by dividing 1 by 10, which equals one tenth, or a yield of 10%.
While yield is a measure of current performance-how much income an investment generates--total return measures per share change in total value over a specified time period. All fund activity that has an effect on net asset value (dividends, capital gains, unrealized capital gains and losses, etc.) is represented in this measure. It provides, therefore, a more complete picture of fund performance than the yield or net asset value alone. The investor may approximate total return by using data that appears in the "Per Share Changes and Capital Income" section of the prospectus. Changes in yield do not reflect a corresponding increase or decrease in the fund's net asset value. A fund may increase yield by purchasing investments that are riskier but offer higher interest payments. But, the higher yield may be offset by a deteriorating capital position or a lower total return.
COSTS: Costs are important because they lower your returns. A fund that has a sales load and high expenses will have to perform better than a low-cost fund, just to stay even with the low-cost fund. Find the fee table near the front of the fund's prospectus, where the fund's costs are laid out. You can use the fee table to compare the costs of different funds. The fee table breaks costs into two main categories: 1. Sales loads and transaction fees (paid when you buy, sell, or exchange your shares), and 2.Ongoing expenses (paid while you remain invested in the fund).
ONGOING EXPENSES: These are expenses as a percentage of the fund's assets, generally for the most recent fiscal year and basically include the management fee (which pays for managing the fund's portfolio), along with any other fees and expenses. High expenses do not assure superior performance. Higher expense funds do not, on average, perform better than lower expense funds. However in case the fund provides special services, like toll-free telephone numbers, check-writing and automatic investment programs, then the higher expenses are justified. Note carefully any difference in expenses as even a small variation can make a big difference in the value of your investment over time. Check the fee table to see if any part of a fund's fees or expenses has been waived. If so, the fees and expenses may increase suddenly when the waiver ends (the part of the prospectus after the fee table will tell you by how much). Many funds allow you to exchange your shares for shares of another fund managed by the same adviser. The first part of the fee table will tell you if there is any exchange fee.
RISK: It is quite difficult to compare a fund's risk adjusted return. But there are a couple of ways to do so. A fund's Sharpe ratio, named after its inventor, Nobel Prize winner William F. Sharpe, essentially shows you how much return the fund earned for each unit of risk that it took, and it's easy to compare different funds against each other this way.
Lots of websites will display a fund's Sharpe ratio, usually under a category called "Modern Portfolio Statistics." There's also Morningstar risk, which is a variation of the Sharpe measure based on how often a fund underperformed Treasury bills. And there's beta, which shows how much the fund moves relative to the volatility of the market. But ultimately the real risk is you: If your fund goes down a lot, will you sell? If it goes up, will you buy more then? Most of the risk of investing isn't in your investments, it's in you.
INVESTMENT PHILOSOPHY: You can get a clearer picture of a fund's investment goals and policies by reading its annual and semi-annual reports to shareholders. Whether a fund believes in value investing, or is aggressive in its style of investing etc. all these have a bearing on the performance of the fund.
SIZE OF THE FUND FAMILY: The size of a fund's family does matter. In large fund families moving from one type of fund to another is easier. For example, the market is showing bearish signs and you want to get out of your stock fund and into a money market fund. This transaction would most likely be cheaper and easier within the same fund family. Also fund families generally waive load fees when switching funds if you originally paid a comparable load. This policy of switching from one load fund to another has also been used to reduce tax obligations. Large fund families can spread out their normal operating costs. For example, a large fund family can have a bigger research department than smaller ones at a lower cost. Economies of scale usually favor the 'big guys'.
SIZE OF THE FUND: Bigger is usually better. The bigger funds can diversify better, attract better talent and have access to more information. However, if the fund's investment style focuses on small-capitalization stocks, bigger isn't always better. The success of many small-cap stock funds often depends on their ability to move in and out of holdings quickly. Larger small-cap funds, especially those that have ballooned recently, can't always achieve the same gains. In fact, some small-cap funds are so large they drastically affect the stock prices of companies they buy and sell.
SOME POINTS TO CONSIDER: Mutual funds are not guaranteed or insured by any bank or government agency. Even if you buy through a bank and the fund carries the bank's name, there is no guarantee. Mutual funds always carry investment risks. Some types carry more risk than others. The fund's portfolio has investment risk directly related to the securities it contains as well as to general market and business conditions. For example, an aggressive growth fund, because the prices of securities in its portfolio are more volatile, is generally riskier than an income fund, which may invest in conservative stocks and bonds whose prices do not fluctuate greatly but that pay high dividends or interest. Regardless of the investment strategy or portfolio no fund can escape market risk. Understand that a higher rate of return typically involves a higher risk of loss. Past performance is not a reliable indicator of future performance. Beware of dazzling performance claims. Shop around. Compare a mutual fund with others of the same type before you buy.
Golden rule of Mutual fund investing- When small stocks do better than big ones, funds will beat the market. When big ones do better, the market will outperform the funds. If you think small stocks are due for a run, then you would expect actively managed funds to beat the indexes. Determine your financial objectives and how much money you have to invest. Make sure the fund's objectives coincide with your own. Don't change your objectives or exceed the amount set aside for investment unless you have good reason. Always obtain all available information before you invest. Request the prospectus, and the latest shareholder report from each fund you are considering. Be on the alert for incorporation by reference. You will have "no excuse" for not knowing this information, if a problem arises. You may be legally presumed to know materials incorporated by reference in a prospectus or other documents. Always determine all sales charges, fees and expenses before you invest. Shop around among the many funds offered and compare the various fees and costs connected with funds that appeal to you. Learn the costs of redemption.
Sometimes investors are surprised to learn that they have to pay to get out of funds through back-end loads or redemption fees. Find out the redemption costs before you invest so you won't be unpleasantly surprised when you redeem your shares. Never treat the risks of investment in a fund lightly. Weigh the risks of the funds you want to buy against your ability to tolerate the ups and downs of the market and your investment goals. Be extra cautious when considering investing in funds with high yield/high risk portfolios. Don't be misled by the name of a fund. Some funds have been given names denoting safety, stability and low risk, despite the fact that the underlying investments in the portfolio are volatile and highly risky.
Points to Remember
- People invest in mutual funds in order to achieve diversification without the time and cost of tracking hundreds of individual securities.
- There is no ideal number of mutual funds to own.
- Diversify among different asset classes to help reduce risk and potentially increase the rate of return of your portfolio.
- Diversify among different investment styles to potentially reduce risk and increase returns.
- Owning too many funds means you may be paying for active management when you really hold the market.
- Your investment adviser can help you evaluate each fund to determine its role in your portfolio.
- In choosing mutual funds, your first task is to formulate your investment objectives and identify your time frame.
- The next step is to identify which types of mutual funds match your investment goals and risk tolerance.
- Companies such as Crisil and dedicated websites provide statistical information on mutual funds.
Once you have identified the fund categories that seem appropriate to your investment objectives, you will want to take a close look at individual funds in each of the categories.
Article Source: http://www.articlesbase.com/investing-articles/how-to-invest-in-mutual-funds-454199.html
About the Author sandhya dubey(Lecturer)
M.COM., MBA(FINANCE)
NSE CERTIFIED
Kanpur
INDIA
