Library / MiyeeStockBuddy: The Complete Guide to Indian Markets

Part 18. Mutual Funds and Systematic Investing

Most of the money that most people should have in equity belongs in mutual funds rather than in individual shares. This is not a consolation prize. It is the arithmetically better answer for anyone who cannot spend several hours a week reading annual reports, and it is the correct answer for the core of almost every portfolio.

18.1 What a Mutual Fund Is

A pool of money from thousands of investors, managed by a professional, invested according to a stated mandate. You own units of the pool rather than the underlying shares. The value of one unit is the Net Asset Value, or NAV, which is simply the total value of everything the fund owns divided by the number of units outstanding.

Think of it like this

A group of neighbours each puts money into a common fund to buy a building. Nobody owns a specific flat; each owns a share of the whole building in proportion to what they put in. If the building is worth six crore and there are sixty thousand shares, each share is worth a thousand rupees.

That thousand rupees is the NAV. When the building appreciates, the NAV rises. Nobody has to find a buyer for a specific flat, and nobody needs to know which flats are the good ones.

Careful here

A low NAV does not mean a fund is cheap, and a high NAV does not mean it is expensive. A fund at an NAV of 12 and one at 340 are equally likely to rise 10 percent next year. NAV reflects only how long the fund has existed and how it has done, not what it costs you.

Funds are occasionally sold on this misunderstanding, usually as a "new fund offer available at just ten rupees". A new fund is a fund with no track record. That is the only thing the ten rupees tells you.

18.2 The Kinds of Fund

Category	What it holds	Who it suits
Index fund or ETF	Whatever is in the index, in the same proportion	Almost everyone, as the core holding
Large cap fund	The largest hundred companies	A conservative equity holding
Flexi cap fund	Any size, at the manager’s discretion	A single diversified equity fund
Mid cap and small cap funds	Smaller companies	Higher growth and much larger falls
Sectoral or thematic fund	One sector, such as banking or technology	A concentrated bet, not a core holding
Debt fund	Bonds and money market instruments	Money needed in the next few years
Liquid fund	Very short term instruments	An emergency fund, or money parked briefly
Hybrid or balanced fund	A mix of equity and debt	A single fund for someone who wants one decision
ELSS	Equity, with a three year lock in	Tax saving under the older tax regime

18.3 The Two Choices That Decide Most of Your Return

Direct plan, not regular plan

Every fund is sold in two versions. The regular plan pays a commission to the distributor who sold it to you, and that commission comes out of the fund’s returns every year, forever. The direct plan does not. The portfolio is identical. The manager is identical. The only difference is the fee.

What the difference costs over twenty years

Ten thousand rupees invested every month, at 12 percent a year before costs.

Direct plan, expense ratio 0.6 percent:

Effective return 11.4 percent. Value after 20 years, roughly 91.3 lakh

Regular plan, expense ratio 1.7 percent:

Effective return 10.3 percent. Value after 20 years, roughly 79.0 lakh

Difference 12.3 lakh

For the same fund, the same manager and the same portfolio. The only difference

is who received the commission, and it was not you.

The rule to remember

Choose the direct plan every time unless an adviser is genuinely giving you advice worth 1 percent of your portfolio a year. Some are. Most distributors selling regular plans are not advising, they are selling, and the fee is charged annually on the whole amount regardless.

Index funds versus actively managed funds

An index fund simply buys everything in the index and charges very little for doing so. An active fund employs a manager to pick, and charges considerably more. The question is whether the picking is worth the extra fee.

The evidence across most markets over most long periods is that the majority of active funds fail to beat their benchmark after costs, and that the ones which succeed in one decade are not reliably the ones that succeed in the next. In Indian large caps, where the market is well researched, the majority of active funds have struggled to beat the index over long periods. In small and mid caps the case for an active manager is stronger, because the coverage is thinner and there is more genuine mispricing to find.

A structure that is hard to argue with

Core: a broad index fund. Low cost, no manager risk, no chance of picking the fund that underperforms for a decade.

Satellite: one or two active funds in mid or small caps, where a good manager has more to work with.

Not: eleven funds. Eleven equity funds own largely the same eighty companies. You have not diversified, you have paid several managers to do one job and made your own tax accounting harder.

18.4 The Expense Ratio, and Why Small Numbers Matter

The expense ratio is the annual fee, charged as a percentage of your money, deducted daily from the NAV. You never see a bill, which is exactly why it goes unnoticed.

Fund type	Typical expense ratio, direct plan	What it costs on 10 lakh a year
Index fund	0.10 to 0.30 percent	1,000 to 3,000
Large cap active fund	0.5 to 1.0 percent	5,000 to 10,000
Mid and small cap active fund	0.7 to 1.2 percent	7,000 to 12,000
Regular plan of the same fund	add roughly 0.8 to 1.2 percent	add 8,000 to 12,000

One percent a year sounds small and is not. Over thirty years it compounds into roughly a quarter of the final corpus. It is also the one variable in fund investing that is known in advance and entirely within your control, which is more than can be said for the returns.

18.5 The Systematic Investment Plan

A SIP is a standing instruction to invest a fixed amount on a fixed date every month. It is not a product and it is not a kind of fund; it is simply a way of paying into one.

What it actually does

Because the amount is fixed and the NAV varies, you automatically buy more units when prices are low and fewer when they are high. This is called rupee cost averaging, and it lowers your average purchase price compared with buying the same number of units each month.

Rupee cost averaging, over four months

10,000 invested each month, as the NAV moves around

Month 1 NAV 100 units bought 100.0

Month 2 NAV 80 units bought 125.0

Month 3 NAV 70 units bought 142.9

Month 4 NAV 90 units bought 111.1

Total invested 40,000

Total units 479.0

Average cost per unit 83.5

The simple average of the four NAVs is 85. You paid 83.5, because the months

when the price was low bought more units. The falling months helped you.

The part that is psychological rather than mathematical

The larger benefit of a SIP is not the averaging. It is that the money is invested before you have a chance to have an opinion about the market.

Almost every investor who tries to time their entry ends up buying more when they feel confident, which is after prices have risen, and stopping when they feel frightened, which is when prices are low. A standing instruction removes the decision, and removing the decision removes the mistake.

The single most valuable thing you can do with a SIP is not to stop it during a market fall. That is the period when it is doing its most useful work, and it is precisely when people cancel.

What a SIP does not do

Careful here

A SIP does not protect you from loss. If the market is lower in ten years than it is today, your SIP will have lost money. It reduces the risk of investing everything at a single bad moment; it does not remove market risk, and it is sold as though it does.

It also does not guarantee a return. Projected figures of twelve or fifteen percent a year in a sales illustration are assumptions, not promises, and the past returns shown beside them are usually chosen from a flattering period.

18.6 The SIP Arithmetic, Worked Out

The formula matters less than seeing what the numbers do, and what they do is dominated by time rather than by amount or by return.

Monthly SIP	For 10 years at 12%	For 20 years at 12%	For 30 years at 12%
5,000	11.5 lakh	49.5 lakh	1.75 crore
10,000	23.0 lakh	98.9 lakh	3.49 crore
15,000	34.5 lakh	1.48 crore	5.24 crore
25,000	57.5 lakh	2.47 crore	8.74 crore

Read the ten thousand rupee row across. Doubling the period from ten years to twenty years did not double the result, it more than quadrupled it. Adding a third decade multiplied it by three and a half again. The final decade contributes more than the first two combined, because it is the decade in which the largest amount is compounding.

The rule to remember

Starting is worth more than optimising. Someone who starts a modest SIP at twenty five and never adjusts it will almost certainly finish ahead of someone who spends three years researching the perfect fund and starts at twenty eight with a larger amount. The years are the asset, and they are the one thing you cannot buy later.

18.7 STP and SWP, Briefly

Facility	What it does	When it is useful
SIP	Invests a fixed amount monthly from your bank	Building the corpus
STP	Moves a fixed amount monthly from one fund to another	Deploying a lump sum gradually, usually from a liquid fund into equity
SWP	Withdraws a fixed amount monthly to your bank	Drawing an income in retirement, in a tax efficient way

An STP solves a real problem. If you receive a large sum, such as a bonus or the proceeds of a property sale, investing all of it on one day means the whole amount is exposed to whatever the market does that month. Parking it in a liquid fund and moving it into equity over six or twelve months spreads that risk, at the cost of leaving part of it in a lower returning asset in the meantime.

18.8 How Mutual Fund Gains Are Taxed

A summary for orientation. The rules and rates change with almost every budget, so confirm the current position before you act.

Holding	Treated as	Note
Equity fund held over a year	Long term capital gains	A concessional rate, with an annual exemption threshold
Equity fund held under a year	Short term capital gains	A higher fixed rate
Debt fund	Taxed as per current rules for debt	The treatment of debt funds has been changed more than once recently
ELSS	Equity treatment, with a three year lock in	Deduction available under the older tax regime
Dividends from any fund	Added to your income	Taxed at your slab rate
Two practical consequences Switching between funds is a sale and a fresh purchase, and it triggers tax. Frequent switching in search of last year’s best performer is expensive twice over: once in tax and once because last year’s best performer is a poor predictor of next year’s. Each SIP instalment has its own purchase date for tax purposes. When you redeem, the units are counted oldest first, so the instalments from the last twelve months are still short term even if you have been investing for a decade.

18.9 Choosing a Fund Without Being Sold One

1. Decide the category first, then the fund. The category, meaning large cap against small cap against debt, decides most of your outcome. Which fund inside the category is a much smaller decision than people treat it as.

2. Check the expense ratio and insist on the direct plan. This is known in advance and is one of the few things you control.

3. Look at ten year returns, not one year returns. One year returns tell you which style of investing happened to be in fashion, which is not a quality you can rely on repeating.

4. Check whether the manager changed. A ten year record built by someone who left three years ago is not this fund’s record.

5. Look at the worst period, not just the average. How far did it fall in the worst twelve months of its life? That is the number you will actually have to live through.

6. Check the fund size against its category. A very large small cap fund struggles, because it cannot buy meaningful positions in small companies without moving their prices.

Careful here

Ignore star ratings and "top performing fund" lists entirely. They rank on past returns, which is the least predictive information available. A fund ranked first over three years is usually a fund whose style suited the last three years, and styles rotate.