FundsIndia Explains: Why all mutual funds may not suit you

Some of you ask us for best mutual funds to invest in and when we ask you for details on your time frame, the purpose of your saving and so on, you just ask us to give you the best mutual funds. Unfortunately, we cannot. There are different categories of mutual funds and not all of those will fit you unless we know your requirement

Let us give you some examples of how you may end up choosing a wrong fund if you merely go by returns or ask for best funds to invest in.

Not all debt funds have low risk: Those of you who invested in dynamic bond funds in January 2017 looking at the past performance of double digit returns, may have been shocked to see their portfolio in losses by March. Dynamic bond funds, as a category react to interest rate movements or perceived rate changes and can be subject to short-term falls. In February when the RBI did not cut rates, this category saw a sharp drop in the price of bonds (as yields moved up). If you had invested in this category for the short term, you may have been hurt. The drop, though, was made good in few months. Similarly, investing in gilt funds based on their stellar returns of 16% (category average) in 2016, may have disappointed you in 2017. If you had invested in these funds believing that your capital would be intact like deposits, that was not to be. Other fund categories such as ultra short-term funds or liquid funds would have been a better choice. When equity funds don’t suit you.

Equity funds are for the long-term: If you have been a FD investor all your life and then are lured to equity and invest in an equity fund, then you should be prepared to lose money in the short term. Equity investors, with short-term need such as saving for marriage of their child in a year’s time, burnt their fingers in 2008. In a year like 2008, had you invested Rs 10,000 in equity funds then your money would have been reduced to Rs 4,851 by the end of the year. The truth was, equity fund was not right for you for such a short time frame. Equity funds require at least a 5-year time frame to avoid such steep capital losses and get inflation-beating returns. Even within the equity category, there are mid-cap funds that may be unsuitable for you if your ability to take sharp falls is low.

Looking for income with wrong funds: Investing in any equity or equity-oriented fund with an idea of generating regular income is not a good idea. These funds cannot generate steady returns. There will be years of a big bounty followed by years of dips. Take the case of falling markets such as 2008 or 2011, equity/equity-oriented funds would have struggled to generate regular dividends for you. And remember, mutual funds can declare dividends only from profits they booked. In prolonged periods of losses this becomes difficult. Such periods will not only leave you dry without income but erode the capital that you diligently kept for income generation. If you need money regularly from your investment, you should be choosing a debt fund with a systematic withdrawal option to generate such cash flows.

Investing only to avoid taxes: Arbitrage funds are low-risk equity options with tax benefits of equity category; that is, there is no capital gains after 1 year of holding and dividends are exempt from tax. But is that reason enough for you to go for this category? If you have a longer time frame, then other categories can deliver better returns. For example, chances are that a debt-oriented fund (with a small dose of equity) would have delivered better over a 2-3 year time frame. For the longer time frame, it makes more sense to go for regular equity funds for superior returns. Options such as arbitrage funds are used more by high networth individuals or institutional investors as a proxy for debt to avoid taxes. For a retail investor with a longer time frame or someone in the lower tax bracket, such complex products may not be necessary. For the shorter time frame, arbitrage funds is not entirely risk free and cannot be a substitute for liquid funds. Arbitrage funds have in fact shown a 35% chance of 1-day losses, based on their rolling returns.

The above illustrations simply highlight the point that you cannot invest in a mutual fund without knowing why/for what you wish to invest and whether the fund suits such specific requirement. This is another reason why, if you are a newbie to mutual fund investing, reading up and researching a bit or seeking the help of our advisors is a prudent thing to do.