Mutual Funds: Risks versus Rewards

Mutual funds are subject to the following risks:

• Market risk: The first and foremost risk that is inherent in any mutual fund is the market risk. Your returns are completely dependent on the market and you cannot get regular or fixed returns on your investment. If the market is bearish, you could make negligible profits or even losses, but at the same time, a bullish market will give you great returns. Even with debt funds, the interest rate changes could affect your dividends.
• High costs: One thing that most people overlook while investing in mutual funds is the cost involved. Apart from the cost of opening a new mutual fund, you will be required to pay a variety of fees such as fund management charges, entry and exit loads, redemption fees, and commission charges. The amount of fees will depend on the kind of fund you have chosen. The more aggressive and risky a fund, the greater the fees is likely to be. These fees are applicable irrespective of whether the fund is doing well or not.
• Taxation: Taxes are applicable on both capital gains and dividend payouts received from mutual funds. On equity-oriented funds, the tax is 15% for short-term capital gains and no tax on long-term gains, but on debt funds, short-term gains are added to your income and taxed as per your tax slab rate, while on long-term gains you have to pay 20% tax with indexation and 10% without indexation. Dividend distribution tax is applicable in 2 circumstances: Asset Management Companies (AMCs) have to pay 15% of the dividends declared as tax, and investors who earn more than Rs. 10 lakh as dividends have to pay 10% of it as tax.
• Lock-in period: Many funds such as an MIP or SIP have a lock-in period that prevents you from liquidating the fund whenever you want it. You may have to wait for 3-5 years to be able to withdraw your fund even if you cannot afford to keep it active any more.
• Need for cash availability in funds: A mutual fund is not held by a single investor but by multiple people. This means that a lot of investors will be pooling in money and wanting to withdraw money at any time of a given day. For this, funds need to have liquid cash available in surplus. But having a lot of liquid cash lying around is a wastage of investment for the fund overall.
• Over-diversification: This is not always a problem, but some funds tend to over-diversify and get all over the market. It's better to have a fund that is moderately diversified - enough to protect your investment and give you good returns - than have one that puts itself in many boats. Owning several mutual funds investing in similar companies or sectors also does not help diversify your investment.
• Lack of control: Mutual funds are managed by an AMC and the manager assigned to the fund. These funds are also owned by multiple persons and not just you. All trading decisions are taken by the fund manager and you have little or no involvement in the decision-making process. Investors who are active and knowledgeable in market trends and who like to be in control of their portfolios will find this very limiting and frustrating.

It is important for an investor to know what they are putting their money into, and this is where understanding both the sides of mutual funds helps. No investment is ever the safest - except maybe a term deposit in a nationalised bank - and carries risks with it. The market functions on the principle of risk-taking, and the prudent ones with the right choices and decisions can grow their capital faster. Choose a mutual fund based on your personal risk tolerance level and you will be able to meet the goals you set for your investment. 

GST rate of 18% applicable for all financial services effective July 1, 2017.