Mutual Funds: Risks versus Rewards

Mutual Fund advertisements on television and print come with a fair warning: “Mutual Funds are subject to market risks. Please read the offer document carefully before investing.” Like any investment product, mutual funds have both risks and rewards associated with it. Where you have a chance to gain money, you could also lose money.

Rewards of Mutual Funds

Let us first look at the benefits of starting a mutual fund:

  1. Investment growth: The key reason why people invest in mutual funds is the growth it allows to their investment. This growth is tied to the market performance and economic development. Depending on the fund you’ve chosen, your returns could be as high as 40%. This means that if you invested Rs. 1,000, you would get Rs. Rs. 1,400 at the end of 1 year.
  2. Professional management: For a novice investor, the fund management afforded by mutual funds is a boon. Having the fund managed by a professional means that your money is in safe hands and you do not need to worry about day-today investing decisions. If you were to trade in individual shares, then you would have to be buying and selling stocks and paying attention to a lot of indices and market trends, but with mutual funds, you can leave it to the professionals.
  3. Choices: Once you decide to invest in a mutual fund, you have several options to choose from. Whatever your style of investment – low-risk, moderate-risk, high-risk, active, passive – there will always be a mutual fund that suits you. You can choose from a range of mutual funds such as equity funds, debt funds, index funds, Monthly Income Plans (MIP) and Systematic Investment Plans (SIP), diversified funds, growth funds or value funds.
  4. Liquidity: It is easier to convert mutual funds to cash than with any other mode of investment. Because of the high demand for mutual funds, you can easily sell off and encash your units. All you need to do is let your fund manager know that you want to get out of the scheme. It’ll take just a day or two to finish the process, and get the cash back in your linked bank account.
  5. Risk reduction through diversification: Mutual funds are ideal for diversification of your investment. Diversity ensures that you are not putting all your eggs in the same basket and cushions you from market upheavals. Instead of choosing which stocks are best to add diversity to your portfolio, you could leave it to the fund manager, or choose a blended fund, hybrid fund or diversified fund – all of which have built-in variety and safety. Most mutual funds invest in different sectors and market, thereby ensuring a degree of protection to the returns.
  6. Ease of operation: Mutual funds can be compared, bought, sold and managed online as well as offline. Most of the information about mutual funds is available online, which helps you research adequately before investing in them. They are also hassle-free once you leave things to the discretion of the fund manager.

Risks of Mutual Funds

Mutual funds are subject to the following risks:

  1. 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.
  2. 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.
  3. 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.
  4. 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.
  5. 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.
  6. 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.
  7. 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.

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