UAE: How do you select low-cost mutual funds? How do you decide which fund best suits your needs?

Mutual Funds are what most industry experts identify as the simplest way of investing. This guide takes you through in detail of what the buzz is all about and whether it would be a right fit for you.

If you are somebody who does not know how to make your hard earned money work out good returns for you – with the added benefit of not making much of an effort – this may be it!

Mutual funds in a nutshell

Mutual funds are essentially baskets filled with different types of investments like stocks (company stakes) and bonds (loan agreements), among others.

Mutual funds are extremely popular because they allow you to pick one fund, which contains different stocks, and not worry about (as one may say) ‘putting too many eggs in one basket’ – as you likely would if you bought individual stocks – monitoring company’s annual reports, or keeping up with industry news.

How mutual funds work is it collects money from investors and invests the money on their behalf, and in doing so it charges a small fee for managing the money.

This means you’ll be able to invest in portfolios that you wouldn’t be able to afford alone because you’re investing alongside other investors. For example, there are large-cap, mid-cap, and small-cap mutual funds, but also mutual funds that focus on biotechnology, communication, and even Europe or Asia.

Directly or through an advisor?

If you are investing directly, you will invest in what is called a ‘direct plan’ of any mutual fund scheme. If you are investing through an advisor or intermediary, you will invest in the ‘regular plan’ of the scheme.

These options can be availed with every mutual fund since the start of 2013. The two options apply to the same mutual funds that you have chosen to invest, managed by the same fund manager who invest in the same bonds and stocks.

If you are investing directly, you will invest in what is called a ‘direct plan’ of any mutual fund scheme. If you are investing through an advisor or intermediary, you will invest in the ‘regular plan’ of the scheme.

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The only difference between these two is, in case of a ‘regular plan’ your mutual fund house or manager pays a commission to a broker or an agent to essentially do the work of choosing and monitoring the investments for you. And in case of a direct plan, no such fees or commission is paid.

If you see yourself as a diligent investor with deep knowledge, meaning that you can pick and track your own mutual funds, then the direct plan is better.

The advisor then provides no extra value and does not deserve their fee. For most people, however, relying on someone's recommendation is the only option. We will go through in detail how these options work next.

How do ‘regular’ plans work?

As discussed earlier, ‘regular’ mutual fund plans are those mutual funds that are bought through a mutual fund broker, distributor, or advisor.

However, for every regular fund, the fund house pays a commission to the middleman for introducing a new investor to their plan(s), which gets added to your expenses or as charges on the fund (expense ratio), and hence, regular funds are slightly more expensive than direct funds.

Although this is more popular than ‘direct’ plans, as most of the websites and applications offer only ‘regular’ plans. The only action required from your side is to come up with the documents and your fund manager (bank or brokerage) handles the rest.

Invest directly?

If you want to invest directly, you will have to visit the website of the mutual fund or its authorized branches with relevant documents. (As an NRI, you will need to furnish documents like your latest photograph, attested copies of PAN card, passport, residence proof (outside India), and bank statement.)

While filling up a mutual fund application form – whether online via the website of a mutual fund or by being physically present, to invest directly without the help of an advisor, you need to ensure that you tick or select the ‘Direct Plan’ option.

FAQ Time (Possible questions that you may come across at this stage)

• How would I know what is risky or what is not?

To answer that, let us consider a few examples to further illustrate the difference between high-risk and low-risk investments.

Biotechnology stocks are notoriously risky. Between 85 per cent and 90 per cent of all new experimental drugs will fail, and, not surprisingly, most biotech stocks will also eventually fail. Thus, there is both a high percentage chance of underperformance (most will fail). In comparison, a country’s ‘Treasury bond’ (a government-issued loan contract that earns interest until maturity) offers a very different risk profile. There is almost no chance that an investor holding a Treasury bond will fail to receive the stated interest payments.

• How do I decide how much risk can I take on?

The ability to take risks is evaluated through a review of an individual's assets and liabilities. An individual with many assets (bank balance, property, no loans, etc.) and few liabilities (loans) has a high ability to take on risk. Conversely, an individual with few assets and high liabilities has a low ability to take on risk.

Every individual is different, and it's hard to create a steadfast model applicable to everyone, but here are two important things you should consider when deciding how much risk to take.

• One is ‘time horizon’, which is before you make any investment, you should always determine the amount of time you have to keep your money invested.

• Determining the amount of money you can stand to lose is another important factor.

• By investing only money that you can afford to lose or afford to have tied up for some period of time, you won't be pressured to sell off any investments because of panic or cash-shortage.

Every individual is different, and it's hard to create a steadfast model applicable to everyone, but there are important things you should consider when deciding how much risk to take.

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To keep in mind

An important fact to keep in mind is that there are only a few online portals which offer a facility to invest in ‘direct’ plans and a lot of these portals are run by private firms that offer advisory financial planning services, usually for a fee.

Even though one may invest in mutual fund schemes on such portals, many banks offer an option to invest in mutual fund schemes on their internet banking portal.

Also note that, buying from a Bank, such as HDFC Bank, means you are using a distributor. Even if you buy an HDFC Mutual Fund, HDFC Bank acts as a distributor. The only way to buy “Direct” is to have “Direct” in the fund scheme name. If the scheme doesn’t say “Direct” in your statement report, you are paying commissions.

Which is better – ‘Direct’ or ‘Regular’?

The direct plan of mutual funds gives higher returns than the regular funds as they do not include broker fees. (These commissions generally range between 0.8 to 1.5 per cent annually.)

While direct plans are cheaper, low cost should not be the only criterion for selecting a fund. An advisor can help you analyse the track record, matches your risk profile and invests your money in a fund which is suitable for the goal you are investing for. Corporate houses have dedicated finance teams, so it is easy for them to select the right fund.

The advantage of investing in a ‘direct plan’ is that you save on the commission and the money invested would add sizeable returns over a long period. The biggest drawback of this method is that you will have to complete the formalities, do the research, and monitor your investment... all by yourself.

The direct plan of mutual funds gives higher returns than the regular funds as they do not include broker fees. (These commissions generally range between 0.8 to 1.5 per cent annually.)

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Investing directly is like buying a product from the manufacturer directly, whereby the cost to customer would be lower.

But investing in a mutual fund scheme directly is not as simple as buying a shirt or a pair of trousers or a TV from a factory outlet, because choosing a mutual fund scheme requires adequate knowledge and awareness of the mutual fund product, especially the market risks that are associated with the potential rewards.

Types of Mutual Funds in India

The mutual funds in India under four broad categories: ‘Equity Mutual Funds’, ‘Debt Mutual Funds’, ‘Hybrid Mutual Funds’ and ‘Solution-oriented Mutual Funds’

• Equity mutual fund scheme: These schemes invest directly in stocks. These schemes can give superior returns but can be risky in the short-term as their fortunes depend on how the stock market performs. Investors should look for a longer investment horizon of at least five to 10 years to invest in these schemes. There are 10 different types of equity schemes.

• Debt mutual fund schemes: These schemes invest in debt securities. Investors should opt for debt schemes to achieve their short-term goals that are below five years. These schemes are safer than equity schemes and provide modest returns. There are 16 sub-categories under the debt mutual fund category.

• Hybrid mutual fund schemes: These schemes invest in a mix of equity and debt, and an investor must pick a scheme based on his risk appetite. Based on their allocation and investing style, hybrid schemes are categorised differently.

• Solution-oriented schemes: These schemes are devised for particular solutions or goals like retirement and child’s education. These schemes have a mandatory lock-in period of five years.

Indian mutual funds give you access to international stocks and any other country-linked assets such as US Treasury Bonds.

Charges, fees and frauds

The total expenses (what they charge you) incurred by your mutual fund scheme are collectively called expense ratio. The expense ratio is generally in between 1.5-2.5 per cent of the average weekly net asset value of the mutual fund schemes.

As with any business, running a mutual fund involves costs. Funds pass along these costs to investors by charging fees and expenses. Fees and expenses vary from fund to fund. A fund with high costs must perform better than a low-cost fund to generate the same returns for you.

Even small differences in fees can mean large differences in returns over time.

For example, if you invested $10,000 in a fund with a 10 per cent annual return, and annual operating expenses of 1.5 per cent, after 20 years you would have roughly $49,725. If you invested in a fund with the same performance and expenses of 0.5 per cent, after 20 years you would end up with $60,858.

It takes only minutes to use a mutual fund cost calculator to compute how the costs of different mutual funds add up over time and eat into your returns.

When it comes to avoiding fraudsters, by law, each mutual fund is required to file a prospectus and regular shareholder reports with the regulator.

Before you invest, be sure to read the prospectus and the required shareholder reports.

Additionally, the investment portfolios of mutual funds are managed by separate entities known as “investment advisers” that are registered with the regulator (Securities and Exchange Board of India). Always check that the investment adviser is registered before investing. Link for checking: https://brokercheck.finra.org/

What are the benefits and risks of investing in mutual funds?

Easy to Understand – Anything can be made into something more complex than it needs to be and mutual funds are no exception to this truth. However, mutual funds require no experience or knowledge of economics, financial statements, or financial markets to be a successful investor.

Easy to Buy – Mutual funds are offered at brokerage firms, discount brokers online, mutual fund companies, banks, and insurance companies. Even beginning investors can easily open an account at a no-load mutual fund company, such as Vanguard Investments, and open an account within minutes.

Broad Market Exposure – One mutual fund can invest in dozens, hundreds, or even thousands of different investment securities, making it possible to achieve diversification by investing in just one fund. However, it is smart to diversify into several different mutual funds.

Low Minimums – Most mutual funds have minimum initial investment requirements of $3,000 or less. In many cases, if the investor initiates a systematic investment program (SIP) with the company, where they have a fixed dollar amount or fixed number of shares purchased once per month, the initial investment can be as low as $1,000.

Most mutual funds have minimum initial investment requirements of $3,000 (Dh11,019) or less.

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FAQ Time (Possible question that you might come across at this stage)

Risks – All funds carry some level of risk. With mutual funds, you may lose some or all of the money you invest because the securities held by a fund can go down in value. Dividends or interest payments may also change as market conditions change.

A fund’s past performance is not as important as you might think because past performance does not predict future returns. But past performance can tell you how volatile or stable a fund has been over a period of time. The more volatile the fund, the higher the investment risk.

Note: Net asset value (NAV) is a key indicator for any mutual fund investor. The NAV represents nothing but the value or worth of the entity (in this case the mutual fund) in the market.

For example, if you want to buy $10,000 (Dh36,729.50) worth of mutual fund ABCDX, and the NAV as of yesterday's close was $100 (Dh367.30), that would mean you purchase 100 shares.

However, if the NAV increases drastically on the day you made your purchase, you would actually be purchasing more than the 100 shares you originally planned.