Did you know the total number of mutual fund folios as of April 30th 2024 stood at approximately 18.15 crores? With the increase in the number of retail participants in the Indian stock markets, this number is set to increase further. While investment in mutual funds is often considered to be one of the most popular investment options, it is important to know all about this investment option before taking the plunge. This primarily includes the advantages and the disadvantages of investing in mutual funds. Check out this blog to know more about the pros and cons of investing in mutual funds and start investing today.
Some of the key factors that should be considered while investing in mutual funds include,
One of the primary factors to be considered is the alignment of the mutual fund’s investment objective and time horizon with that of the investor’s own financial goals and risk tolerance.
Another factor to consider is the historical performance of the fund across different market cycles and the reputation of the fund house including their track record, investment philosophy, and regulatory compliance.
The expense ratio is another major factor that can affect the mutual fund investment decision.
The fund manager of any fund is more or less directly responsible for its performance, therefore, it is advisable to also review the qualifications as well as the expertise and experience of the fund manager before taking the investment decision.
One of the primary benefits of investing in mutual funds is its liquidity feature and the ease of buying and selling mutual fund units along with understanding the costs involved for the same. This makes it a crucial factor to consider while investing in mutual funds.
Risk is an inherent part of mutual funds and therefore effective risk management practices followed by the fund to mitigate risks like credit risk, market risk, and liquidity risks should also be evaluated.
Tax implications are an integral part of investment in mutual funds as they impact the overall returns for investors. This makes it an important decision to consider while investing in mutual funds.
Investors should verify that the mutual fund adheres to all regulatory standards established by the Securities and Exchange Board of India (SEBI) and other pertinent authorities. This ensures the protection of investor interests.
Mutual fund investments have been attracting investors for decades due to the multiple benefits or advantages that they offer. Some of the advantages of mutual funds investing are discussed hereunder.
Mutual funds are an appealing option for investors due to their ease of investment and cost-effectiveness. Many mutual fund schemes have a low minimum investment requirement which makes them accessible to individuals with varying financial capacities. This accessibility is crucial in a country like India with a diverse economic landscape and investors with different levels of disposable income. Furthermore, mutual funds pool money from multiple investors which enables investors to benefit from economies of scale. The transaction costs and management fees per investor are effectively much lower compared to direct investment in stocks or other securities. This makes mutual funds a convenient and affordable way for retail investors, who may not have the expertise or resources to manage their investments actively, to participate in the financial markets.
Investors often have specific financial goals, such as buying a house, funding their children's education, or planning for retirement. Mutual funds facilitate goal-based investing by offering a variety of schemes tailored to different objectives and risk profiles. For instance, investors with a long-term horizon and a higher risk tolerance may opt for equity mutual funds to achieve capital appreciation, while those with a more conservative approach may choose debt funds for stability and income generation. This customisation allows investors to align their investments with their financial aspirations, thereby creating a roadmap towards systematically achieving their goals.
The mutual fund landscape in India is diverse, offering a wide array of investment options to cater to various investor preferences. Equity Funds, Debt Funds, balanced funds, sector-specific funds, and thematic funds are among the many choices available. This variety enables investors to construct a well-diversified portfolio that suits their risk appetite, investment horizon, and return expectations. For example, a young investor with a long-term outlook may opt for a combination of equity and hybrid funds for growth potential, while an investor nearing retirement may prefer a mix of debt and conservative equity funds for stability and income.
The regulatory framework governing mutual funds in India is overseen by the Securities and Exchange Board of India (SEBI) which plays a crucial role in instilling trust and confidence among investors. SEBI regulations ensure transparency, fair practices, and investor protection within the mutual fund industry. Investors can rely on a regulatory framework to safeguard their interests, monitor fund performance, and access accurate and timely information about their investments. This regulatory environment contributes to a well-functioning mutual fund ecosystem that promotes market integrity and investor confidence.
Mutual funds are managed by experienced fund managers who conduct rigorous research and analysis to make informed investment decisions. These professionals monitor market trends, economic indicators, company performances, and sectoral developments to identify opportunities and manage risks effectively. Professional fund management offers a valuable advantage, especially for investors who may not have the time or expertise to analyse individual stocks or sectors. It allows investors to benefit from the expertise and insights of seasoned professionals, enhancing the potential for optimal investment outcomes.
Diversification is a fundamental principle of investing, and mutual funds excel in this aspect. By investing in a diversified portfolio of securities across asset classes, sectors, and geographies, mutual funds reduce concentration risk and mitigate the impact of adverse market movements on investors' portfolios. The ability of mutual funds to spread risk effectively helps investors achieve a more balanced and resilient investment portfolio, aligning with their risk tolerance and financial goals.
Mutual funds harness the power of compounding, which is the process of generating earnings on both the initial investment and the accumulated returns over time. Investment in mutual funds through SIPs (Systematic Investment Plan) or reinvestment of dividends and capital gains can benefit investors by using the power of compounding and thereby growing their wealth steadily. This long-term wealth creation potential is especially valuable for investors with a disciplined approach and a patient investment horizon. The power of compounding amplifies returns over time and allows investors to achieve their financial objectives, such as wealth accumulation, retirement planning, or legacy building.
The Income Tax Act 1961, provides tax benefits on certain categories of mutual fund investments for investors in India. For example, Equity Linked Savings Schemes (ELSS) qualify for tax deductions under Section 80C of the Income Tax Act up to Rs. 1,50,000 in a financial year thereby reducing their taxable income and saving on taxes. Furthermore, investors can also claim the benefit of indexation on long-term investment in debt mutual funds and tax exemption from capital gains of up to Rs. 1,00,000 in case of long-term investment in equity mutual funds. This tax efficiency makes mutual funds, particularly tax-saving funds like ELSS, attractive for investors in India seeking to optimise their tax liabilities while building wealth over the long term.
We have discussed many advantages of mutual fund investments above. However, mutual fund investments are not free from any limitations. Let us now understand a few of these disadvantages of mutual funds investing.
Investing in mutual funds involves relying on the expertise and decision-making of fund managers. While professional management can be an advantage, it also introduces a risk factor related to the competency and performance of the fund manager. If the fund manager underperforms or makes suboptimal investment decisions, it can negatively impact the returns of the mutual fund. Investors should assess the track record and experience of fund managers before investing to minimise this risk.
While diversification is the key and inherent benefit of mutual funds, investors should also be aware of the risk of over-diversification. Investing in too many funds across different sectors or asset classes can dilute potential returns and increase portfolio complexity. It is, therefore, important for investors to strike a balance between diversification and concentration, ensuring that their mutual fund portfolio is well-diversified but not excessively spread out.
Investing in mutual funds means ceding control over investment decisions to fund managers. While this can be advantageous for investors who prefer a hands-off approach or lack expertise in financial markets, it also means relinquishing control over individual stock selection, portfolio allocation, and timing of trades. This lack of control can be a disadvantage for investors who have specific investment preferences or wish to customise their portfolios based on market conditions or personal goals. Investors should carefully assess their comfort level with relinquishing control and consider alternative investment options if greater control is desired.
Mutual fund performance can be subject to challenges related to performance persistence. Past performance is often used as a benchmark for fund selection, but it does not guarantee future success. Mutual funds that outperform their benchmarks or peers in one period may not consistently maintain that level of performance. Factors such as changing market dynamics, economic conditions, fund manager changes, and fund size can influence performance persistence. Investors should, therefore, not rely solely on historical returns when selecting mutual funds but should also consider qualitative factors such as investment strategy, risk management practices, fund objectives, and fund manager tenure.
One of the primary drawbacks of mutual funds is the fees and expenses associated with them. Mutual funds typically charge management fees, operating expenses, and sometimes sales loads or commissions. These fees can eat into investors' returns over time, especially if they are invested in funds with high expense ratios. It is therefore essential for investors to compare the fee structures of different mutual funds and consider the impact of fees on their overall returns.
‘Mutual funds are subject to market risk’, this famous line describes mutual fund performance in a gist. It implies that the value of investments can fluctuate based on market conditions, economic factors, and geopolitical events. Investors may face the risk of capital loss during market downturns when markets experience volatility due to various domestic and global factors. While diversification within mutual funds can help mitigate some of this risk, it's crucial for investors to be aware of the inherent market risk associated with mutual fund investments.
Certain types of mutual funds, such as closed-end funds or funds with lock-in periods, impose redemption restrictions on investors. For example, closed-end funds have a fixed maturity period, and investors cannot redeem their units before maturity. Similarly, tax-saving funds like Equity Linked Savings Schemes (ELSS) have a lock-in period of three years. These redemption restrictions limit investors' flexibility and liquidity, especially if they need to access their investments during the lock-in period. It is, therefore, important for investors to be aware of these redemption restrictions and consider their liquidity needs and investment horizons when choosing mutual funds.
Investing in mutual funds can be either through direct mutual funds or regular mutual funds. Most brokers would have investors think that investing in regular mutual funds is a good option as they do not have to worry about the hassles of dealing with the fund for a small expense. However, the load of hidden expenses under regular mutual funds eat into the potential returns thereby lowering the ultimate benefit for investors. In the long run, more funds would go to the fund distributor or the broker in the case of regular mutual funds as compared to direct mutual funds. Therefore, investors need to do their own analysis and evaluate the pros and cons of investing through direct mutual funds or regular mutual funds rather than relying solely on broker or distributor advice.
Investing in mutual funds is generally considered to be safer than investing directly in individual stocks for investors. Mutual funds offer diversification across a basket of securities, reducing the impact of adverse movements in any single stock. Professional fund management and regulatory oversight add another layer of safety ensuring that investments are managed by experienced professionals and comply with regulatory guidelines. However, it's important to note that mutual funds still carry market risk, and investors should align their investment choices with their risk tolerance and financial goals.
Investment in mutual funds is steadily increasing over the past decades backed by the increasing participation of retail investors across various segments of Indian stock markets. With a thorough study of the pros and cons of investing in mutual funds, investors can create sound investment portfolios that truly reflect their risk perception and match their investment goals.
This article is an extension of our series on covering the basics of mutual funds. Let us know if you have any queries on this topic or need further information on mutual funds and we will address them in our upcoming pieces.
Till then Happy Reading!
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Marisha Bhatt is a financial content writer @TrueData.
She writes with the sole aim of simplifying complex financial concepts and jargon while attempting to clarify technical and fundamental analysis concepts of the stock markets. The ultimate goal is to spread vital knowledge and benefit the maximum audience. Her Chartered Accountant background acts as the knowledge base to help clarify crucial concepts and create a sound investment portfolio.
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