A Beginner's Guide To Mutual Fund Investment Procedures

Investing in mutual funds is a long-term commitment, so it's important to follow the right procedure. Here is a step-by-step guide on how to invest in mutual funds:

1. Decide on your investment goals: Are you investing for retirement, a child's education, or a short-term goal like buying a home? This will help you determine the right mutual fund strategy.

2. Pick the right mutual fund strategy: Consider your risk tolerance and time horizon. If you're investing for the long term, you may want to focus on stock-based mutual funds for potential higher returns. For shorter-term goals, bond market mutual funds or high-yield savings accounts may be more suitable.

3. Research potential mutual funds: Use tools like the Mutual Fund Observer and Maxfunds to compare past performance, expense ratios, load fees, and management style.

4. Open an investment account: You can invest in mutual funds through an employer-sponsored retirement plan, such as a 401(k) or 403(b). Alternatively, you can open a brokerage account and invest through individual retirement accounts (IRAs), taxable brokerage accounts, or education savings accounts.

5. Purchase shares of mutual funds: Ensure you have enough money deposited in your investment account. Mutual funds may have higher investment minimums than other asset classes. You can buy mutual funds directly from the fund company, through a broker, or online via a fund's website or a fund aggregator.

6. Set up a plan to invest regularly: Consider setting up recurring investments to grow your wealth over time. This can also help you pay less per share through dollar-cost averaging.

7. Monitor and rebalance your portfolio: Regularly review your investments to ensure they still align with your financial goals and risk tolerance. This may involve making adjustments to maintain your desired asset allocation.

8. Understand the fees and costs: Mutual funds typically charge management fees, exit loads, broker commissions, transaction charges, and selling costs. Be sure to factor these into your investment decision.

9. Complete the Know Your Customer (KYC) process: This is a mandatory step to verify your identity and address before investing in mutual funds.

10. Choose the right type of mutual fund: Mutual funds can be categorised into equity, debt, and hybrid funds, each with unique risk-return profiles. Seek advice from a financial advisor if needed.

Understand the different types of mutual funds

There are several types of mutual funds, each with its own unique characteristics and risk profile. Here are the main types of mutual funds you should know about:

• Stock Funds or Equity Funds: These funds invest primarily in stocks or equities. They are typically categorized based on the size of the companies they invest in, such as large-cap, mid-cap, or small-cap companies. They can also be classified by their investment approach, such as aggressive growth, income-oriented, or value funds. Equity funds can also be divided into domestic and international funds, depending on whether they invest in stocks from companies based in the United States or abroad.
• Bond Funds or Fixed-Income Funds: Bond funds invest in income-generating securities issued by governments and corporations. They are considered less volatile than stock funds and are suitable for investors seeking regular income rather than capital appreciation.
• Money Market Funds: These funds invest in short-term, low-risk debt instruments, such as government bonds, treasury bills, and certificates of deposit. While they are considered safe investments, they may offer lower potential returns compared to other types of funds.
• Index Funds: Index funds are passively managed funds that aim to replicate the performance of a specific market index, such as the S&P 500 or the Nasdaq. They have lower expenses than actively managed funds, as they require less research and investment decisions.
• Sector Funds: Sector funds focus their investments on a specific industry or sector, such as technology, healthcare, or aviation. While they can be a great way to invest in a particular industry, they may not offer the same level of diversification as other types of funds.
• Balanced Funds or Hybrid Funds: These funds invest in a combination of stocks and bonds, aiming to balance the potential for higher returns with the risk of losing money. The allocation between stocks and bonds can vary, with aggressive funds holding more equities and conservative funds holding more bonds.
• Target-Date Funds: A type of balanced fund that automatically adjusts the asset allocation based on a specified target date, usually retirement. As the target date approaches, the fund gradually shifts to a more conservative mix of investments.
• Specialty or Alternative Funds: This category includes various types of funds such as hedge funds, managed futures, commodities, and real estate investment trusts (REITs). It also includes socially responsible investing (SRI) funds, which focus on companies that meet certain environmental, social, and governance (ESG) criteria.

When choosing a mutual fund, it's important to understand your financial goals, risk tolerance, and investment horizon. Each type of mutual fund has its own advantages and disadvantages, and it's crucial to consider the fees and expenses associated with each fund. Diversification is also key, as investing in multiple types of mutual funds can help spread risk across different asset classes and sectors.

Research and compare funds

Researching and comparing mutual funds is an important step in the investment process. Here are some key considerations to help you make informed decisions:

Risk and Return Analysis:

• Consistency of Returns: Evaluate the consistency of returns generated by the fund over time. Look for funds that demonstrate consistent returns rather than focusing solely on the quantum of returns.
• Risk-Adjusted Returns: Consider the volatility of returns. For example, a return of 14% with 10% volatility is preferable to a return of 16% with 30% volatility.
• Benchmarking: Compare the fund's performance against relevant market indices or benchmarks. This will help you assess if the fund is outperforming or underperforming the market.

Fund Characteristics:

• Portfolio Mix: Examine the portfolio mix and diversification of the fund. Be wary of funds with high portfolio concentration risk or poor asset quality.
• Expense Ratio: The Total Expense Ratio (TER) represents the annual fee charged by the fund for management and operational costs. Compare funds to find those with competitive expense ratios, as lower fees can result in higher net returns.
• Fund Performance: Analyse the fund's performance over different time periods, such as three, five, and ten years. Look for funds with consistent long-term performance.

Investor Suitability:

• Risk Appetite: Ensure that the fund aligns with your risk tolerance and financial goals. Consider your investment horizon and whether you are comfortable with potential fluctuations in the value of your investment.
• Investment Approach: Decide between active and passive fund management. Active funds aim to beat the market through professional management, while passive funds seek to replicate market performance, often with lower fees.
• Fund Type: Choose between open-end and closed-end funds. Open-end funds have no limit on the number of investors or shares, while closed-end funds have a fixed number of shares offered during their initial public offering.

Due Diligence:

• Fund Factsheet: Review the fund factsheet, which provides essential information about the fund's strategy, performance, fees, and risks.
• Fund Ratings: Consider the ratings assigned to funds by reputable research organisations. These ratings can provide insights into the fund's performance, risk profile, and potential.
• Fund House Reputation: Assess the reputation and stability of the fund house or management team. A stable and experienced management team may be better equipped to navigate market fluctuations.

By carefully considering these factors and conducting thorough research, you can make more informed decisions when comparing and selecting mutual funds for your investment portfolio. Remember to diversify your investments across different funds and asset classes to manage risk effectively.

Decide on your investment goals

Before investing in mutual funds, it is important to identify your goals for the investment. Ask yourself: What is my objective? Do I want long-term capital gains, or is current income more important? Will the money be used to pay for college expenses, or to fund a retirement that's decades away?

You should also consider your personal risk tolerance. Can you accept dramatic swings in portfolio value, or is a more conservative investment more suitable? Risk and return are directly proportional, so you must balance your desire for returns against your ability to tolerate risk.

Finally, consider the desired time horizon. How long would you like to hold the investment? Do you anticipate any liquidity concerns in the near future? Mutual funds have sales charges, and that can take a big bite out of your return in the short run. To mitigate the impact of these charges, an investment horizon of at least five years is ideal.

If you plan to invest to meet a long-term need and can handle a fair amount of risk and volatility, a long-term capital appreciation fund may be a good choice. These funds typically hold a high percentage of their assets in common stocks and are therefore considered to be risky. Given the higher level of risk, they offer the potential for greater returns over time. The time frame for holding this type of mutual fund should be five years or more.

If you need current income from your portfolio, then an income fund may be a better choice. These funds usually buy bonds and other debt instruments that pay interest regularly.

If you have a long-term need but are unwilling or unable to assume substantial risk, a balanced fund, which invests in both stocks and bonds, could be the best alternative.

• Mutual funds are safer than picking stocks.
• Mutual funds are a long-term commitment.
• You need to complete your Know Your Client (KYC) process to understand the risks and rewards of investing in mutual funds.
• You can either do a physical KYC or an e-KYC with your Aadhar card that is mapped to your PAN number.
• Mutual funds also insist on an In-Person Verification (IPV) before completing your KYC.
• You can either go through a broker or give a Direct Application at the office of the mutual fund.
• Direct Applications pay a lower Total Expense Ratio (TER) and hence a higher Net Asset Value (NAV).
• Brokers can provide advisory services on fund selection.
• You should opt for the Direct Plan only if you are confident of managing your entire mutual fund investments on your own without any expert assistance.
• You can also opt for the online purchase of mutual funds.
• Funds are allocated an ISIN number, and you can hold mutual funds in your demat account along with your equity shares and other similar assets.

Choose a brokerage account

You can buy mutual funds through an online broker or the fund manager themselves. However, there are some differences between the way mutual funds trade and the way a stock or ETF trades.

When choosing a brokerage account, you should consider the following:

• Affordability: Mutual fund investors can face two kinds of fees: from their brokerage account (transaction fees) and from the funds themselves (expense ratios and front- and back-end “sales loads”).
• Fund choices: Workplace retirement plans may carry only a small selection of mutual funds. You may want more variety than this. Some brokers offer hundreds, even thousands, of no-transaction-fee funds to choose from, as well as other types of funds like ETFs.
• Research and educational tools: With more choice comes the need for more research. It's vital to pick a broker that helps you learn more about a fund before investing your money.
• Ease of use: A brokerage's website or app won't be helpful if you can't make sense of it. You want to understand and feel comfortable with the platform.

If you're looking for a brokerage account to buy mutual funds, you could consider Merrill Edge® Self-Directed, which offers a wide range of no-transaction-fee mutual funds.

Alternatively, you could buy mutual funds directly from the company that created the fund, such as Vanguard or BlackRock, but doing so will limit your choice of funds. You can also work with a traditional financial advisor to purchase funds, but this may incur some additional fees.

Understand the fees

Understanding the fees involved in investing in mutual funds is crucial, as they can significantly impact your investment returns. Here's a detailed overview of the fees you need to know about:

Types of Fees

Mutual fund fees can be broadly categorised into two types: Annual Fund Operating Expenses and Shareholder Fees.

Annual Fund Operating Expenses

These are ongoing fees associated with the cost of managing the fund, including paying fund managers, accountants, legal fees, marketing, and other administrative costs. These fees are typically between 0.25% and 1% of your investment in the fund per year. Actively managed funds, which aim to beat average stock market returns, tend to have higher annual fund operating expenses compared to passively managed funds, such as index funds, which aim to mirror the performance of a benchmark stock index.

Shareholder Fees

Shareholder fees are one-time costs incurred when you buy or sell mutual fund shares. These include:

• Sales loads or commissions: Charged when you buy or sell shares, typically calculated as a percentage of your investment. Front-end loads are paid at the time of purchase, while back-end loads are paid when you sell your shares.
• Redemption fee: Charged when you sell your shares within a short period after purchasing them, usually within 30 to 180 days.
• Exchange fee: Charged when you transfer your shares to another fund offered by the same investment company.
• Account fee: Charged for maintaining your account, often applied if your account balance falls below a specified minimum.
• Purchase fee: Paid directly to the fund at the time of purchase, separate from the front-end sales load.

Factors Affecting Fees

The fees associated with mutual funds can vary depending on several factors:

Active vs. Passive Funds

Actively managed funds, which involve a more hands-on approach and aim to outperform the market, tend to have higher fees compared to passively managed funds. This is because actively managed funds require more comprehensive management, research, and trading activities, resulting in higher costs.

Fund Size

Small-cap funds, which invest in smaller companies, tend to have higher expense ratios than large-cap funds. This is because small-cap funds incur higher costs for research and trading, and they often have higher turnover ratios, impacting trading costs.

Fund Type

Different types of mutual funds, such as equity funds, bond funds, and international funds, will have varying expense ratios due to differences in investment strategies, research requirements, trading costs, and other factors.

How to Minimise Fees

When investing in mutual funds, there are several strategies you can employ to minimise fees:

• Select low-cost funds: Opt for funds with low expense ratios, as these will have a significant impact on your returns over time.
• Choose no-load funds: No-load funds do not charge sales commissions, helping you minimise costs.
• Use discount brokers: Discount brokers often offer no-transaction-fee mutual funds, reducing the cost of buying and selling funds.
• Invest in ETFs: Exchange-traded funds (ETFs) typically have lower management fees and no sales loads, making them a more affordable option.

Understanding the Impact of Fees

Even small differences in fees can lead to substantial differences in your investment returns over time. Therefore, it is essential to carefully consider both the annual fund operating expenses and shareholder fees when investing in mutual funds. Utilise tools such as a mutual fund calculator to understand how fees can impact your returns.

Frequently asked questions