You have painstakingly evaluated the plethora of mutual funds and found the fund that best meets your needs. All that's left to do now is to invest. Right?
Wrong. You now have to wade through concepts such as asset allocation, rupee cost averaging and rebalancing, understanding of which is essential to make your investment a success. These weighty words could make the timid give up any thoughts of investing.
But fear not. MFs have introduced various tools that make it simple for individual investors to build these concepts into their investment plan. Here are some terms you are likely to come across often.
Rupee cost averaging. Rupee cost averaging allows an investor to bring down the average cost of buying a scheme by making a fixed investment periodically, like Rs 5,000 a month. An investor gets more of the investment product (equities or MF units) when markets are low and less when markets are high. This results in the average cost per unit for the investor being lower than the average price per unit over time.
Systematic investment plans and systematic transfer plans are the tools to implement this strategy. The investor needs to decide on the investment amount and the frequency. More frequent the investment interval, greater the chances of benefiting from lower prices. Investors can also benefit by increasing the SIP amount during market downturns, which will result in reducing the average cost and enhancing returns.
STP allows investors who have lump sums to park the funds in a low-risk fund like liquid funds and make periodic transfers to another fund to take advantage of rupee cost averaging.
Rebalancing. Rebalancing a portfolio periodically ensures that asset allocation is maintained and that the portfolio does not become more risky than what is acceptable. When equity funds do well, their proportion in the overall portfolio value goes up and so does the overall risk.
Or, when the debt component goes up, the growth drivers in a portfolio come down with a reduction in the equity component. Rebalancing involves booking profit in the fund class that has gone up and investing in the asset class that is down. This restores the original allocation that was made to suit the needs and risk profile of the investor.
Trigger and switching are tools that can be used to rebalance a portfolio. Trigger facilities allow automatic redemption or switch if a specified event occurs. The trigger could be the value of the investment, the net asset value of the scheme, level of capital appreciation, level of the market indices or even a date.
The funds redeemed can be switched to other specified schemes within the same fund house. Some fund houses allow such switches without charging an entry load.
To use the trigger and switch facility, the investor needs to specify the event, the amount or the number of units to be redeemed and the scheme into which the switch has to be made. This ensures that the investor books some profits and maintains the asset allocation in the portfolio.
Diversification. Diversification of resources into more than one asset class (equity, debt, cash, real estate, gold) reduces the overall risk in a portfolio. An equity investor may like to include debt to stabilise the portfolio, or, a risk-averse investor may like a small exposure to equity to better his returns.
One way to do this is through the dividend transfer option. Under this, the dividend is reinvested not into the same scheme but into another scheme of the investor's choice. For example, the dividends from debt funds may be transferred to equity schemes. This gives the investor a small exposure to a new asset class without risk to the principal amount. Such transfers may be done with or without entry loads, depending on the MF's policy.
Tax efficiency. The story doesn't end at deciding what's the best way of investing. The returns, too, have to be structured in a way that is tax efficient. Returns can be in the form of periodic dividends or capital appreciation.
Investors in equity funds have to choose between the growth and dividend reinvestment options. Dividends from equity funds are exempt from tax in the hands of the investor.
Long-term (more than one year) capital appreciation is again exempt from tax whereas short-term gains are taxed at 10 per cent. Investors who have a short-term horizon should look at the dividend reinvestment option to reduce tax-outgo on short-term capital gains. Long-term investors don't have to worry about what option to take, as both are equally tax efficient.
Debt funds have to pay a dividend distribution tax of 12.50 per cent (plus surcharge and education cess) on dividends paid out. Investors who need a regular stream of income have to choose between the dividend option and a systematic withdrawal plan that allows them to redeem units periodically. SWP implies capital gains for the investor.
If it is short-term, then the SWP is suitable only for investors in the 10-per-cent-tax bracket. Investors in higher tax brackets will end up paying a higher rate as short-term capital gains and should choose the dividend option.
If the capital gain is long-term (where the investment has been held for more than one year), the growth option is more tax efficient for all investors. This is because investors can redeem units using the SWP where they will have to pay 10 per cent as long-term capital gains tax against the 12.50 per cent DDT paid by the MF on dividends.
Reducing cost of investment. Investors can save on cost of investing (entry load) by going the direct route -- the MF's offices, collection centers or through the websites. The saving can range from 1-2.25 per cent depending on the type of fund.
Other than understanding the various facilities offered by MFs, maximum benefit can be drawn if investment decisions are based on a well-defined financial plan. For example, it shouldn't be that high returns from one scheme get negated by tax outgo on another.
The facilities that have been discussed here are offered by all the leading fund houses and bring the advantages of reducing risk, simplicity and affordability for the investor. However, investors need to verify and evaluate the details and factors such as costs, tax implications and minimum applicable investment amounts before committing to a service.
All these tools can be initiated and terminated by the investor by submitting the appropriate application. Usually there is a time lag before the service becomes available. Used intelligently these are services that can take efficient investing out of textbooks and into your portfolio.