How to Choose Your First Fund

Useful, simple to understand and simple to execute. Those should be the qualities that your first fund investments should have.

For beginners, these requirements are generally best satisfied by tax-saving funds or balanced funds. Here's why:

When you start off investing in mutual funds, it makes sense to invest in a fund that invests mostly in equity. The reason for this is that you are likely to have no equity investments at all. Investors at an early stage of their investing life generally have bank deposits, PPF and other fixed-income investments. Since equity is the best form of long-term investment, and mutual funds the easiest and safest way to invest in equity, it follows that the type of fund you choose must be an equity fund.

There are two types of funds that are uniquely suitable as beginners' funds. These are Tax-Saving Funds and Balanced Funds.

Tax Savings Funds: Tax saving funds are also called ELSS funds as their formal name in the tax law is Equity-Linked Savings Scheme. They are basically all-equity funds investments in which are eligible for tax exemptions under Section 80C of the Income Tax Act. Under Section 80C, you can invest up to ₹1.5 lakh in a set of investments, one of which is ELSS funds. More details about the tax saving aspects are at this URL: https://www.valueresearchonline.com/tax/ . Since they are equity funds, one should invest in them long-term. This long-term imperative is compulsorily enforced because under the tax laws, investments made into these funds are locked in for at least three years. Because of this lock-in, investors tend to have a good experience of getting reasonable returns from these funds. It prevents the short-termism that can overcome inexperienced investors in normal equity funds. Inexperienced investors often tend to get into equity funds when the markets are high and then get out cared when the markets have dropped. ELSS funds prevent this behaviour at both ends.

Balanced Funds: Balanced funds, also called hybrid funds combine equity and debt investments in a certain ratio. In order to maintain this ratio, the fund manager will typically disinvest from holdings that have gained more and invest in holdings that have gained less.

Here's a detailed example. Let's say a balanced fund is designated to hold 70 per cent of its holdings in equity and the rest in debt. Let's say there's a month in which the stock markets are rising strongly and the value of the fund's equity holdings rise by 20 per cent. The debt holdings keep rising at the normal pace and during this month they go up by about 5 per cent. At the end of the month, for each rupee that it started with, the funds' equity holdings are up to 84 paise and the debt holdings to 31.5 paise. This means that it now has 81 per cent in equity-more than it's meant to. The fund manager will sell off some shares and invest the proceeds in debt, bringing down the percentage to 70 per cent.

This is called asset rebalancing. Effectively, the gains that were made in equity are protected now. The great advantage of balanced funds is that they are inherently safer than pure equity funds. They gain well when the markets gain but when the markets fall, they fall less sharply, thus protecting the gains that were made in the good times.

Questions

1. Which of these qualities is important in your first fund:
   • Simple to understand
   • Very high returns
   • Investment in Equity
2. Which of these types of funds are uniquely suitable for starters?
   • Government securities funds
   • ELSS funds
   • International funds
   • Balanced Funds
   • Post Office Funds
3. What is lock-in period for ELSS funds?
   • Three Years
   • Five Years
   • Till the investor retires
4. In what do balanced funds generally invest?
   • Shares
   • Gold
   • Bonds
   • Land
   • Paintings