What are the factors we should look at before starting investing through SIP?

Curranty Systematic Investment Plans (SIPs) are one of the most favourite investment instruments advised by all the investment advisors. Many of us get confused that SIP is a product. So, before jumping on to understanding how to choose the best SIP, let’s first get some clarity on what SIP really means.

What is SIP

A SIP or we call as systematic investment plan is an investment method to invest at regular intervals (monthly, quarterly or annually) in specific mutual funds schemes, which in turn invest in the markets. Being a flexible instrument, SIPs help to build wealth and instil the habit of saving even we are normally undisciplined. The major benefit of investing in SIPs is the power of compounding. We earn compound interest on our investment, thereby, increasing our investment amount significantly over the long run.

How to Select the Best SIP

When we have to reach some place we need to select a right vehicle i.e. For 5 km distance the suitable vehicle can be a bike or car, for 500 we may prefer a train and for 5000 km we have to use aeroplane. What a bike can do a plane cannot similarly what a plane can do bike cannot. In investment also we have certain financial destinations like kids education, buying home, kids marriage or self-retirement hence Choosing the right fund to invest in via a SIP is very critical to earning high returns and also to get the money at the time it is required. Therefore we should keep in mind the following factors when deciding which SIP to invest in.

1.    What is my Investment Objective:

We should know the purpose of investment before starting the investment in a fund. We need to ask ourself two questions. 1) Are we investing for the short term or the long term? And, 2) what is my risk appetite? Our investment horizon and risk profile will help to determine which type of fund will best suited. For example if we are a risk-averse investor and want consistent returns, without a high up-down reaction, debt funds might be more your thing. If we are ready to take some risk and investment horizon is medium, balanced funds could be the answer. Or if we are in for the long haul and are comfortable with market volatility, equity funds can be the right option.

2.    What type of Fund should we invest in:

There are different type of mutual funds, and it is very important to know which type is suitable for our risk appetite. Let’s understand the basic types of mutual funds:

(i) Asset-based mutual funds

a)   Equity Funds – In these funds money is invested in equity shares. These funds are further categorised into various types: large cap, diversified, mid cap, small cap, sector specific and index funds.

b)    Debt Funds – In these funds money is invested in fixed income securities i.e. debentures, bonds and government securities, commercial papers, certificate of deposits etc. These funds can be further classified based on investment tenure: money market, income and fixed maturity funds.

c)     Balanced Funds – These are hybrid of equity and debt funds and try to capture the best of both worlds to an investor. They counter equity fund’s risky profile by simultaneously investing in debt instruments to ensure steady returns to the investor.

(ii) Structure-based mutual funds

a)    Open-ended – In these schemes an investor can enter or exit these funds at any time, without restriction.

b)   Close-ended – These funds are open for investment for a specific time during the scheme’s launch. Once the new fund offer (NFO) closes, no further investments can be made. These funds have specific maturity dates on that date either redemption can be made or money can be switched to other open ended funds.

3.    What are the Tax implications:

In mutual funds schemes we get certain tax benefits which should be kept in mind while investing.

For equity mutual funds, all dividend is tax free in the hands of investors and capital gains are tax free after one year of investment. For less than one year 15% is the tax rate on equity mutual funds. Balanced funds having equity part of 65% and more are treated as equity funds.

In debt funds an investor get indexation benefits after three years which comes under long term capital gain rules. For less than three years the short term capital gain is added to the income of investor and taxed according to the tax bracket he/she falls in. In debt funds the dividend is tax free in the hands of investor however there is dividend distribution tax paid by mutual funds which is in the range of 28.84%- 34.608%

Therefore it is very important to keep the tax implications in mind while deciding the investments.

4.    What are Entry or Exit load:

Few years back, while investing in funds we need to pay some entry charges called as entry load. However, Securities and Exchange Board of India (SEBI) has stopped funds from levying an entry load. So, now, the only time we pay is when we are exiting/redeeming a fund before a specific time this is called an exit load. The fee varies with scheme, investment tenure and amount. For example, there is a fund which has exit load of 1% if redeemed before one year and we have invested one lakhs rupees and it grows to 1.10 lakhs in ten months and we wish to withdraw now then we will actually get 108900 /- only (1.10 lakhs -1% of 1.10 lakhs). Exit loads too are regulated by SEBI and all the fund houses have to follow the directives.

5.    How the fund has performed in the Past:

Past performance of a funds many not necessarily be repetitive however still it makes lot of sense to analyse the historical performance of the funds vis a vis other funds.  Performance does not includes returns only but we should also analyse its volatility, excess returns earned by fund manager’s ability, returns compared to benchmarks and other peer schemes. A comparison of historical performance will tell us how strong or weak a fund is and whether it can withstand market volatility. We should avoid funds that perform strongly when the market is high but collapses as soon as the market also falls. When studying the trends, we should look more on long term, say 5 years and 10 years and avoid a myopic view.

6.    What are the expenses:

This expense ratio comprises management fee and administrative costs, and is essentially a fund’s annual fee which it charges to perform its duties. A mutual fund scheme which have higher assets under management usually have lower expense ratios, making them a go-to option. A difference of 0.5% in expense ratios of two funds may not look significant but should not be taken lightly. Consider Fund A with an expense ratio of 2.5% and Fund B with 2%. Now, for these two funds to give same returns, Fund A will have to outperform Fund B every single year. While this may seem possible, in the long term, maintaining this performance could be difficult. Simply put, a high expense ratio can pull down a fund’s performance, however we should also look at how much alpha (additional return) a fund manager is generating if the expense ratio is higher. If our research has filtered down to funds that are similar in nature, we can choose among them on the basis of expense ratio.

7.    Who is the Mutual Fund Company:

Every mutual fund company have its own systems, process, peoples etc. These factors impacts the overall performance of its various mutual fund schemes. A fund is as good as its fund house. The decisions taken by the mutual fund company shapes a fund’s return-yielding capacity and growth. If the fund house does not take the right calls, investors will end up losing money. Before investing, read about the fund house and the fund scheme you intend to invest in. We should get a copy of the scheme information document and key information document to get details about the fund house’s investment approach, number of schemes offered, funds/products designed with investors in mind, and more. Answers to these questions will enlighten us to decide which fund house will be able to help us reach your investment goals.

Finally, investment is not just a numbers game but an emotional decision. It is not just one time decision but a long term continuing process. Hence it is very important that we should consult an expert not just to understand what is it as of now but also to understand the future implications and how should we carry on so as to achieve our financial goals comfortably without any shocks and surprises.