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Mutual funds offer a variety of options through which you can invest in or divest from them: each option has its own advantages and it is very helpful to know of your various options.
Lump sum investment:
This is the simplest manner of investing in a mutual fund. You have a certain sum of money (lets say, Rs 100) and you want to invest it in one go. You approach the mutual fund company with your cheque for the amount you want to invest.
The main risk with this investing strategy is that you are locked in to the valuations of the underlying security as on a particular date. If, for example, the prices were to go down from this point, you would lose money on the entire investment. Similarly, if you have timed the investment right, you will see a good rise on your entire investment.
Systematic Investment Plan (SIP):
In order to avoid the risk mentioned above, you can instead invest the sum over a period of time. Mutual funds allow you to periodically invest in them (lets say 5 investments of Rs 20 each). You can invest on a weekly, monthly or quarterly basis with the mutual funds.
This way you will avoid the risk of locking in to one single valuation but you will get an 'average' of the valuations on the various dates that you invest.
SIP is very helpful in a volatile market. Since you invest a fixed amount, you buy more of the security when its prices fall and less when it is more expensive.
Mutual funds define the dates on which you can make the regular investments (typically 1st/7th/15th/21st of every month). If you are a salaried employee, you will realize that you have surplus monthly savings and hence this can become a preferred option for you. You receive your salary on the 5th of the month and hence you can make the investment every 7th of the month.
You can fill the SIP application form and inform the mutual fund that you want to invest on 7th every month.
Almost all mutual funds provide an Electronic Clearing Scheme (ECS) with the major banks: this means that you can sign an order to your bank that you allow the mutual fund company to take a specified sum of money from your bank account on specified dates for a specified period.
This saves you the hassle of signing post dated cheques or of sending cheques on a periodic basis to the mutual fund.
Systematic Transfer Plan (STP):
In the above example, if you had a lump sum of money and wanted to do an SIP, you would have to park your extra money (i.e., Rs 80, which is Rs 100 minus the first installment of Rs 20) somewhere.
Mutual funds, realizing this issue, offer an STP. Here, you can invest the entire sum of money (Rs 100) with the fund: you put in Rs 20 in the equity fund, while putting the extra sum (Rs 80) in cash or debt funds.
Over the next four months, you can request the fund to transfer Rs 20 (plus the gains/losses) each month to the equity fund. This saves you the hassle of creating a communication between your mutual fund and your bank through ECS.
Similarly, if you believe that you would gradually want to move your exposure in IT to lets say, pharma, you can create an STP between your investments in the IT fund and the pharma fund.
This way you do not suddenly shift exposure in one go, but do it gradually. If you are approaching a milestone, you can use this instrument to move your exposure from equity to debt funds � so that you have more certainty around the final figure that you will receive.
Systematic Withdrawal Plan (SWP):
This is, as the name suggests, the reverse of the STP. Here you gradually withdraw money from the mutual fund. Assume you need Rs 20 over the next 5 months and you have Rs 100 invested in a mutual fund.
You can request the mutual fund to return 1/5th of your money (including the gains/losses) every month for the next five months. If your bank account details are provided, the fund will deposit the money directly in your bank account. This is typically used when you are nearer to a milestone or during your retirement.
Lock-in and capital gains tax:
In all systematic cases, you need to be careful about lock-ins and capital gains tax. Each date of your investment is treated as the date when you made or divested the investment. The first date of your SIP/STP is NOT considered as the investment date for all your subsequent dates.
Hence, if the mutual fund has a lock-in provision, then all different investments will have different dates when the lock-in gets over. Similarly, when calculating your taxes, the date of each investment is used to determine whether the particular sale would attract (the harsher) short term or (the concessional) long term tax rate.
You can devise your investments into mutual funds in a wide variety of ways. Knowing the various options can not only help you get better returns (or lower risk) but also force you into the discipline of savings!
The author is Director, PARK Financial Advisors Pvt. Ltd., Mumbai. He is an IIM-Ahmedabad alumnus. He can be contacted at firstname.lastname@example.org
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