13.5 Selecting Options in Mutual Fund Schemes and Do's and Don'ts

Two Independent Choices

Plan   -> Regular or Direct       -> determines COST
Option -> Growth or IDCW          -> determines whether income is DISTRIBUTED

All four combinations exist, and the two decisions are made independently.

Choosing the Plan

The honest framing: the direct plan's saving is real and compounds; it is also frequently smaller than the cost of one badly timed exit or one mismatched allocation. The comparison is the cost of the regular plan against the value of what the distributor does.

For an investor with time, knowledge and demonstrated temperament, direct plans are rational and a distributor should say so. For most investors, professional support is worth its cost provided the professional actually delivers it — quantified goals, a documented allocation and risk profile, scheduled rebalancing and availability when markets fall.

Choosing the Option

Why growth generally wins:

• Gains compound within the scheme rather than being distributed and taxed
• Tax is deferred until redemption
• Capital gains rates are usually lower than slab rates — for a 30%-slab investor in an equity-oriented scheme, 12.5% long-term against 30% on distributions
• The investor controls the timing and amount of any withdrawal

Why IDCW reinvestment is the worst combination: no cash is received, the distribution is taxable at slab rates, and stamp duty of 0.005% is charged on the units issued. The growth option accumulates the same amounts with neither charge. An investor found in IDCW reinvestment for an accumulation goal should be moved to growth.

Do's

Do begin with the goal, horizon and risk profile. Category follows from these; scheme follows from category.

Do quantify the goal in future-value terms. INR 15 lakh today at 8% inflation is roughly INR 37.8 lakh in twelve years, and the plan must be sized against the second figure.

Do check the tax regime before recommending ELSS. Under the new regime the section 80C deduction is unavailable, and the lock-in buys nothing.

Do review the investor's existing portfolio before adding to it.

Do compare like with like — same category, same periods, Tier 1 benchmark on a TRI basis.

Do weigh cost heavily, since it is the only factor whose effect is certain.

Do read the portfolio, not only the return — capitalisation split, rating profile, duration, turnover, overlap.

Do prefer rolling returns over trailing returns.

Do disclose commission, including on the competing schemes considered, and mention that direct plans exist.

Do explain the risk-o-meter and the scheme-specific risk factors.

Do ensure nomination is registered on every folio, or the opt-out declaration signed.

Do document the goal, profile and reason for each recommendation, dated.

Do review annually and rebalance on a schedule.

Don'ts

Don't select on last year's ranking. Category leadership rotates, and buying the previous year's leader often means buying a strategy as its favourable conditions end.

Don't say a low NAV is cheap. NAV per unit reflects a scheme's age and distribution history, not the valuation of its portfolio. This applies with equal force to an NFO at INR 10.

Don't guarantee or project returns. Mutual funds carry no assurance of return, and saying otherwise is a conduct breach as well as a misrepresentation.

Don't describe a debt scheme as a fixed deposit substitute. Debt schemes are marked to market and carry interest-rate and credit risk.

Don't churn. Switching to generate commission costs the investor tax and load, and is an express breach of the AMFI Code.

Don't over-diversify within a category. Five large cap funds hold substantially the same companies.

Don't ignore the horizon. Equity for a short goal and cash for a long one are both errors.

Don't recommend a switch without stating the tax consequence. A switch is a redemption.

Don't rebate commission or offer inducements. Expressly prohibited.

Don't create your own performance material. Use AMC-approved material; self-made charts almost never satisfy the period, benchmark, TRI and caution requirements simultaneously.

Don't accept forms signed in blank.

Don't promise a particular day's NAV. Applicable NAV depends on receipt at an Official Point of Acceptance and, for purchases, on realisation of funds.

The Test to Apply

Before finalising any recommendation, ask one question:

If this investor's file were reviewed in five years by someone entirely neutral, would the reasoning recorded today explain why this scheme was suitable for this goal?

If the answer is yes, the recommendation is sound. If the only available explanation is that the scheme was highly ranked at the time, it is not — and that is precisely the file that fails an AMC due-diligence review.