Things to Consider While Making Lump Sum Investment in Mutual Funds in India

First things first – What exactly is lump sum investment in mutual funds?

As the name suggests, you invest a “lump sum” amount in one go.

Contrast this with SIP. For most salaried people, a specific portion of their salary is earmarked as savings and invested into mutual funds every month.

However, suppose you sell an old house or inherit some amount of cash and you need to invest that amount. This is the case where you would do a lump sum investment in mutual funds.

Why make the distinction?

This is an important question. End of the day, you are making investments into mutual funds. Why bother with the distinction.

Key reason for difference is the amount of risk involved in both the styles. With SIPs, you invest every month thus an inherent cost-averaging is built into this style.

Investing lump sum is way more risky. You invest everything in one shot. You are covered if you happen to buy when markets are down. But if the markets are high, you might end up losing money.

Given this, it is very important to consider these 3 things before making lump sum investment in mutual funds:

1. What are the risks involved?
2. What funds should you select?
3. What strategy should you adopt?

Let’s discuss each one in detail.

What are the risks involved?

As mentioned above, investing lump sum is pretty risky and you should be aware of it. Ideally you should be able to quantify the risk.

Let me do that for you.

But first let me introduce a term called Price-to-earnings ratio (more commonly called PE Ratio).

PE is one of the most widely used metric to gauge market valuations (if the market is expensive or inexpensive or fairly valued). For the sake of simplicity, let’s just understand PE as follows: If PE ratio is high, it means that markets are expensive and may correct in near-to-medium term. If PE ratio is low, markets are cheap and is a potentially a good time to buy.

Remember buy low, sell high!

In this blog, we will use the P/E levels of Nifty 50 index derived by dividing the Nifty value by the profit of its underlying stocks (on a per share basis).

What we will do is see how your returns would have turned out if you would have invested in NIFTY 50 index at different PE levels.

The way to understand this table is as follows:

Suppose you invested in NIFTY index on all days when PE was greater than 25 and held for 5 years. Then your average return would have been 2.2%. Also, 19.7% of times, you would have ended up with negative returns.

Now that is risky! Keep this in mind as we will revisit this again.

What funds should you select?

Don’t pick funds on an ad-hoc basis or based on star ratings.

Pick funds based on a time-tested framework that is based on data.

I will not talk about the framework in detail here. For those of you interested in knowing more, I have detailed out this framework in our blog Looking for the Best Mutual Funds to Invest? It’s a bit trickier than you think!

As per the framework, as of today, here is the list of best performing mutual funds across categories:

What strategy should you adopt?

Now this is the most important and the trickiest part.

There are simply too many open-ended questions. While making the decision, you would feel something like this:

I have covered this topic in a much greater detail in this blog Lump sum Investment – how to invest lump sum amounts in Equity Mutual Funds.

So, what are the solutions?

Option 1: Invest everything in one go and hold on for long term

You have already selected the best funds, and you are willing to wait it out. What could possibly go wrong?

A lot, actually.

Look at the table below. I have just shown the worst-case return on the funds listed above:

As can be seen, most of the funds delivered low single digit returns in the worst case. And the schemes that did deliver a double digit (or high single digit returns) are the ones incorporated in or after 2008. And so, they never bore any brunt of the 2008 crash.

For funds that were incorporated in or before 2006 (SBI Focused Equity and Franklin Smaller Company), just look at the worst-case performance.

Crux of the matter is that you can end up with very poor returns irrespective of the funds you pick.

Option 2: Systematic Transfer Plan (STP) – A better way but still not the best

What If we convert our lump sum investment into a SIP style investment? I can then benefit from cost-averaging and reduce the risk.

Correct.

And this methodology is called Systematic Transfer Plan or more commonly STP.

STP is the most commonly used strategy for making lump sum investments in equity mutual funds.

It essentially means that you invest your lump sum money into a relatively low risk holding funds (liquid, arbitrage) and then systematically switch to equity mutual funds over a certain period of time (6 months, 12 months, 18 months…).

Is STP any good?

The only way to answer this is to look at the data. What we will do is compare the performance of a pure lump sum investment (everything into equity in one go) with STP strategy with 6, 12 and 18 months staggering.

We will use Nifty index as proxy for our equity mutual fund and a liquid fund as our holding fund. We will run this analysis on last 20 years of data.

A beautiful pattern emerges. As you increase the staggering of your STP, your volatility decreases and hence the worst-case performance keeps getting better. But you achieve this by compromising on your average returns.

To sum it up, STPs are good if you want to reduce risk in your investments. But you then compromise on your returns.

Wait, Option 1 is a complete no no and Option 2 (STP) is not that great. Is there a anything better?

Option 3: Finpeg Lump sum strategy

Scroll up and relook at the PE table again. There is an undeniable pattern that emerges – “timing your entry matters and matters significantly”.

And this is only once such pattern. If you dig deeper and dig properly, there are many such patterns to be found.

Plain vanilla strategies like one-shot lump sum, SIPs or STPs completely ignore these patterns.

What if we decided to use these patterns to build intelligent investment strategies. Can we do better than STPs?

Yes, we can.

And that’s what we have done at Finpeg. Using such distinct historical patterns, we have trained our algorithms to bring a lot of intelligence into your mutual fund investing.

But don’t take my word for it. Let’s revisit the above table again with a minor addition. In the last row, I have added the performance of Finpeg Lumpsum Strategy on Nifty during the same time period.

I rest my case.

Do visit our website and if you find our approach interesting, do get in touch.

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