Many experts believe that mutual funds offer a wise solution to all your investment woes. The wide array of benefits they offer makes them one of the most popular choices across the globe. One of the most crucial features that make mutual funds investor-friendly is that they facilitate diversification by allowing you to invest in equity, debt, and gold. Also, you can reinvest the interests and dividends in additional funds shares, which generate extra income, thereby growing your portfolio. Other key features that describe mutual funds are affordable, liquid, and convenient. You can start your investment journey by putting the amount as little as INR 500 with the help of a Systematic Investment Plan (SIP).
There are wide ranges of options available with so many categories and types of funds that can perplex anyone. So, how to choose the right mutual fund is the most sought-after question asked by any investor. Now that we have understood some basics of mutual funds in other articles of this series, it’s time to write down specific quick and easy points that should be considered while choosing the best mutual fund for you. A brief overview of some essential criteria are outlined below-
Determine your goals, focus on your risk tolerance and decide upon time duration
At every stage of our life, we set goals according to our age and needs. No one apart from us can best understand our needs and requirements. The purpose or objective of your investment solely depends on what you want to achieve by putting your hard-earned money into schemes, shares, property, or any venture. The driving force behind taking up investment is gaining a desirable profit and creating wealth. The objective behind investments can be anything like buying a house, buying an automobile, accumulating money for your child’s education and marriage, or saving for retirement, which is decades away. To be precise, goals can be both short-term as well as the long- term.
The time duration for which you want to put your money in the scheme should also be addressed. You need to know whether you want your money to be liquid shortly, or you can afford to invest for long periods. For instance, if you’re willing to reduce the burden of sales charges on funds, then you have to put your money in the concerned fund for a minimum of 5 years.
You are also advised to assess your risk-taking capabilities while zeroing in on the best fund category. Generally, experts suggest that generating high returns is related to taking higher risks. However, high chances don’t need to award you high returns every time. So, its utterly personal choice of the investor whether he wants to go for investments that go up and down owing to the market fluctuations or opt for a traditional strategy generating him a regular income without involving many risks. It is advised to never invest in funds that do not match your risk profile.
So, your investment objective, risk type, and time duration determine your choice of investments. For instance, if your primary goal is creating wealth over a long period, then you can go for an equity fund that focuses on investing in equity-linked instruments such as growth stocks and shares. They involve high-risk elements and generate higher income. Equity funds invest around a significant part of them in equity shares of companies in different proportions and the remaining amount in debt instruments to minimize risks up to some extent and make sudden redemption possible.
However, in case you are a person who is hesitant to take higher risks and wants a regular steady income, you could invest in debt or fixed income funds. Some fixed income generating instruments are corporate bonds, treasury bills, government securities, commercial papers, etc.
For instance: A man who is approaching retirement should seek to invest in debt or fixed-income funds which are less risky and can generate moderate returns. If the same person who is approaching 60 years of age invests in high risks funds, let’s say a sectoral fund such as pharmaceutical fund may or may not receive good returns when he chooses to redeem money in the next few years. Likewise, a situation may arise where your value of money may reduce with the reversal of fortunes of pharmaceutical companies. Then you may face troubles as you have had no regular income after retirement and you lost part of your invested capital too. So, it’s clear that the product you chose wasn’t wrong; instead, it only didn’t match your risk profile and needs. As a thumb rule, the closer your goal is, the lesser the risk you ought to take.
Some key takeaways
- Low-risk investors who can afford little or no risk can go for liquid funds, ultra-short duration funds for a period of up to 3 years. For a medium time duration, an investor can choose short duration funds for 3-5 years. In case these investors want to invest more than five years, they can select large-cap funds.
- Medium risk investors are those who are willing to take a moderate amount of risk for modest returns. Those wanting to invest for less than three years can go for short duration funds. Otherwise, for the medium duration of 3-5 years and long term (>5 years), balanced funds and multi-cap funds respectively can be chosen.
- The investors who can afford to risk their capital or lose them in anticipation of significantly high returns are high-risk investors. For a short duration, they can go for arbitrage funds, whereas for the medium term, they can choose a hybrid equity fund. For longer duration high-risk investments, investors go for small-cap and mid-cap funds. High-risk investors additionally go for sectoral funds depending upon the potential of a selected industry or sector.
- Go for a fund that agrees to your philosophy. The approach with which a specific scheme is designed may vary depending upon its philosophy. Plans are drafted based on two types of style, namely value and growth investing. Former is the one where the investors seek underperforming stocks, while the latter is where the people involved prefer buying the best.
Many successful investors like Warren Buffet, Benjamin Graham (Buffet’s mentor), and hedge fund manager Seth Klarman practice value investing. Value investors look for stocks that appear to trade at lower than their intrinsic value, i.e., those stocks which are undervalued by the majority of investors are picked up by them. They buy very few stocks each year and hence, over time can garner positive returns.
The second approach towards investing is a situation where the investors seek companies that offer growth and exhibit potential growth in the future too. Investors look for such companies which are growing continuously and buy their stocks at high prices with the confidence of selling them at even higher prices.
The direction of the economy
The global and national economy directly impacts our markets. The market fluctuations influence our portfolio while affecting the performance of the funds. So, it is essential to have a broad understanding of the economy and the factors that are affecting it.
Some of the factors which affect the economy are decisions of government or performance of various sectors and industries. Diversifying your portfolio can help you deal with the ups and downs of the economy.
Diversify your portfolio
Diversification is a strategy where various asset types and investments are blended within a portfolio. You should reflect on spreading your wealth across multiple sectors or stocks rather than concentrating it on a single one. While you diversify your portfolio, you are not concentrating the risk to any individual asset. A biased portfolio that is inclined towards one particular asset or stock can expose you to significant risks. While visiting a website of any mutual fund during your research, make sure to check the history of the scheme. Examine if the fund has maintained a well-diversified portfolio in the past. You should go through all the details of the fund before putting your money in it.
Role of fund
Different funds products such as equity or balanced or index equity or Gold ETFs or sectoral equity or balanced funds etc. play different roles in your portfolio. You should think of designing a holistic portfolio where you need to identify a particular reason as to why a specific fund is required in your folio. You can make a clean and balanced portfolio by considering the role of each fund.
Now comes a question, how to research mutual funds? One of the snapshot techniques while deciding upon which funds you want to buy is to review the performance of funds in history. You can analyze the performance of funds based on factors namely, consistently outperforming its peers, volatility, and size of the fund.
A fund should be consistent and outperform its’ peers.
Here, consistency is the key, and you should not get trapped into the ratings of the last few years and instead try to examine the performance of funds for around ten years. A good fund is the one which can give you good returns over a long period and not once in a while in 1 or 3 years.
While selecting the funds, an investor should check for the consistent performance of funds concerning the benchmark index and category average. A benchmark index is an index to signify the returns your fund has earned in comparison to returns it sought to have made. The fund you chose should be compared to the benchmark and other funds of the same category.
The other parameter to judge consistency is category average which means the average returns of all schemes in the concerned category. You have to make sure that you are comparing the identical form of funds. For example, a small-cap equity mutual fund should be compared only with small-cap funds. An equity fund can’t be compared with debt funds or vice versa.
A fund that consistently outperforms its’ peers is generally considered to positive fund. But, here is a disclaimer, though past performance is a good indicator, it doesn’t guarantee future results.
Volatility of funds
Fund’s NAV fluctuates according to the behavior of the market, making them volatile. For example, volatility is expected for high risk and high return funds. However, for low risks funds, returns aren’t erratic. Out of five risks (alpha, beta, r-squared, standard deviation, and Sharpe ratio), two of them, namely, standard deviation and beta help measure volatility.
Size of funds
The fund size should be optimal enough for you to liquidate your money whenever you find it suitable. Also, the large size of the fund indicates that most investors procure the fund over other funds. Generally, a higher number of subscriptions for the schemes refers to high assets under its management (AUM) which implies that the investor finds fund manager and the associated funds reliable
Fund manager’s experience
A fund manager is the one who is capable of generating maximum profits by directing your investment in the correct direction by observing the market trends. So, it is imperative to inquire about his experience before choosing any fund. Also, you can examine the performances of the funds that were managed by the same manager in the past. The efficiency of the manager can be understood from how he handled funds during difficult times and his ability to generate returns consistently. The experience and judgment of an efficient manager can help you design a well-balanced portfolio.
Go for an experienced fund house with a disciplined team.
We learned about the critical role of a fund manager in a fund house. Now, what if the manager has to exit? That is when a capable fund house with a disciplined set of workers can come to your rescue. An AMC, built with a robust organizational process with efficient management teams can function well and discharge their duties in adverse situations.
Check for the expense ratio, exit load, and turnover ratio.
Fund houses charge some amount of fees from investors. These fees could be anything such as commission paid to the brokers, fees charged by the fund manager and expenses charged by an AMC for managing and operating the funds. A lower ratio gives you more profits and a higher one indicates little benefits. Direct mutual fund schemes offer the lowest expense ratio as there is no commission for distributing those funds. Generally, bigger funds have lower expense ratios.
Exit load is another extra expense that an investor has to bear if he wishes to withdraw from the scheme before the stipulated time. There can be an emergency, and you may need cash urgently. So, to avoid extra load on your pocket, it is suggested to choose funds with the least exit load to get better returns.
The turnover ratio of mutual funds is a qualitative parameter that can give you a brief idea about taxation and the performance of funds. For any mutual fund, this ratio is the percentage of fund’s holdings that are acquired and disposed of each year. Funds with a lower turnover ratio require lower costs to manage costs and hence, give good returns. Funds with high turnover ratios will have higher costs involved in trading and taxes.
The time in which the funds could be liquidated
Before investing your money, you should be clear about your needs. It is normal to face cash crunch owing to any emergency in the future. So, it is wise to choose funds that can be liquidated to fulfill your requirements at critical times.
We hope that we have been able to help you understand the things to keep in mind when we choose the best mutual funds for yourself. In case you feel that you might need help in any other tropic, then please feel free to contact us in the given comment section below.