As an investment, a mutual fund has several benefits. It offers a higher rate of returns than most conventional investment instruments. You are guided by experts in the field who help develop your investment strategy. You can start with a very modest sum. You don’t have to deal with the unnecessary hassle of chasing paperwork. And if that’s not enough, you can disinvest at will, opting to liquidate your fund when you choose.
If you have chosen to invest in mutual funds, it is a great decision. But how do you pick mutual funds which are the right fit for you?
(Read more: What is a mutual fund?)
Wondering how to choose mutual funds from a wide range of options? Here are the factors that help you to select mutual funds:
A fund’s track record is the first thing you should look at.
Past performance gives you an idea of how stable the fund will be in the future. You can assess roughly what kind of returns you may expect if there are no drastic changes in the economy.
Check out both short-term and long-term returns. This is an all-important step if you’re learning how to choose mutual funds. Did people who invest for one year get good returns? What about two-year investments? Ask for the figures. How did the fund perform when the market was sluggish? A strong fund would weather a bearish market without much change or a drastic fall. Look at the last downturn and see how the scheme fared.
(Read more: Mutual fund terms and concepts?)
Mutual funds always offer some risks associated with the market. This may be high or low, depending on the kind of assets the fund invests in. You need to be careful here. Assess your risk appetite and think of your investment horizon. Say, you want to stay invested for three years. You may have a certain goal in mind. You may want to build a certain corpus. Or, you know you can’t afford to risk beyond a certain amount of money. This stock-taking will help you select mutual funds effectively.
Ask the right questions:
Identifying your investment needs and targets is an important step. It can narrow down your choices, helping you to pick mutual funds that bring good returns.
If saving for retirement over decades, long-term capital gains would be your focus. You might also have medium-term financial targets—like saving to pay a down payment on a house or funding your children’s higher education. Equity mutual funds could bring the desired capital appreciation over the medium or long run.
Seeking an extra income source? Investing in a debt-oriented monthly income plan (MIP) or a systematic withdrawal plan (SWP) could fetch you a regular income.
Consider also whether you can afford to keep the money locked away for several years. If you expect to incur big costs in the near term, liquid funds could be a good investment choice.
A healthy mix is good for you. It balances risk. When your portfolio is diverse, it simply means that you are investing in different assets and different sectors. So, your portfolio may have a mix of debt and equity instruments. Or, you may have a mix of sectors or industries that you have invested in. This protects your money from being lost due to a crash in any one particular industry. It’s a matter of not keeping all your eggs in one basket.
Mutual funds are a good option if you are new to investing. Since each fund invests in a mix of assets, your investment is already diversified. But how does the investment fit in with your overall portfolio? It is important to check.
For instance, you might have investments in five different funds. But if all of them focus on the same sector, that is not diversification. If market events hurt businesses in that sector, it would have an adverse impact on your mutual fund portfolio.
Take steps to safeguard your capital. Spread your investments across different sectors and companies. This way, if a particular sector does badly or a group of companies faces turbulent times, your investment will be cushioned. And don’t just look at stocks. Other categories—such as arbitrage funds and fixed-income funds—could add a further layer of protection to your mutual fund portfolio.
Read more: What is an equity fund?
A fund may offer high returns. But does it have a high cost? What is the net profit you’d be making? Think about whether you will be better off investing in a low-return fund that has low cost. This could push up your profit margin. Calculate carefully. Say, you want to stay invested for five years. Even a 2% difference would add up to a lot.
Before investing, check the fund’s expense ratio. This covers the fund manager’s commission and the basic operating expenses of the fund house. The figure itself could be quite small—perhaps no more than 1.5%. But even a small percentage could eat into your returns.
Consider the entry and exit loads as well. An entry load is paid out of your initial investment—although many funds no longer levy this charge. As for the exit load, it applies only if you redeem the units before a specified time limit.
Run the numbers before placing an investment order. It may seem like minor savings today. But it could accumulate into a substantial sum if you stay invested for several years.
Consider the impact of tax on your mutual fund returns before investing. The tax treatment varies depending on the type of fund. So it is important to know exactly how things stand:
In both cases, dividend income is taxable. The amount is added to the investor’s income and taxed as per their income tax slab.
From 1 July 2020, a stamp duty of 0.005% will apply on buying mutual fund units. The added cost is likely to have a bigger effect on schemes like debt funds which have shorter holding periods.
One of the biggest advantages of mutual funds is that you get professional advice and guidance to help you invest wisely. But the experts themselves make a big difference.
Say, a fund has been very successful in the past. But the earlier fund manager suddenly is not managing the fund any longer. Would you feel comfortable investing with a new manager handling the fund? It may be a better idea to wait and watch how it does under a new manager. Ask around about the fund manager and their investment strategy. Invest only if your vision matches theirs.
The fund manager of an actively managed fund has a lot of work to do. They are tasked with adjusting the fund’s asset composition to ensure the best returns for investors. To achieve this, the fund manager scrutinises assets, company fundamentals, and key sectors. Market trends and macroeconomic factors are also factored in. All this pushes up the cost of running an active fund. You will find it reflected in a higher expense ratio.
Providing a contrast are passively managed mutual funds. One example is the index fund. Such a fund tries to replicate the performance of a benchmark index. Its portfolio corresponds to that of the chosen index. The fund’s asset allocation is changed only if there is a corresponding change in the asset composition of the benchmark index. Since the work put in is minimal, the expense ratios of passive funds are much lower.
Even after you tick off everything, there is no fail-safe strategy here. Every fund carries a certain risk. You can’t eliminate it, but you can certainly take a calculated risk. You can calibrate your exposure to risk.
Now that you know how to select mutual funds, read all the fine print. The prospectus that comes with a fund tells you what to expect. Funds with higher returns may carry higher risks. So, you will have to figure out what you want—the chance to make more money or to protect your investment from being lost.
Just remember one thing: Patience pays. If you wait and stay invested, your chances of getting reasonable returns will be higher. Do not give in to knee-jerk reactions to market changes. Don’t buy or sell when the market turns. But don’t hold on to a poor performer either. A dose of judiciousness, a modicum of risk-taking, and a good fund manager should help you make the most of your mutual fund investments.
(Read more: How mutual funds work?)
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