For retails investors, mutual funds form an important investment vehicle in their financial planning. Using the systematic investment planning route to invest, investors can ride on long term investing and meet all their financial goals.
The art of selecting a mutual fund for investing your hard earned money is not a tough ask. It is not easy as well but with a few rules and parameters, ordinary investors like you and me can do this ourselves.
How to choose a mutual fund from the wide variety of types of mutual funds available? This article tries to document how to select a mutual fund in India.
Invest for a purpose
Firstly, align the mutual fund to a particular future financial goal that you might have. If you have a long term goal, say retirement for which you need money for, then equity diversified mutual funds could be the ideal choice. If the idea is to protect capital and save for a car that you wish to purchase in say 2 years time, a debt mutual fund is ideal.
For how many years you need to park your money with the mutual funds is what I am referring to here. Equity funds should be held for at least 3-5 years because equities are long-term investment vehicles while debt funds can be invested for short periods of time.
Mapping your mutual fund investments to your goal, which is nothing but your need, will help define which type of mutual fund you need.
Map your risk
With the purpose done and dusted, focus on your risk profile. Risk assessment is an important task in any investment decision. Your risk should ideally match the risk of the investment vehicle.
Remember a mutual fund takes more risk to generate high returns – so if you are investing in it, are you taking high risk – check whether this is in line with your expectations.
To take an example, if you can take high risk, equity diversified mutual funds is the way to go; moderate risk calls for balanced funds and low risk calls for debt mutual funds.
Understanding how consistent performance was delivered with respect to risk is important – risk adjusted returns and protection of capital need to be taken into account. Do not go with a fund that takes a huge amount of risk to generate returns.
Mapping your risk to the mutual fund is an important step.
Performance of the mutual fund
So what about performance ?
While past performance of a mutual fund is an indication of how it might perform in the future, it cannot only be the factor. One needs to assess the performance of a mutual fund over many ups and down of the economy and stock market – over a long period of time rather than short.
The more rough waters a mutual funds has gone through and delivered performance the more you can depend on it.
To take this further, look for consistent performance over say 3, 5 or 10 years. Mutual funds tag their performance against some benchmarks so ensure that they do better than the benchmarks.
Compare the mutual fund with its peers – but don’t compare apples with oranges. Ensure you compare say, large caps with large caps and mid caps with mid caps – comparing a large cap against a mid cap is a strict no no.
Does size of the mutual fund matter ?
The size of the fund can be another parameter on how to choose a mutual fund – select one that is not too small, neither too big.
A very small fund might struggle with high charges which eat into the returns while a very big fund always faces a challenge of deploying the money effectively.
Honestly, I am not sure what high size is defined here because the largest of the mutual funds still perform well and are doing so consistently.
Pedigree of the fund house and fund manager
Go with fund houses that have a strong presence in the financial world and have funds that have a reasonably long and consistent track record. Such fund houses have robust processes and are not necessarily dependent on people to drive profits.
So when those people leave, the processes ensure that the performance of the fund is not impacted.
But truth be told – a fund manager can make or break the fortune of a fund. So while the track record of a fund house is important, the track record of a fund manager can also be a factor on how to select a mutual fund.
Many investors follow a fund manager and exit mutual fund schemes when the fund manager changes.
Cost of the mutual fund
A fund house has some costs associated with running a mutual fund. This can be ascertained by looking at the expense ratio of the mutual funds.
Funds with high expense ratios can impact returns in the long term so do compare this parameter between mutual funds. Mutual funds with low expense ratios should be good as long as other factors are also accounted for.
There is another factor on how to choose a mutual fund which can be looked at – turnover ratio. This ratio measures the churn in portfolios of mutual funds – how often does the fund manager buy and sell. A high turnover ratio is not good while a low one is also not healthy.
Are there any other parameters missing here on how to select a mutual fund which you use ? I would like to include them in this article.