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.
How to Select a Mutual Fund-
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 in How to select a mutual fund.
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. This will eat into the returns. While a very big fund always faces the challenge of deploying the money effectively.
Honestly, I am not sure how high size is defined? 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. It must 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 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.
How to select a mutual fund – Costing
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.
What happen to the SIPs if the unit holder expire. Can his/her nominee carry on the SIPs or it will stop automatically.
@Chandan,
In that case the nominee has to inform the company that the holder has expired and if they want to stop they can stop the SIP’s or if they want to continue they can by becoming the holder and appointing new nominee. There is paper-work involved for the above procedure.
Thanks Rakesh…
I do not know this for sure but can a nominee become a holder of units of the deceased and then continue as is. Looks like a niche question to me.
Very information article. A good reckoner for people wanting to invest in mutual funds, each and every point is important. I would like to discuss on Pedigree of the fund house and fund manager. Prashant Jain is one guy associated with HDFC for a very long time and has done wonders, as long as he is with HDFC i know my money is in safe hands. On the other hand i used to follow Sandip Sabharwal who started his career with SBI and did good work there for over 10 years but then later moved to JM/Birla and screwed-up. I used to follow him and invested but then he turn is back on investors. He was hardly there for one year. For that guy it was all about $$$$. Now he is with Prabhudas Lilladhar, i don’t track him anymore.
Yeah, Sandip Sabharwal did in that sense shoot himself in the foot.
There are lots of fund managers who are doing so good, maybe we should cover an article on them.
Maybe an Infographic !
Good idea! I never followed fund managers, in fact never checked who is the fund manager while selecting a MF, and have no clue on their report cards. An infographic will give some picture, which is always handy while making a fund selection.
For me there are 3 important factors that should be balanced while selecting a MF: –
– Cost
– Risk
– Performance
As long as you are aware of the above three factors and are able to balance it as per your appetite, you should do just fine.
Important thing is to invest and keep monitoring the MF investment periodically, at least once a year.
Yeah, these 3 things matter a lot. What priority do you give to these 3 – is there any order or all 3 are of equal importance ?
Well more or less I think they are equally important. But I’d probably give a slightly extra importance to the performance. If a fund is consistent high performer I might compromise on risk and cost i.e. I might go with high risk and high cost.
So if I have to give weightage, I’d give 40% to performance and 30% each to cost and risk.
Before selecting mutual funds portfolios have to be designed for our short term medium term and long term goals.While designing the portfolios proper asset allocation of asset classes like equity, debt and gold has to be done.
While selecting funds for portfolios, diversification across types of funds as well as fund houses has to be done.Time diversification has to be done by monthly systematic investing.
Overdiversification is not needed.So more than around seven funds should not be selected.Diversification should be in style and not in numbers.
Agreed Anil. All these points are very valid.
Liked your statement – Diversification should be in style and not in numbers
This is true as most of the investors buy a lot of MFs and invest a paltry amount if each of them. A lot of these are also NFOs.
They would have been better off if they had selected a few good mutual funds and invested systematically in them.
Normally an investor should select around five funds.One can be a bond fund and the remaining can be diversified equity mutual funds one from each category like large cap, large & midcap, mullticap and mid & small cap. Bond fund is for rebalancing. One can also opt for a balanced fund if one wants.All funds should be from different fund houses.
While selecting funds core and satellite approach should be adopted.Core which will form around 70% of the portfolio should have large cap and large & midcap funds with a consistent long term record.
Satellite will have other funds.One can have one gold fund and one sector/thematic fund if one wants.
@Anilji,
Thanks for your views on picking up MF, you mentioned that we should pick funds from different fund houses but if there are funds which are performing exceptional then i believe there is nothing wrong in picking two funds from the same fund house. HDFC Equity and HDFC Prudence are two great funds which have given good returns to investors in the long run and i have been investing in both of these funds.
There are many fund houses which have a number of good funds.If we try to select all good funds of a fund house then we will have a large number of funds in our portfolios which will amount to overdiversification.Then there is fund manager risk also.HDFC Top 200, HDFC Equity and HDFC Prudence are managed by the same fund manager.In the past these funds have given good returns.But for the past one year the returns have not been very good and there are a lot of funds of other fund houses which have given far better returns.Even HDFC Balanced which is managed by other fund manager has given better returns.If you see the stocks of these funds you will find that a lot of stocks of these funds are identical as they are manged by the same fund manager.Hence we do not get true diversification by investing in these funds.
If in the past one fund manager has delivered very good returns it does not follow that we can get similar returns in future also.
@Anilji,
Very valid justification, thank you. Will make note of it.
Nice article. I think if all these points are more than enough to choose a good mutual fund to invest.
For little more detail, a person should take care of diversification if he already holds any MF or going to invest in more than one MF. I think this is nicely explained by Anil Kumar Kapila. One more thing can be checked is sector diversification of a fund (Financial, Technology, etc.) at least which are major three sector the fund invests and better it’s not tilted more to any one sector until you need such kind. Also if one selects Balanced then Equity debt ratio should be checked.
With sectorial funds one has to be very careful. Their performance is seasonal and driven by government policies. If government policies are not favouring one sector it is not going to perform very well.
How much percentage of sector allocation is good for a mutual fund ?
I would say 10-15% in a sector should be good.
Hmmmm, I was using my stock market portfolio allocation.
10 – 15% overall in sector funds. I am not investing in any sector fund now, used to invest in power sector 4-5 years back but the performance was average.
Not more than 10%, overall, not in each sector.