How to select the best Mutual Funds?

by Rishabh Jain

Mutual Fund is where several investors share a common investment objective pool in the money intending to earn returns. They issue units to the investors and invest the pooled funds in securities according to the objective of the investors.

It is not about selecting the best Mutual Fund Scheme but the right scheme. You might have seen people investing in mutual funds suggested by someone else. How can the scheme that was fit for that person be fit for you?

Most of the investors today do not do proper research about the fund where they are going to park their hard-earned income. To get the returns expected out of the investment one should consider the factors given below before investing.

Before selecting the appropriate mutual fund. One should also have then knowledge of the types of Mutual Fund categories.

Top Factors to select the best mutual funds:

Investment objective

Objectives provide investors the clarity of the reason for the investment. Each investor has their objectives and goals for investing. For some, it might be buying a car, it might be covering the college expenses of their children, there might be investors who might have the goal to purchase a home or accumulating funds for the marriage of their children, and so on.

So from the above instance, we can understand that investment objectives can be different for different investors. Therefore, it is very important to clearly define the objective before investing and according to the objective one should be selecting the mutual fund to invest in.

Time Horizon

The time for which the investor wants to keep their funds invested in Mutual Fund is termed as Time Horizon. Investors have some short-term goals as well as long-term goals. Goals can be as short as 1 day and as long as more than 5 years. Based on these goals the investor decides for how long they might want to hold their investment to achieve the goals.

For example, If you are accumulating funds for the marriage of your child, who is going to get married after 10 years, then 10 years is your time horizon.

Not all mutual funds are suitable for every time horizon. Different Mutual Fund Scheme gives you the best return for different time horizons. For instance, Equity Funds ( Funds that invest in shares of different companies) would give significant returns if held for more than 4-5 years. Similarly, if you want to invest only for a shorter term say 3-4 months, then Liquid Fund( Funds that invest in debt instruments for a shorter term, i.e. up to 91 days) would be suitable for you. So, it is important to know the time you would need to achieve your objective and invest in the funds accordingly.

Risk Tolerance

Have you seen Investors losing all their money in Markets? Why do you think they face such losses that they even have to sell their Home and Assets? Here comes the importance of Risk Tolerance/ Risk Appetite. These people lose their money because the risk that they take is much more than what they can afford. For example, some people invest all the money they have earned till now in markets without even understanding the downside. In simple words, Risk tolerance refers to the amount of risk one can tolerate/take.

Therefore, you need to understand and recognize yourself as an investor, whether you are a conservative investor who wants to be on the safe side, a medium risk-taking person, or a person who can take high risk. Some people have a high risk-taking capacity, whereas some do not.

Risk is directly proportional to reward, i.e. High risk gives higher rewards. But that does not mean that to gain higher rewards you would go beyond your risk tolerance. It is better to earn fewer returns than to lose everything.

There are different Mutual Fund Schemes according to different risk profiles. Like, Equity Funds are considered to be high-risk instruments, so they will be suitable for those who can take high risk. Debt funds are low-risk instruments and are best for conservative investors. And Hybrid Funds are best for investors who can take the medium risk. Therefore, before investing it is important to understand your risk-taking capacity.

Return Consistency

Let us consider a situation say, you as an investor wants to invest in a Mutual Fund scheme and there are two funds that you have sorted out. You want to invest only in one scheme. Two funds that you sorted out are:

  1. A fund that gave 8% return in the first year, 14% return in the second year, and 5% return in the third year. AND,
  2. A Fund that gave a 10% return in the first year, 10.5% return in the second year, and 11% return in the third year.

Which fund would you select out of the above two? 2nd one right? And why? Because of consistent returns. The only difference between the two funds is the returns. The returns of Fund 1 are very fluctuating whereas returns of Fund 2 are consistent.

A good Fund gives or tries to give a consistent return despite the fluctuations in the Markets and the Benchmark (NSE and BSE).

So before selecting the scheme, don’t forget to check the 3-year and 5-year returns and then decide whether the fund gives consistent returns or not.

Fund Manager’s Experience

Fund Manager is a person who is responsible for managing the scheme offered by the Fund House. In simple words, Fund Manager decides what stocks to invest in, when to invest, and in what proportion to invest. He manages the Fund’s portfolio.

As we know, Stock Market is all about the experience. With experience comes greater skills and crucial knowledge. So, it is important to check who is the Fund Manager of the Fund you will be investing in, how many funds is he managing or has managed till date, and how much return has his funds given in the past.

A fund with a good Fund Manager will be able to provide significant returns even during the bad days of the market as it will benefit from the experience and resilience of the manager. However, if the Fund Manager isn’t good enough, the fund might not perform the way expected.

Assets Under Management (AUM)

Asset Under Management(AUM) indicates the total amount of capital the Mutual Fund scheme is currently managing. In other words, it is the size of the Fund. AUM keeps on changing with the change in the no. of people investing in that particular scheme.

The AUM value also includes the returns earned by the fund. For example, suppose 90 investors invested Rs. 1000 each in a fund, so the AUM is Rs 90,000. Now, that fund gave a return of 10%, so the current AUM will be Rs 99,000.

An increasing AUM may specify positive fund performance or that a no. of investors have bought in. And a decreasing AUM would reflect that a no. of investors are redeeming the units, which may not be a good sign. The AUM of different Mutual Fund schemes of the same category must be compared before making a decision. Like AUM of Large Cap Fund should be compared to another Large Cap Fund only and not any other category.

Also higher the AUM, the higher would be the liquidity in the Fund. As an investor, you must not only rely on the AUM as it may not always give a correct picture, just because other investors are investing in that fund does not mean you should be doing that too.

Expense Ratio

The amount that the Asset Management Company (Company that manages the assets of the Mutual Fund scheme by appointing the Fund Manager) deducts from the investments made as maintenance fee is referred to as Expense Ratio. Asset Management Company (AMC) charges a certain percentage of the fee in return for the services provided by them. In numerical terms, it indicates the Total percentage of Sales to the Total Individual Expenses.

For Example, if you invest Rs. 10,000 in a scheme whose expense ratio is 1.5%, then it means that you will be paying Rs. 150 out of Rs. 10,000 invested by you to the Fund House as a fee.

The expense ratio has an inverse relationship with profitability i.e. lower the expense ratio, the higher would be the profitability. And higher the expense ratio- the lower would be the profitability. As it gets deducted from the amount you are investing thus reducing the investment by a certain percentage.

The expense ratio also depends on the Asset Under Management (AUM). If the AUM of a fund is small then, the expense ratio tends to be high because the fund will have a small number of investments (assets) to meet its expenses. Similarly on the other hand, if the AUM is significant, the expense ratio would be low. So, do check the AUM of the fund also while evaluating the expense ratio.

Exit Load

Like Expense Ratio, Exit Load is the amount charged by the Asset Management Company(AMC) at the time of redeeming the units/ exiting the fund. In simple words, it can be termed as an Exit Penalty.

Exit Load is not charged by all the funds. it is charged only by those Fund Houses in which the investors redeem the units during the lock-in period. Some Funds have a certain lock-in period within which if the investor exits the fund i.e. withdraws the investment and returns, then the exit penalty is charged.

Suppose you invested in a Fund which has a lock-in period of say 1 year. Now if you are invested for that 1 year and then exit the fund, you won’t be charged with the exit load. But because of some emergency if you redeem your units within 1 year, then you will have to pay the exit load.

Before investing an investor must check the exit load too, and invest in those funds that either charge very less exit load or none.

Consider Tax Rates

When selecting the Mutual Fund, the investor should have a clear idea about the tax applicability. Taxes are charged on the returns earned at the time of redeeming the units. The basis of taxation is the period for which you were invested and the tax rate that is applicable for you.

Taxes are charged on two types of gains i.e Long Term Capital Gains (LTCG) and Short Term Capital Gain (STCG). LTCG is simply the gain that you earn on the capital invested for 12 months or more. And, STCG is the gain earned on the capital invested for less than 12 months.

In the case of Equity Funds, you are allowed an exemption if your LTCG is up to Rs. 1 Lakh i.e. if your return is less than Rs. 1 Lakh after holding for 1 year and you want to redeem your units now, you won’t have to pay taxes on that amount. If LTCG is more than Rs.1 Lakh, then the applicable tax rate is 10%. STCG is taxed at 15%.

In the case of Debt Funds LTCG ( in debt fund the period is 36 months or more) is taxed at 20% and STCG (period less than 36 months) is taxed as per the tax slab you fall into (5% or 10% or 30%).

If an investment is made under any tax saving fund i.e. ELSS (Equity Linked Saving Scheme) for more than 3 years as it has a lock-in period of 3 years, then the investor gets a maximum deduction of up to Rs. 1.5 Lakh under Section 80C. ELSS funds might be helpful for those investors looking to save taxes.

Performance against Index

It is an important factor to compare the Mutual Fund performance against the Index as it serves as a benchmark. It shows the potential that the fund has. For instance, If the Mutual Fund you are looking to invest in has given a 9% return in the last 5 years whereas the Index has given a 13% return, then the fund you are investing in has not given a good performance.

And otherwise, if the index has given a 9% return in the last 5 years but your fund has given a 12% return then the performance of your fund is considered good. Therefore, before investing do check the Fund’s performance against the index and then take the decision.

Conclusion

As we have seen, there are a no. of factors that can affect investing in a particular scheme. And no single factor can stand alone, all the factors are interlinked with each other. Only going through 1-2 factors won’t give you any clear decision. Therefore, it is very important to check all the factors before making any investment decision. The more you research the less likely is that your investment would fail. The factors while selecting the Mutual Fund should be compared to those of peers, and then the best one should be selected.

FAQ’S

What is a Mutual Fund?

Mutual Fund is a financial product where a no. of investors share a common objective pool in their money to earn returns. They issue units to the investors and invest the pooled money in different securities according to the objectives of the investors.

What is an Asset Management Company (AMC)?

AMC is the company appointed by the Mutual Fund House, which manages the assets of the Fund House. The AMC appoints the Fund Managers who decide where to invest, what stocks to invest in, and in what proportion. The fund managers are appointed by the AMC to manage the investments made by the investors in the Mutual Fund.

What are the secrets to select Mutual Fund?

The three most important factors you must know about yourself, to select the right Mutual Fund are:
1. Investment Objective: Before selecting the Mutual Fund to invest in, it is very important to ask yourself that why are you investing? Without an appropriate investment objective, you won’t be able to select the Mutual Fund that would be appropriate for you.

2. Time Horizon: Not all Mutual Funds are suitable for every time period. Different Fund gives you the best returns for different time horizon. There it is important to understand that whether your investment objective is for a short-term perspective or a long-term.

3. Risk Tolerance: Before investing it is also important to understand the amount of risk that you as an investor can bear. As different funds have different types of risk associated with them. Therefore, analyzing your risk profile before investing might give you a clear picture of which fund is suitable for you.

Do all Mutual Fund scheme charge exit load?

No, not all schemes charge exit load. It depends on the type of fund you are investing in. Different schemes charge a different proportion of exit load. Therefore, it is important to check the exit load before investing and invest in those funds that charge less or no exit penalty.

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