How to choose a Mutual Fund?

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John: So, you want to start investing in a mutual fund. Great!!! Which fund are you planning to invest in?

Jess: ABC mutual fund scheme from XYZ AMC.

John: Hmm….okay. Anyway, it was nice meeting you. I gotta go now. Will see you later.

5 years later,

John: Hey Jess, how have you been? It’s been a while.

Jess: John!!! Am good. How about you?

John: Am doing well. So how’s your mutual fund investment going on?

Jess: Don’t ask. I closed it 2 years ago. Returns were very bad and I needed money at that time. I won’t invest in any mutual fund scheme ever.

John: You cannot blame all mutual fund schemes due to one bad investment. Tell me something, why did you choose ABC?

Jess: When I started, the scheme was giving great one-year returns. My best friend Jeff also recommended it to me.

John: I see. It seems that you didn’t choose the proper fund.

Jess: I had so many options to choose from. I didn’t know which one to choose. So I asked Jeff and saw the previous year returns.

John: Well, you clearly made a very common mistake. You didn’t analyze the fund schemes properly.

Jess: I guess you’re right. I want to invest again, but don’t want to make the same mistake. Do you know how to choose the best mutual fund? Will you teach me?

John: Sure.

Many of us face this issue when we decide to invest in a mutual fund scheme. With so many kinds of Mutual Funds out there, many giving similar returns, we get confused and pick the wrong ones, the ones that don’t suit our investment style, are not aligned with our goals and etc. The consequence of which is we close the fund after a few years and blame the stock market and the AMCs. So, how do we go about choosing a mutual fund? Well, the selection process is very easy. Read on to learn…

  • Know your goals and risk tolerance: First and foremost, identify your objectives. Why do you want to invest in a mutual fund? What are your expectations from it? How do plan on utilizing the returns? Answering these questions is half of the battle. Identify the term of your investment. Is your investment for financing college education or to save for retirement? Identify your goals. Do you want regular income from the fund or capital appreciation over time? You should also identify your risk appetite. Are you willing to risk dramatic swings in your portfolio or you prefer a stable portfolio? You also need to assess the time horizon for which you’ll be investing. How long will you be able to keep investing without any drastic change in lifestyle?
  • Understand the Fund Type to know if it’s aligned to your investment style and goal: Understand whether the fund you’re considering is a capital appreciation scheme or an income scheme. Long-term capital appreciation schemes (Growth funds) generally invest in common stocks, hence are volatile. But, along with the risk, comes opportunity of huge returns. So, if you’re willing to take risks and desire wealth appreciation over a longer term, then you may be suited for Growth funds. If you’re a conservative investor and desire current income from your investment, it’s best to go with an income fund. If you don’t want too much volatility but want capital appreciation over long-term, Balanced Funds may be the best option for you.
  • Know the expenses: Every mutual fund has associated costs. The costs eat up a large chunk of the returns resulting in sub-par performance most of the time. Thus it is essential to minimize the costs as much as possible. Always try to go for no-load (no entry and exit load) funds. That way, your entire invested amount will be utilized in buying units. Also, always check for the Management Expense Ratio (MER, as Investopedia simply puts it – the total percentage of fund assets that is being charged to cover fund expenses). The lower the ratio, the better. Always factor in the MER when comparing different mutual funds. Another important metric to check is the fund’s turnover ratio, which is how long the manager keeps the stocks in the scheme’s portfolio. If the manager buys and sells stocks frequently, the expenses are going to be higher.
  • Research the fund’s Past Performance over a relatively longer duration: You should always research a fund’s past results. Was it consistent with the overall market returns? Did it underperform? If yes, then why. Don’t go for a mutual fund after seeing great returns for only one year as you should invest in a mutual fund that can perform well over up as well as down market cycles. The fund’s track-record of performing well against its benchmarks has to be consistent over a longer duration (ideally 5 – 10 years). If a mutual fund has been around five years or more, it is likely that a portion of the past returns have happened in different market environments. This will also help in understanding the portfolio manager’s performance under diverse circumstances. The fund manager’s track record also provides valuable insights as he’s the ultimate decision maker. Thus, his experience and view point will matter. If there has been a change in the manager, then without panicking, keep a watch on the performance of the new manager. If the performance is not as desired, then you may take a decision to exit. Do remember that just like a bad quarter doesn’t mean that the entire duration will be bad, the fund’s stellar performance in one quarter doesn’t guarantee the same throughout the term.
  • Know the mutual fund scheme’s Asset Size: This parameter is different for equity and debt schemes as the investment value per investor is higher in debt schemes. Thus, the comfortable size in equity is hundreds of crores (1 Crore = 10 Million) and for debt it should be thousands of crores. The fund scheme should have a considerable asset under management (AUM). Less AUM in any scheme is very risky as the exit of any big investor can adversely impact the overall performance of the mutual fund scheme. Also, too big of AUM can also affect the performance of the scheme as it makes difficult to acquire and dispose stocks without impacting them dramatically in their price.

Thus, keeping all the above factors in mind, you should choose the mutual fund that will help you achieve your financial goals. Yes, it seems to be a huge task, but due diligence will surely pay off. Happy Investing…

Smart investing doesn’t involve just money, but time as well. – WalletFunda

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