Four steps to selecting the right mutual fund

An increasing number of Indians are now opting for mutual funds to invest and grow their hard-earned savings. But as the mutual fund industry has grown over the years, so has the number of schemes and their investment style. At the heart of it, mutual funds are a pooled investment product where the asset manager collects funds from a large number of investors and then uses them to buy various financial assets as per its investment mandate. 

Based on their mandate and investment goals, a mutual fund manager can invest in all kinds of assets ranging from stocks, government bonds, corporate bonds, private debt, money market instruments, precious metals, commodities, currencies, and even units or other mutual funds. 

The returns generated from these investments are then distributed among the investors by way of capital appreciation and dividends in the proportion of their initial investment in the scheme.

Though there can also be close-ended schemes where the asset manager sells a fixed number of units through a new fund offer and no fresh funds flow into the fund afterwards.

The sheer diversity of mutual fund schemes available in the market means there is now a scheme to suit any investment style or financial goal. According to data from the industry body Association of Mutual Fund of India (AMFI), investors can now choose from nearly 7500 different kinds of mutual fund schemes.

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While choice is always good, this can also be bewildering and overwhelming for investors.

Selecting the right mutual fund, however, can be a breeze if you ask the right questions and leave out the noise around the product. Here are five factors to focus on while looking for the right mutual fund to invest in:

1.       What are your investment goals? You need to answer this question before you decide to invest in any mutual fund. Are you looking for long-term appreciation in your capital or savings or do you wish to earn a regular income from your pool of savings? Secondly, what are your financial goals? Will the proceeds from investment be used to pay for your child's higher education, fund a marriage or are you saving for retirement that is 20 or 30 years away? Once you have identified your investment goals, use it to weed out the non-suitable funds from the universe of schemes and create a list of potential funds that you could invest in.

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If you are investing to meet long-term financial goals such as a child's higher education or retirement but won’t mind a fair bit of downside risk and volatility, a growth-oriented diversified equity scheme or exchange-traded funds will be a good option for you. But if you are investing for a shorter period and you can’t afford downside risk then go to a debt fund of a matching tenure. 

However, if your objective is to generate a regular income from your investment then you can invest in a dividend equity fund and opt for the dividend option. Alternatively, you can invest in an income fund that usually buys bonds and other debt instruments that pay interest regularly. These interests are then passed on to investors by way of regular dividends.

2.       Expenses ratios and management fees. Mutual Funds make money and pay for the expenses involved in managing the investment by charging fees from the investors. There are SEBI mandated limits on the total fees that mutual funds charge, but overall charges or the total expenses ratio (TER) can be as high as 3 per cent or as low as 0.2 per cent depending on the kind and nature of the fund and its investment style. 

As a general rule, actively managed equity schemes have higher TER while debt funds have lower TER. Passive equity schemes or ETFs also have a much lower TER than actively managed diversified equity schemes. 

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But this also depends on your investment horizon. If you are investing to meet finances that are a few months or a few years down the road then TER becomes more important compared to scenarios where you are investing for 10 years or more.

3.       The fund’s reputation or its past performance. In financial markets, past performance is not a guarantee for future success but it's an important criterion to weed out undesirable funds from your list. You can follow a nuanced approach and look for the fund performance during various phases of the market, say during the February to March 2020 sell-off and the subsequent rally from April 2020 to October 2021. 

Also, compare and contrast the fund performance in the last six months with the movement in benchmark indices such as the BSE Sensex or the changes in the interest rates. It will provide you with an insight into the investment style and philosophy of the fund manager. It helps you match the fund with your investment goals, risk tolerance and investment horizon. But remember, past performance should not be the sole criteria to select a fund.

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4.       The fund size or its Assets Under Management (AUM). Theoretically, a fund size or its assets under management (AUM) has no impact on its performance or ability to generate higher returns and meet its investment objective. This is especially true of equity schemes. Empirical data however suggest that some funds get too big and they begin to lag behind their peers in terms of generating returns. 

This is because big funds are by necessity forced to invest in top companies that dominate the benchmark induced by their market capitalisation.

Conversely, smaller funds tend to be volatile and their performance can be greatly influenced by big swings in the stock price of one or two stocks in their portfolio. Given this, it's best to invest in mid-size funds that are neither too big nor too small.

So to conclude, invest in a mutual fund that meets your investment goals, fits your risk appetite, charges a low expense ratio, and has a good track record but is neither too big nor too small. 

Happy investing!

(Karan Deo Sharma is a Mumbai-based finance and equity markets specialist).

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