How to choose the right mutual fund scheme?


A mutual fund pools the funds of innumerable investors to invest in shares or securities defined by the asset allocation policy of the mutual fund scheme. Are you also planning to invest your hard earned money in mutual fund scheme? Then, read this article for an in-depth understanding of how to select the right mutual fund scheme to avoid losses and earn profits.

Mutual funds are the best option for an investor who wishes to invest in the stock market but is wary of the risks involved in share market transactions. An investor can outsource of investing his funds in various stocks to a fund manager in a mutual fund house instead of struggling to invest through his own efforts. The fund manager identifies the right stocks and invests as per the asset pool and allocation pre-determined at the time of offer of the mutual fund scheme. But does the responsibility of an investor end at this stage?

No, this is just the beginning of intent. Choice of a mutual fund is as risky as choice of stocks to be invested in as one wrong decision can bring the returns of the entire portfolio down. Choice of the right mutual fund scheme can be a very cumbersome and research oriented process.

The mutual fund houses have moved from simple equity and debt schemes. There are innumerable mutual fund schemes floated in the market with complicated names like fund of funds, hybrid funds, speciality funds, opportunities fund, Sectoral funds, progressive theme funds and so on. An investor has to tread very cautiously in this market in order to gain through the mutual fund investment.

How to analyse various mutual fund schemes in the market and choose the best ones among them? Most of the fund advisors stress on historical performance as they do not have many parameters to show the performance of their fund. The choice of mutual fund based on short term performance can be a very bad idea and a wrong decision. Performance at micro levels are not very significant in determining the long term future performance of the fund as the market conditions vary with every year and investment decisions are modified accordingly.

How to choose the right mutual fund scheme


Fund size


The corpus size of the mutual fund scheme can be the first factor to choose a fund. A fund should be neither too small nor too big. Too small funds tend to have higher operational costs as compared to bigger mutual fund schemes. Moreover, the flow of market information ahead of the market comes late than the large fund houses as the big research institutions and corporates do not give more importance to small funds.

Similarly, a large size fund can be a problem while the fund house tries to invest in small scrips in the market. They shall not be able to do so without creating a furore in the market about the price movement of the fund. Hence, the large sized mutual funds mainly invest in large cap companies and move in tandem with the market index. The portfolio of large funds is a reflection of the index in its entirety.

The historical performance is also a proof of this choice. Small sized funds record a smaller percentage of growth and large sized funds tend to taper once the AUM(Assets under management) crosses the 3000 crore target.

Criteria for choice of fund

An investor should choose mid-size funds which can have the advantages of both worlds. They have the cost-benefit factor and also ease of investment in small and mid-size company scrips in the market.

Fund house performance record


The second critical factor affecting the choice of a mutual fund is the track record of the mutual fund performance. The fund house and its team managing the investments play a major role in selection of stocks for investment. If the price moves ahead after purchase of the stock by the fund house, then the Net Asset value of the fund increases resulting in profits and more dividends to the investors. The skill and expertise of fund managers and his team has a great role in performance of the mutual fund scheme and that is primarily the reason for certain mutual fund schemes churning profits year after year.
The performance of a fund manager can be tracked to assess the choice of the mutual fund scheme. If the fund manager has a bad reputation of wrong choice of funds, then it can be easier for an investor to totally avoid the fund. Sometimes, fund performance suffers when certain fund managers leave the organisation. Hence, depending totally on an individual capacity can also be hazardous at times.

An investor should look for a fund house which has its processes and criteria of selection clearly laid-out and have not much to do with the fund manager’s discretion alone. The fund house will never deviate from its policies and risk approaches without any concern about the perception of the fund manager.

Criteria for choice of fund

An investor should invest in a fund when the above parameters are clearly ticked as positive.

Investment objective of the fund


Every investor has a certain goal in mind while planning to invest in a mutual fund scheme. The investment objective of the fund should match with the goals of the investor. The investment objectives of a mutual fund scheme can be tax planning, regular income, high returns, dividend growth, capital appreciation, long term planning and so on.

  • Equity funds are more appropriate for tax planning;

  • Short term debt mutual funds are appropriate for regular income;

  • Tax planning mutual funds are appropriate for tax exemption goal;

  • Closed ended equity funds are appropriate for long term planning and capital appreciation.


Criteria for choice of fund

An investor should choose the mutual fund scheme which is conducive to his goals in mind.

Fund performance


The historical performance of a fund might not be a reflection of its future performance. However, the performance of a fund can be compared to its benchmark and in comparison with its peers in the same segment in the share market.

Peer performance involves comparison of the returns of the fund with the performance of same category of funds. The comparison of a large cap fund cannot be made with a mid-sized fund even if the investment objective appears to be similar. Past performance helps an investor assess the fund management quality and fund manager expertise in managing the mutual fund scheme.

The choice of stocks and ability to time the stock market can be judged by comparing the performance of the fund with that of the benchmark set for the fund. Funds performing better than the benchmarks are considered ‘out-performers’ while those which give lower than the benchmark returns are known as ‘under-performers’.

Criteria for choice of fund

An investor should check the fund performance vis-à-vis its peers and the benchmark once the three conditions are fulfilled.

Risk profile of the fund


A fund manager would have generated very high returns but there cannot be any return in stock market without risks involved in it. The investor should definitely factor the risks taken by the fund manager in achieving the returns from the mutual fund scheme.

A fund can never perform alike in all market cycles. Funds get affected by movement in stock markets; some perform well during a bull phase and some during the bear phase. Funds which are considered top performers in a given phase might turn out be under performers in the next market cycle. An investor should consider the standard deviation of the mutual fund which measures the volatility and risk that the fund carries with it.

Criteria for choice of fund

An investor should opt for mutual fund schemes with relatively lower standard deviation as that would be under the category of standard performers.

Costs of the fund


Cost of a mutual fund involves the operational costs and the administrative costs for maintain the fund, selling and advertising costs, audit fees and custodian expenses. The fund expense ratio is a measure of the cost factor involved in a mutual fund scheme. This ratio is available on the website of the fund house under the details of the specific fund and also in the annual report of the fund house.
There are two types of costs involved in a mutual fund scheme.

  • Expense ratio

  • Exit load


The expense ratio of the mutual fund should be compared with the funds in the same category to judge the long term savings to the investors with respect to diversion of investment amount to meet the costs and multiplied by effect of compounding.

Exit load is the charge paid by an investor while leaving the fund. Mostly the exit charges are applicable up-to 1% if the investor exist the fund within one year of investing in the fund.

Criteria for choice of fund

An investor should choose the mutual fund scheme which has a lower expense ratio as compared to its peers in the same category of mutual funds and invest for a long time horizon.

Conclusion


Many people invest in mutual fund schemes based on opinion of experts which can prove hazardous in the long run. An investor should consider the expert opinion but also cross-check the returns and performance based on the five parameters listed above. If the analysis of a fund appears difficult for an investor, the services of a mutual fund advisor can be taken to invest in the fund appropriate to the needs and goals of the investor.


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Comments

Author: Partha K.18 Jun 2017 Member Level: Platinum   Points : 4

A very useful article from the author. In this article, the author has mentioned various factors which are required to be taken into account for choosing suitable mutual fund scheme(s). The present article has covered some of the factors. I am briefly mentioning some more factors which must be taken into account for short-listing/selecting mutual fund scheme:-

(a) The goal and time horizon of the investor: This is the most important factor for choosing mutual fund scheme. As a thumb rule, it can be stated that if the goal is more than 5 years away, the investor must go for equity-based scheme. A goal for which time horizon is less than three years, the investors must go for debt oriented hybrid scheme.
(b) Within a particular category, the investors can compare the performance and quality of various schemes by comparing some useful ratios, like Alpha, Beta, R-squired, Standard Deviation and Sharpe ratio. There are various websites which indicate these ratios for the benefit of investors.

I compliment the author for this useful article. This has been written in a manner which the new investors will find attractive.



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