Top five tips to pick good mutual funds

Are you interested to invent in mutual fund schemes but confused by the different types available in Indian market? Read this article and understand the basis of selecting schemes suitable for your individual needs.

People are nowadays willing to take a little bit more risk to get better returns than the returns from fixed-rate instruments, from their investments. For this purpose, mutual fund schemes are the most preferable investment vehicle, which are managed by professional managers with all modern tools and techniques. However, investors generally become very confused to choose a particular mutual fund scheme from thousands of such schemes. Getting confused, either they do not invest in mutual funds, or choose wrong fund schemes which do not suit their purposes. In the subsequent part of this article, an attempt has been made to explain the specific criteria by which an investor should choose mutual fund schemes which suit his purpose.

Identifying goals and risk tolerance

Before acquiring units in any fund, an investor must first identify his/her goals In respect of the money being invested. Are long-term capital gains desired, or is a current income preferred? Will the money be used to pay for college expenses of the son, or to supplement a retirement after ten years or so? Identifying a goal is important because it will enable the investor to drastically cut down the list of more than 2000 mutual fund schemes available in the public domain in India. In addition, investors must also consider the issue of risk tolerance. Is the investor able to afford and accept volatile swings, or is a more conservative investment oriented? Identifying risk tolerance is as important as identifying a goal. Finally, the issue of time horizon must be taken care of. Investors must think about how long they can afford to lock their money, or if they anticipate any liquidity-related issue in near future. This is because mutual funds have exit load and that can take a considerable portion out of an investor's return over a short period of time. Ideally mutual fund unit-holders should have an investment horizon of at least five years or more.

Types of mutual fund

If the investor intends to use the money in the fund for a longer-term need and is willing to withstand a fair amount of risk and volatility, then the style or objective he/ she may be suited for is a long-term capital appreciation fund. These types of funds hold a high percentage of their assets in common stocks and so they are volatile in nature. They also carry the potential for a significant appreciation of assets over time. On the other hand, if the investor is in need of current income, he/she should acquire units in an income fund. Government and corporate debts/bonds are the two most common holdings in an income fund. When an investor has longer-term need but is unwilling to assume substantial risk, a balanced fund which invests in both stocks and bonds, is the best alternative.

Charges and fees levied by schemes

Mutual funds earn money by charging fees to the investor. It is important to have an understanding of the different types of fees that an investor may face when purchasing an investment. In India, exit load is a significant factor. If the investor withdraws the entire amount or part invested in a mutual fund scheme prior to the minimum holding period mentioned in the information document, he/she has to pay a pre-determined exit load. So, quick withdrawal may cause less appreciation of investment. Furthermore, the investor should also look for the management expense ratio. In actuality, management expense ratio can itself help clearing up any confusion in this regard as it relates to sales charges. The ratio is simply the total percentage of fund assets that are being charged to cover fund expenses. The higher the ratio, the lower is the investor's return.

Evaluating fund managers and past results

As with all investments, the investors should carefully check the fund's past results. To ensure objectivity, perspective investors should ask themselves following two questions when reviewing the mutual fund schemes:
1. Did the fund manager deliver results that were consistent with general market returns?
2. Was the fund more volatile than the big indexes (did the past returns of the scheme vary dramatically)?
This information is important because it gives the investor insight into how the portfolio manager performs under certain conditions, as well as what historically has been the trend in respect of turnover and return.

Size of a fund

Generally speaking, the size of a fund does not restrict its ability to meet the fund's stated investment objectives. However, occasionally a fund can grow too big over time. But how big is too big? There are no benchmarks in this regard, but a fund with asset of more than Rs. 5000 crores or so makes it difficult for a fund manager to acquire a position in a stock and dispose it of without drastic variation in its market price. It also makes the process of buying and selling stocks with anonymity very difficult.

Selecting a mutual fund may seem to be a very difficult task, but knowing the objectives and risk tolerance is half of the battle for an individual investor. If the investor follows the principles mentioned above, he/she would be able to choose appropriate mutual fun schemes suitable for his/her objectives and risk potential and earn significantly better returns than fixed-market investment instruments in the long run.

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