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Are you someone who is looking for investment strategies for how to select best mutual funds but lacks clarity on your investment goals, time horizon, risk appetite and mutual fund performance comparison to other investment tools? If so, you are on right track for your investment plan. In this blog, we will discuss how to choose mutual funds and guide you in the right direction.
Choosing best mutual funds is important for any investor who is looking to grow their wealth while managing risk effectively. With thousands of options available process can seem confusing but it does not have to be.
It is all about following the right process. Mutual funds are investment products where many people put their money together and professionals manage it to reach certain goals.
First, you need to understand the different types of mutual funds available which include growth funds, income funds, liquid funds, ELSS etc. Each type serves different purposes and comes with varying levels of risk and return potential.
Remember there is no one size fits approach, so take your time and choose wisely.
Before moving forward to understand key factors while selecting a mutual fund category understand the different types of mutual funds each focuses on a specific part of the market or investment strategy.
Criteria for Choosing the Top Mutual Fund Type
- Large cap funds: These funds invest in large well known companies that are worth at least $10 billion in the stock market.
- Small cap funds: They primarily target smaller companies, typically valued between $300 million and $2 billion in the market.
- Value funds: These funds look for undervalued stocks, meaning they're believed to be worth more than their current market price.
- Growth Funds: Growth funds invest in companies that are growing quickly aiming to increase their value over time. These funds often target companies with a high potential for long term capital appreciation even if they have a relatively high P/E ratio.
- Income Funds: These funds aim to provide regular income to investors through dividends or interest payments, they invest in dividend paying stocks.
- Tax Saving Mutual Funds (ELSS): These funds invest in equity and offer tax benefits under Section 80C of the Income Tax Act. They carry higher risk but can provide good returns if the fund performs well.
- Liquid Mutual Funds: These funds invest in short term securities like commercial papers and treasury bills, focusing on providing liquidity rather than high returns. They are low risk options suitable for short term investing needs.
Choosing a mutual fund involves considering two main factors: first, you assess the key factors related to the category of mutual fund you want to invest in and then you evaluate the specific factors of individual funds within that category.
Key Factors While Selecting A Mutual Fund Category
When it comes how to select best mutual fund category there are a few key factors to consider that can make a big difference in reaching your financial goals.
1. Investment Goal
Before putting your money into any investment it’s important to figure out what you’re aiming for. Are you looking to make money over the long time or do you need regular income right now? Are you saving up for your kids’ college or planning for retirement down the road? Defining your goal helps narrow down the many investment options out there. Your goal could be anything from buying a home or car to funding your children’s education or enjoying a comfortable retirement.
Once you know why you’re investing, it’s easier to pick the right type of investment. You might go for something like stocks or bonds or maybe a mix of both depending on what fits your goal.
For example, if your objective is to grow money over time you might opt for stocks. If saving on taxes is a priority you might look into options like tax saving funds.
2. Time Horizon
Time horizon just means how long you plan to keep your money invested in a mutual fund. It could be really short a day or longer over five years. The type of fund that’s best for you depends on how long you want to invest.
If you are thinking short term like less than a year, you might want to look at something called liquid funds or ultra short duration funds. These are good for shorter timeframes because they invest in things like short term debt.
If you’re thinking a few years between one to three years short duration funds could be a good fit.
For longer term goals of more than five years you might consider equity funds. These tend to have a higher potential for growth over time but they can also be more volatile in the short term.
When deciding how long to invest think about whether you might need your money soon. Keep in mind that mutual funds often have fees when you buy or sell them so it’s best to plan to hold onto your investment for at least five years to minimize these costs. What are these costs we will discuss further just wait and keep reading.
The market can be unpredictable in the short term but historically it has shown higher returns over longer periods. Here’s a quick overview of which types of mutual funds are typically better for different time horizons:
| Time Horizon | Mutual Fund |
|---|---|
1 day - 3 months | Liquid Funds |
3 months - 1 year | Ultra Short-duration Funds |
1 year - 3 years | Short-duration Funds |
3 years - 5 years | Hybrid/Balanced Funds |
More than 5 years | Equity Fund |
3. Risk Appetite
When thinking about investing, it’s crucial to assess how comfortable you are with the possibility of your investment fluctuating in value. Are you someone who doesn’t mind taking risks or do you prefer to play it safe and stick with more stable options? Understanding your risk appetite is key to making informed investment decisions that align with your financial goals and personal preferences.
Considering the importance of assessing risk, SEBI mandated in 2015 that all mutual fund houses display a riskometer. This tool provides investors with a clear indication of the level of risk associated with their investment ranging from low to high. By understanding where you fall on this risk scale you can make more informed decisions about which investments are suitable for you.
- Equity mutual fund: If you invest in mutual funds that focus on stocks (equities) your investment might go through ups and downs because the stock market can be unpredictable. However over time you could potentially make a lot of money with these types of funds especially if you're willing to leave your money in for a long time and can handle some risk.
- Debt mutual funds: If you invest in mutual funds that focus on government bonds or corporate bonds (debt) your investment is likely to be more stable. But the trade off is that you might not make as much money compared to stocks.
Key Factors While Selecting A Mutual Fund Scheme
After you’ve figured out which type of mutual fund matches your investment goals, time frame and risk tolerance. Here is the time to pick a specific one within the various mutual fund schemes on the basis of the following factors:
Benchmarking Performance
Comparing a mutual fund’s performance to a benchmark helps investors see if it’s meeting its goals or not, if a mutual fund focuses on large companies its benchmark would also include large companies.
SEBI requires mutual funds to use the Total Returns Index (TRI). These benchmarks consider not just the stock prices but also any dividends reinvested back into the fund. This makes them a more accurate measure of performance.
It’s essential to assess a fund’s performance over a period, to see how it performs across different market conditions. If a fund consistently underperforms its benchmark over three, five, seven or ten years it might not be a wise investment choice.
Performance vs Peer
Assessing a mutual fund’s performance involves considering how it performs up against peer funds in the category. This comparison helps us understand how well the fund has performed overall. It’s important to compare apples to apples, like large cap equity mutual funds with other large cap funds not mixing them up with mid cap or debt funds.
Performance Consistency
When choosing a mutual fund, it’s crucial to look beyond just high returns consistency is key. It should be able to deliver steady returns even when the stock market is experiencing both upward and downward trends.
Let’s compare two funds. Fund A shows returns of 9%, 9.5% and 10% over three years. Fund B, displays returns of 12%, 1% and 5.5% during the same period. Fund A’s consistent performance makes it a better choice.
When evaluating a fund’s track record it’s important to ask yourself a few key questions:
- Did the fund manager consistently match or outperform the overall market?
- Was the fund’s performance more stable compared to major market indexes?
- Did the fund have a high turnover rate, which could lead to increased costs and tax implications for investors?
Fund Manager Experience
When you’re choosing a mutual fund, it’s important to consider the experience of the fund manager. Look into how long they’ve been managing the fund you’re interested in as well as any other funds they currently manage or have managed in the past.
A skilled fund manager will make a big difference in how well a mutual fund performs. They’re responsible for deciding where to invest the fund’s money and how to allocate it among different stocks or securities. If they are experienced then there is a chance that they can take a poorly performing fund and turn it into a top performer. On the other hand, if the manager isn’t efficient the fund might not do as well. By being cautious and paying attention to the manager’s track record, you can find mutual funds that are a good fit for you.
In today’s digital age it’s easier than ever to keep track of your investments. Whether through your broker, apps or financial publications you can monitor performance and portfolio updates effortlessly.
Expense Ratio
Expense ratio of a mutual fund shows the fee charged by the fund’s managers for handling and running the fund. This fee covers various expenses like administration, management, advertising and distribution. SEBI sets a limit of 2.25% of the total fund assets for this figure. When you compare direct plans to regular plans direct plans usually have a lower expense ratio because they don’t pay distribution commissions. If the expense ratio is lower the mutual fund scheme tends to offer higher net returns.
Choose mutual funds with a lower expense ratio because even though the percentage might seem small but it can have a big impact when applied to your entire investment portfolio. The expense ratio depends on the Assets Under Management (AUM) with higher AUM typically leading to a lower expense ratio.
Entry and Exit Load
Entry load is the fee charged by fund houses when investors invest in a mutual fund, whereas exit load is the fee charged when investors redeem their investment within a short period.
This fee is to discourage quick exits and the immediate outflow of cash from fund houses. However, most fund houses have removed entry loads. As an investor it’s wise to choose mutual fund schemes with zero or minimal entry and exit loads.
Fund Size
When we talk about the size of a mutual fund we’re referring to how much money it manages. Some people believe that bigger funds are better but that’s not necessarily true. What really matters is the fund’s performance. If a smaller fund has a better track record than a larger one it may be a better choice for investors.
When a fund does well, more people may invest in it. But just because a fund is big doesn’t mean it’s the best choice. Investors should pay attention to how well the fund performs
Taxes
When you invest in stocks or mutual funds and earn money, you need to pay taxes on those earnings. The tax rate depends on how long you’ve held onto your investment. Equity funds incur a 10% tax on Long Term Capital Gains (holding period of 12 months or more) exceeding Rs 1 Lakh, while Short Term Capital Gains ( less than 12 months) are taxed at 15%.
In this blog, we try to answer how to select best mutual funds, readers are advised to follow the criteria for selection of mutual funds that fit your goals or consult a professional adviser.
