Mutual funds is a type of investment vehicle wherein an investor’s funds are combined with others investors; who have similar financial goals. The funds are invested into securities like stocks, bonds, money market instruments etc based on the investment objective of the fund. Investing in mutual funds saves time and energy that an investor would spend in creating a well-diversified portfolio.
In India, there are various types of equity and debt mutual funds available-
● Growth funds (sector-specific, index, tax-saving funds)
● Liquid funds
● Debt mutual funds or fixed-income funds
● balanced funds,
● monthly income plans or hybrid funds,
● And gilt funds
Knowing about different mutual funds, where do they invest and how they generate returns is not enough.
While selecting a mutual fund category one must be clear about three things-
Investment objective,
Time,
Risk tolerance
An objective can be children’s education fund, house, car, health, vacation et cetera. An investor must decide for how long he wishes to keep his money invested in a mutual fund scheme. The period can range from one day to 5 years. If the investment period is longer, around 5 years or more, then equity funds are preferred.
Every investor has a different appetite for risk and the choice of mutual fund should resonate with the same. Five levels of risk associated with mutual funds are – low, moderately low, moderate, moderately high and high.
Once these things are clear, an investor can move to the selection of a mutual fund scheme which depends on various factors.
Performance against benchmark index-
While selecting a mutual fund an investor must see performance against the benchmark index. Every mutual fund scheme has a benchmark index against which its performance and stock allocation is compared. The benchmark index is the guiding light for investment. That is why the asset allocation of the benchmark index should reverberate with the investment objective of the scheme. In simpler terms when a mutual fund is focused on FMCG stocks, the benchmark index should be an FMCG index. (The old math saying that goes, ‘you can’t equate onions and tomatoes’)
Comparing the scheme-
The performance of a mutual fund scheme is compared against its peers to understand its competence. Comparison has to happen among the same type of mutual fund schemes to decide which one is better to invest in. (Since you cannot equate onions and tomatoes, you must compare tomatoes and tomatoes to see which one tastes the best)
Return frequency-
Consistency of returns in a mutual fund scheme is an important factor for an investor. A good scheme provides consistent returns over a period and not whirlwind returns. The consistency has to be maintained in both bullish and bearish markets. (Every tomato must taste good)
Expense ratio-
Asset management companies charge fees for the management, administration and distribution of a mutual fund. Any mutual fund scheme will provide higher net returns if the expenses are less. SEBI has capped the expense ratio at 2.25% of the total fund. This expense ratio must be considered while choosing direct or regular mutual fund schemes, to generate maximum net returns (This expense ratio is provided in the fact sheet of mutual funds). Direct plans are lucrative as there is no brokerage cost associated. FIVE CAPITAL provides a range of services on direct mutual funds investing. You can check it out here.
Report card of the AMC-
The track record of AMC and the experience of the fund manager must be kept in mind while selecting a scheme. Poor decisions: be it selecting bad stocks or managing them, can cost money to the investors.
Tax Liability-
It is an important aspect that investors should look at before choosing a mutual fund scheme. Mutual funds are very efficient when it comes to post-tax returns. For equity funds, a tax of 10% and above is levied on long-term capital gains, 15% is levied on short-term capital gains. Debt funds provide indexation benefits for capital gains too.
Entry-Exit load-
It is the fee charged by fund houses when investors exit/enter a mutual fund scheme, though most fund houses have removed the entry load. The investor must select a fund house with minimal or zero exit load to increase net returns.
Takeaways-
1. Mutual fund must be well allocated in debt and equity to get maximum benefit with digestible risk.
2. Choose mutual funds with well managed and professionally run AMC so it maximizes returns and minimizes cost
3. Mutual fund schemes must be compared with market index and peers to gauge its performance. It must provide consistent returns in all market scenarios.