Are you shopping for mutual funds and are confused by a plethora of options that exist in the market? In that case, it is always advisable to take a step back and answer the following questions that will aid the screening and selection process to find the fund you need and steer your investment journey in the right direction.
1. How to find the right match between my financial goals and the fund?
Self-reflection becomes paramount in this case. One needs to analyse and understand their financial goals/aims/objectives, risk appetite and the time horizon that they would want to stay invested in the fund.
The investment objectives typically fall into 3 categories, namely – Growth, Capital Preservation and Income generation. These are also determined by the life stage of the investor coupled with other factors. Being clear with the investment objective becomes important as there are no investment vehicles that satisfy or balance all the objectives of all the categories together.
For example, an investor whose objective is growth would be open to investing in small-cap funds which have high volatility and offer high returns. Whereas an investor who is investing for capital preservation would not be comfortable with this fund due to its range of volatility or market fluctuations.
2. What are my expected returns over a period of time?
Past performance is not an indicator of the future performance of a fund. However, an average return provided by the fund over a period of 5 and 10 years gives the investor a broader perspective of the fund’s performance during the course of the market cycles – factoring in the fund’s stability.
It also aids in comparison across various options that are in the market. The performance in a market up-turn should be analysed in conjunction with the performance of the fund in a market downturn, assessing its capability to minimise the losses in that period.
Any fund which has beaten the benchmark over a period of time must be considered as a potential fund for investment. However, the investment objectives and sectors that the fund is invested in, are also some of the factors that are to be considered.
3. What is my cost/expense?
This is determined by the expense ratio, which is the fee charged by the mutual fund to manage your assets on your behalf to provide you with the desired returns. This could also include commission and distribution in case of a regular plan.
When there is a buy/sell in the assets of the portfolio of the fund – also called churning, the investors bear the brokerage fee. It has been observed through research and simple mathematical calculations that a fund with a smaller expense ratio is bound to provide a higher return over a long period of time – where these seemingly minute differences add up to a large difference in your portfolio.
For example, let’s say that a sum of Rs 50,000 was invested initially. After 30 years, one can observe that the fund with the least expense ratio amounted to the largest corpus, whereas the fund with an expense ratio of 1.5% amounted to a corpus that was approximately 2.5 lakhs lesser than its highest peer. Hence, it’s always advisable to compare the expense ratio across the funds before making your choice.
4. Does the fund offer any tax benefits?
One can invest in Equity Linked Saving Schemes (ELSS) that fall under the category of funds that can be claimed for tax benefits under Section 80C of Income Tax Act 1961, where one can save up to Rs 1.5 lakhs per year.
ELSS invest the pool of money from the investors into equity and equity-related instruments. However, there is a lock-in period of 3 years in the case of these funds.
5. What is the time period/time horizon that I should stay invested in the fund?
The choice of the fund also depends on the time horizon that you plan to stay invested for with the fund. If you need liquidity in the next 2-3 years, you could invest in a debt fund for this short-term goal.
However, if the fund is for retirement planning or to fund the educational expenses of your child – long term goals, you could invest in equity funds that beat inflation and provide high returns.
6. What is the composition of the fund? (what does it consist of?)
Once the self-reflection is completed and when you have clarity on your objectives, risk appetite and time horizon, you would want to dig deeper into the composition of the fund. This is an important exercise as the investment strategy of the fund may sometimes not align with your desired objective.
For example, if an investor had narrowed down his investment objective to capital preservation, there are n number (n being a large number) of equity funds that are invested into large-cap companies which would align with the risk appetite of the investor (low risk, stable return).
Despite being under the same umbrella, the fund houses could have different strategies and specific choices of sectors or specific stocks for their large-cap funds – one of the funds could be investing predominantly in pharma or Infrastructure or could be following a weighted average pattern of the index.
This allocation amounts to differences in the returns provided by each of the funds. As an investor, it becomes important to look under the hood and ensure that the funds’ objectives align with your personal self.
7. Who is managing the fund?
Once you have narrowed down the funds, another factor to consider would be to check who would be managing your fund. Mutual funds are considered as instruments that have an active investment strategy, i.e., the fund manager takes decisions on where and how much to invest. The fund performance is hence linked to its manager.
Despite the management of funds being process-oriented, it is always beneficial to check the track record of the fund manager. Though past performance is not an indicator for future returns, a strong track record establishes a sense of comfort and trust in the minds of the investor instead of the one which has a stellar performance for 2 years and underperforms in the next few years.
The investor of today is drowning in the ocean of choices with the sheer volume of the funds available in the market. Selecting a fund becomes a herculean task in these times. However, an investor should spend time on the above questions, evaluate and analyse the options available according to his/her investment objective, risk profile. Understanding these nuances and making pros vs cons chart for each of the options aids in sailing smoothly over the tides of the market.