Mutual funds are a preferred choice among investors today owing to their attractive returns and diversified portfolio. However, as an investor one must remember that no single scheme or set of schemes is suitable for everyone. A suitable mutual fund scheme for an investor is the one which suits his/her investment objective and risk appetite among other factors.
Selecting a mutual fund is a 2-step process – selection of the mutual fund category and selection of a scheme in that category. Here are the factors which an investor should consider while selecting a mutual fund scheme:
Factors for Selecting a Mutual Fund Category
1) Investment Objective
Investment objective refers to an investor’s financial goal which he/she aims to accomplish with the mutual fund investment. The investment objective can be any short-term or long-term financial aspiration of the investor – buying a house/car, financing children’s higher education, going on a vacation, retirement, etc.
2) Time Horizon
Time horizon refers to the time period for which an investor wishes to keep his/her money invested in a mutual fund scheme. It can be either as short as 1 day or as long as more than 5 years. Different fund categories work best for different time horizons. This is because some funds invest in shorter dated debt and others invest in longer dated debt. Equity funds should ideally be chosen if the investment horizon is more than 5 years.
The market can be highly volatile in the short term but tends to provide higher earnings growth over time. The below is a ready reckoner of fund categories for different time horizons:
|1 day – 3 months
|3 months – 1 year
|Ultra Short-duration Funds
|1 year – 3 years
|3 years – 5 years
|More than 5 years
3) Risk tolerance
Risk tolerance refers to the amount of risk an investor is willing to take with his/her invested money. SEBI in 2015 made it mandatory for all mutual fund houses to display a riskometer which consists of 5 levels of risk associated with the invested principal amount. The 5 risk levels are – low, moderately low, moderate, moderately high, and high. The table below gives you the fund categories that are most suitable to different risk levels and time horizons.
|Short Duration (up to 3 years)
|Liquid Funds, Ultra Short-duration Funds
|Medium Duration (3 years – 5 years)
|Balanced Advantage Funds
|Equity Hybrid Funds
|Long Duration (5 years and above)
|Large Cap Funds
|Mid Cap Funds, Small Cap Funds
Factors for Choosing Best Mutual Fund Scheme
After selecting the mutual fund category on the basis of investment objective, time horizon and risk tolerance, choose a mutual fund scheme within that category on the basis of the following factors:
1) Performance Against Benchmark
A benchmark index of a mutual fund scheme is a standard against which its performance and stock allocation are compared. The benchmark index guide the investment philosophy of the scheme. Thus, the asset allocation of a benchmark index should match the investment objective of the scheme. For instance, the benchmark index of a large cap mutual fund should be an index of large cap stocks and the benchmark of a mutual fund focussed on banking stocks should be a banking index.
SEBI has also mandated that mutual funds use the Total Returns Index (TRI) variant of indices as their benchmarks. TRIs are built on the assumption that dividends are reinvested in mutual funds as and when they are declared. In other words, the account for the fact that companies declare and pay out dividends. This makes them better benchmarks than ordinary Price Indices (PI).
2) Performance Against Category
Another factor which is equally important to assess while selecting a mutual fund scheme is its performance in comparison to its active peer group. This helps in getting a holistic understanding of the fund’s performance. This comparison should only be among the same type of mutual fund schemes. For instance, a large cap equity mutual fund can only be compared with other large cap mutual funds and not against mid cap funds or debt funds.
3) Consistency of Performance
A good mutual fund is one which is able to generate good returns for its investors consistently over a period of time and not just whirlwind returns. The fund should be capable of providing consistent returns in both bullish and bearish periods of the stock market.
4) Fund Manager’s Experience
Another important factor to be considered while selecting a mutual fund is the performance of its fund manager and how long he/she has been at its helm. For this, an investor should look at the fund manager’s experience with the fund in question and with other funds currently managed or managed in the past by him/her.
5) AMC Track Record
An Asset Management Company (AMC), also known as fund house, is the company which manages a mutual fund scheme. For example, HDFC Mutual Fund is the name of the AMC which manages schemes like HDFC Equity, HDFC Top 100 or HDFC Small Cap Fund. Many decisions are made at AMC level by the Chief Investment Officer (CIO) of the AMC. A poorly selected stock is often present in several schemes owned by an AMC, because the selection has been made at AMC level. Thus, it is important to check the track record of an AMC while selecting a mutual fund scheme.
6) Scheme’s Assets Under Management (AUM)
The AUM of a mutual fund scheme refers to the value of assets under its management. In other words, it simply means how many subscriptions the scheme has received. In the equity category, especially in small cap funds, a large AUM can make it hard for the fund to enter and exit companies. On the other hand, larger sizes of AUM is favourable in case of liquid and short term debt funds as it makes the fund less vulnerable to redemptions made by large investors.
7) Expense Ratio
The expense ratio of a fund reflects the fee charged by a AMC for the administration, management, promotion and distribution of a mutual fund. All expenses incurred in the running of the fund are included in this figure. This figure is capped at 2.25% of the total fund assets by capital markets regulator SEBI (Securities and Exchange Board of India). Direct plans of mutual fund schemes have lower expense ratio than the regular plans because no distribution commission is paid in the case of direct plans. In general, lower the expense ratio, the higher are the net returns of a mutual fund scheme.