Investing in a mutual fund can be a daunting task. Each mutual fund scheme will have different variations, like growth and dividends plans, complicating the task at hand. Yet there are some simple empirical ways in which an investment decision can be arrived at. Here are some parameters through which the investor can narrow down their search to pick the right fund or scheme:
Goals / Investment horizon
Before contemplating about where to invest, the question the investor should ask is the purpose of the investment. Do you want to buy a house 10 years down the line? Or is it for a new car in the next couple of years? Is it for their children’s education? The goal of the investment will help the investor map out the time required and define their investment horizon. These goals can be then classified as short-term, medium-term and long-term. For example, fund managers will advise investing in equities in the long term. Though past performance does not guarantee future returns, mostly equities have outperformed other asset classes over a duration of five years and above. Different timeframes imply that different types of asset allocation are required.
Risk capacity
Some people are risk averse by nature and will want to play it safe with their hard earned money while other will tolerate greater risk in the prospect of making more money. An individual’s risk appetite is influenced by behaviour, personal situations and market conditions. During a bear market, investors generally are risk averse whereas during a bull market, they are more likely to take risk. However there is an important distinction to be made between a person’s ability to take risk (risk capacity) and the person’s willingness to take on risk (risk appetite). A young adult with a stable income and no liabilities has the capacity to take on more risk but may be unwilling to do so. However, investment decisions cannot be guided by risk appetite alone. There is always a risk-return correlation in finance and unless a person doesn’t take greater risk, s/he may not get higher returns. A rule of thumb that can be followed is to subtract the age of the investor from hundred. The resulting difference can be allocated to equities (riskier) while the remaining can be allocated to non equity products (safer). Thus a 25 year old investor can have 75% in equities whereas the remaining amount can be allocated to non-equity instruments. While this ratio will change for individual investors and they will have to fine tune allocations depending on personal factors like liabilities and income.
Low entry/exit load, expense ratio
The whole point of investing in mutual funds is to beat the returns offered by traditional saving instruments and build wealth. While the fund itself might offer high returns, there are various charges that could bring this down. One of them is the schemes entry and exit load. To put it simply, load is the charge levied by Asset Management Companies or AMCs to compensate the intermediary like the fund distributor. An exit load is levied fund the investor redeems the units. For example if there is an exit load of 1% if the investor redeems his/her units within a year, then 1% of the redeemable amount is deducted by the AMC.
An expense ratio is an annual charge levied by the AMC and consists of fund management fees, registrar fees and marketing expenses. In a nutshell, it is the amount of money the investor pays the AMC to manage the investment. While a fund’s expense ratio is determined by the AMC, the Securities Exchange Board of India (SEBI) has placed limits on how much fund can charge. For equities, the maximum limit is 2.5% whereas for debt it is 2.25%. While these charges may look relatively small, a long term investment in a high expense ratio fund may drastically reduce the returns for the investor. Add that to exit load, and the performance of a fund will be sub-optimal which leads to the next point.
Fund prospectus
For an investor, the fund’s prospectus will help gauge how their investment is performing and where it is headed. The sheer importance can be gauged as the prospectus will list out the investment objectives, strategies, fund manager, past performance, the various charges including the load fees and expense ratios, portfolio ratings and the future outlook. Under SEBI guidelines, every mutual fund house is mandated to make copies of the prospectus available to investors and can be downloaded online.
Fund performance
A mutual fund’s performance should never be looked in isolation but in conjunction with the benchmark indices and the category average. If a fund’s annualised return is around 10% and the market indices are in the same range, the fund’s hasn’t really generated optimized returns. An investment in a fund consistently underperforming than the benchmark indices should be reviewed.
Even if a fund has outperformed the benchmark indices by a decent margin does not necessarily mean others in the same category have not. A look at the category average will help the investor decide to stick with a fund or to switch.
Also an investor should look at the credit rating of the fund which is an indicator at the assets in which the fund manager has invested. A high rating means the likelihood of defaulting is low or none and also indicated timely payments were made. However, credit rating is not indicative of future returns.
Fund Manager
Considering most mutual funds are actively managed, the fund manager is an important aspect while selecting a fund. For a layman, closely tracking the market and piecing through data together is a tedious task. The manager plays the most important role of deciding what to invest in and when. Usually for a fund, a manager and a team of experienced analysts follow every movement of the market to ensure higher returns for their investors. To know more about the fund manager, the prospectus will come in handy as it contains the name and tenure of the fund manager. The past performance of the manager is also available in the factsheets issued by the Mutual Fund Houses.
Understanding the market
Having a fund manager to look after the pooled investment does not mean that the investor should abdicate his or her responsibility. Since every scheme invests across the sectors and in varied industries, an investor should always stay updated on the direction in which these companies are heading. Follow the golden rule of investing- Never invest in companies or business you do not understand. Learn market terms and fundamentals and how they can affect your investment
While one cannot learn market behaviour overnight, it is important to start and continue learning. The avenues are many. Many websites offer online lectures on finance and market fundamentals, literature on mutual funds are extensive and there will always be a friend or colleague ready to explain how they work. Remember, there is no substitute for research.
Disclaimer: Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
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