7 Factors to look for before Selecting the Best Mutual Fund
Created on 28 Nov 2023
Wraps up in 6 Min
Read by 1.3k people
Updated on 29 Nov 2023
I'm sure you've heard people talking about mutual funds and how they can grow over time, haven't you? No doubt, mutual funds are the real deal. What's even better is that getting into them is much simpler compared to handling the unpredictable nature of the stock market.
Wondering why? Well, we've got these financial experts, our very own "sahayak" fund managers. They handle all the research and allocation work, giving you a more chill, bindaas experience. Stress? Woh kya hota he? 🤷♀️
Let's chat about the essentials you want to tick off your list before leaping into any mutual fund scheme. Think of it as your mutual fund investment checklist- 🖐️✌️crucial things to cover.
But hang on a second! Before that, I suggest giving our article on "How to Build a Good Mutual Fund Portfolio?" a quick once-over, more like a warm-up before starting.
First, pick the right mutual fund category, and then select the perfect scheme within that category. Alright, are you ready for the breakdown?
In this article, we’ll cover both! Let’s start by…
How to select a Mutual Fund Category?
There are three things that will help you determine the correct category of mutual fund for you. The following are the factors that an investor should consider when choosing a mutual fund scheme:
1. Investment Objective
The term "investment objective" refers to a financial goal that an investor hopes to achieve through mutual fund investment. The investment objective can be any short-term or long-term financial goal of the investor, such as purchasing a home/car, financing children's higher education, taking a vacation, retiring, and so on.
Just in case you don’t know, we have Recipe by Finology, the all-inclusive financial planning tool helps you determine what kind of an investor you are, which will help you design a portfolio.
2. Time Horizon
The time horizon refers to how long an investor wishes to keep their money invested in a mutual fund scheme. It can be as short as one day or as long as five years. For various time horizons, different fund categories perform best. This is due to the fact that some funds invest in shorter-term debt while others invest in longer-term debt. Equity funds should be considered if the investment horizon is longer than five years.
In the short term, the market can be extremely volatile, but it tends to provide higher earnings growth over time. Take a look at the table below for the list of fund categories for various time horizons:
1 day - 3 months
3 months - 1 year
1 year - 3 years
3 years - 5 years
More than 5 years
Lastly, we have the…
3. Risk Tolerance
The amount of risk an investor is willing to take with their invested money is referred to as risk tolerance. SEBI mandated in 2015 that all mutual fund houses display a riskometer with five levels of risk associated with the invested principal amount.
As you can see in the above image, there are five risk levels:
- Moderately Low
- Moderately High
So, after deciding on a mutual fund category based on investment objectives, time horizon, and risk tolerance, let’s move on to…
How to Select a Mutual Fund Scheme within that category?
Here is the 7-pointers checklist for you 👇
1. Performance against Benchmark
You know how our parents always talk about "Sharma ji ka beta" as the golden standard? Well, mutual funds have their own version of that called a Benchmark Index. It's like the mutual fund's role model – the standard against which we measure its performance and stock choices.
Think of it as the fund's guiding philosophy. The Benchmark Index reflects what the fund aims for. Confused? Let me give you an example to explain things in a better manner. So, if you've got a large-cap mutual fund, its benchmark should be an index of large-cap stocks. And if it's a banking mutual fund, the benchmark should be a banking index, not something like an IT index.
Next up is the…
2. Performance against category
When choosing a mutual fund scheme, comparing its performance to its active peer group is necessary. This aids in gaining a comprehensive understanding of the fund's performance. This comparison should only be between mutual fund schemes of the same type. Because…
For example, a large-cap equity mutual fund can only be compared to other large-cap mutual funds and not to mid-cap or debt funds. Duh! 🤷♀️
3. Consistency of Performance
A good mutual fund is one that can consistently generate good returns for its investors over time rather than just whirlwind returns. The fund should be able to provide consistent returns during both bullish and bearish stock market periods. So check for that as well! Up next is…
4. AMC track record
A mutual fund scheme is managed by an Asset Management Company (AMC), also known as a fund house. For example, SBI Mutual Fund is the AMC that manages schemes such as SBI Equity, SBI Top 100, and SBI Small Cap Fund.
The Chief Investment Officer (CIO) of the AMC makes many decisions at the AMC level. Because the selection is made at the AMC level, a poorly chosen stock is frequently present in several schemes owned by an AMC. When choosing a mutual fund scheme, it is critical to look at an AMC's track record.
5. Scheme's Assets Under Management (AUM)
A mutual fund scheme's AUM refers to the total value of Assets Under Management. In other words, it simply indicates the number of subscriptions received by the scheme. A large AUM in the equity category, particularly in small-cap funds, can make it difficult for the fund to enter and exit companies.
Larger AUM sizes, on the other hand, are advantageous in the case of liquid and short-term debt funds because they make the fund less vulnerable to redemptions by large investors.
6. Fund Manager's Experience
Another important factor to consider when selecting a mutual fund is the fund manager's track record and length of tenure. For a smart investment move, think about the fund manager's experience with the specific fund you're eyeing. Also, take a peek at their track record with other funds – both current and past.
And, as the saying goes, saving the best for last!
7. Expense Ratio
Let me quickly explain what an expense ratio is. It basically shows how much an investment firm charges investors to manage a portfolio, a mutual fund, or an Exchange-Traded Fund (ETF). The ratio represents the fund's total management fees and operating costs.
Now, you might wonder what the ideal number for it is. Well, considering the expense ratio, it should ideally be between 0.5% and 0.75%. Expense ratio greater than 1.5% is considered to be high.
And that wraps up our journey through the article. These are the fundamental aspects you definitely want to keep in mind.
The Bottom Line
You will be good to go if you take the help of the above pointers before selecting the scheme. If you are a person jo baal ki khaal nikalta he, then for further comparison, we would bifurcate the following schemes into Equity, Debt and Hybrid and then compare the P/E Ratio, P/B Ratio, Alpha, Beta, Sharpe, Sortino Ratio. But let’s keep that for the next time!
Until then, Happy Investing, and don’t forget to keep checking Insider by Finology for new articles every week.
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