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Choosing the right mutual fund: Factors to consider

Updated: Sep 25, 2023

Mutual funds have Revolutionised the way individuals invest their hard-earned money.

But what exactly are mutual funds? 

In simple terms, a mutual fund is an investment fund that pools money from multiple investors and invest that money in a diversified portfolio of stocks, bonds, or other assets. 

The Indian Mutual Fund Market

The mutual fund market in India has seen a significant growth in recent years, with a wide range of options being available to the investors. This growth can be attributed to the increasing awareness and preference of Indians towards mutual funds as an investment avenue.

According to Association of Mutual Funds in India (AMFI), “Assets Under Management (AUM) of Indian Mutual Fund Industry as on August 31, 2023, stood at ₹ 46,63,480 crore. 

The AUM of the Indian MF Industry has grown from ₹7.66 trillion as on August 31, 2013, to ₹46.63 trillion as on August 31, 2023 - more than 6-fold increase in a span of 10 years.”

Is Mutual Fund Investment always a smooth ride?

While the potential returns from investing in mutual funds can be attractive, it's crucial to consider the risks involved. Investing in mutual funds, like any investment, carries a certain level of risk. The value of mutual funds can fluctuate based on market conditions, and there is always a possibility of loss. However, by carefully assessing your risk tolerance and investment goals, you can mitigate these risks and make informed decisions.

How to choose the right mutual fund?

Now, let's delve into the factors you must consider when choosing the right mutual fund.

Considering these factors is vital because it allows you to make investment decisions that are tailored to your unique circumstances. It helps you select a mutual fund that aligns with your risk tolerance and investment horizon and maximises the potential for achieving your financial objectives. 

Choosing the right mutual fund requires careful consideration. Here are some key points to remember:

  1. 1. Identify Your Goals, Risk Tolerance and Investment Horizon

a) Determination of clear financial goals is crucial because it helps you define the purpose and time frame for your investments.

  • For example, let's say your goal is to save for your retirement, which is typically a long-term goal. In this case, you may consider investing in equity-oriented mutual funds. These funds have the potential for higher returns over the long run, although they may be subject to market fluctuations in the short term. Equity-oriented funds typically invest in a diversified portfolio of stocks, aiming for capital appreciation over a longer investment horizon.

  • On the other hand, if your goal is to save for a shorter-term objective, such as buying a house in the next five years, you might want to consider debt-oriented mutual funds. These funds primarily invest in fixed-income instruments like bonds and provide more stability than equity-oriented funds. They are generally considered to have lower risk and can offer capital protection and steady returns.

b) Assessing your risk tolerance is an important step in determining the type of mutual fund that suits your investment preferences. Your risk tolerance is influenced by your comfort level with market fluctuations.

  • If you have a long-term investment horizon and are comfortable with the possibility of higher market fluctuations, to get potentially higher returns, you might consider equity mutual funds. However, if you have a lower risk tolerance and a shorter investment horizon, you may prefer more conservative options like Debt mutual funds, that can provide stability and regular income.

  • Remember, risk and potential returns are directly proportional to each other. Risky investments often come with the potential for higher returns, but they also carry a greater chance of market fluctuations. More conservative options prioritise stability and income generation but typically offer lower potential returns.

c) Your investment horizon, or how long you plan to keep your money invested, can have a significant impact on your tolerance for market fluctuations and potential returns. 

  • A longer investment horizon often allows for greater tolerance of market fluctuations and potentially higher returns.

  • With a longer investment horizon, you also have more time to benefit from the power of compounding. Compounding occurs when your investment gains generate additional returns, which then contribute to future earnings.

  • The stock market tends to experience periods of volatility in the short term. However, over a longer investment horizon, the impact of market fluctuations is often mitigated. By staying invested during market downturns, you give your investments more time to recover and potentially benefit from the market's upward trajectory.

  • A longer investment horizon provides you with the flexibility to adjust your investment strategy over time. As your goals or circumstances change, you can rebalance your portfolio or reallocate your investments to align with your evolving needs.

2. Fund Performance

Evaluate the historical performance of the mutual fund. Look for consistent returns over multiple time periods. You can compare the fund's performance to its benchmark index to gain insights into how well the fund has performed in relation to the market. 

For example, let's say there's a mutual fund. Over the past five years, it has consistently delivered annual returns of 12% on average, while its benchmark index has returned 10% on average during the same period. This indicates that the mutual fund has outperformed its benchmark, potentially making it an attractive investment option.

Many financial websites like Money Control  offer a mutual fund screener to help investors filter and find mutual funds based on specific criteria such as performance, risk level, expense ratio, and more.

For example, you can specifically look into the past returns of a mutual fund. Here, we checked the returns of HDFC Flexi Cap Fund for the past five years. 

**The performance graph of HDFC's Flexi Cap Fund is purely for illustrative purposes. It's important to note that this doesn't imply a recommendation by Ambrela Money. It's simply to demonstrate how the past performance of funds can be considered while assessing them for investment. Always conduct thorough research and consider various factors before making any investment decisions.

It is crucial to remember that past performance does not guarantee future results. It's essential to conduct thorough research, consider other factors such as fund expenses, risk profile, and investment objectives before making any investment decisions.

3. Fund Manager Expertise

Research the experience and track record of the fund manager. A skilled and experienced manager can play a crucial role in the fund's performance and helps assess their ability to make sound investment decisions. 

For instance, let's consider an Equity Fund. The fund manager has over 15 years of experience in the financial industry and a proven track record of consistently delivering above-average returns. His/her expertise in analysing stocks and managing the fund's portfolio has contributed to the fund's success. 

The fund manager’s overall success is not the only significant aspect to take into account. Prior to making an investment in a mutual fund, the fund manager's contribution and performance specific to that fund must also be assessed comprehensively.

Let’s understand this with an example. 

Consider Mr. Prem Kapoor, a highly regarded fund manager associated with the SBI Bluechip Fund. 

Over the past decade, he has successfully navigated the volatile market conditions and consistently generated impressive returns for investors.

One notable example of Mr. Prem Kapoor’s expertise was during the market downturn in 2008. While many funds struggled to minimise losses, his astute decision-making and disciplined investment approach helped SBI Bluechip Fund outperform its peers. By strategically reallocating the fund's portfolio towards defensive sectors and quality stocks, he was able to safeguard investors' capital and capitalise on emerging opportunities.

Mr. Prem Kapoor’s track record, combined with his in-depth research, thorough risk analysis, and proactive portfolio management, has made SBI Bluechip Fund a preferred choice among investors. 

His consistent outperformance and ability to generate alpha highlight the importance of a skilled and experienced fund manager when selecting a mutual fund.

4. Fees and Expenses

Checking the total expense ratio of a mutual fund before investing is crucial because it helps you understand the costs associated with owning the fund. By being aware of these expenses, you can evaluate the impact on your investment returns and make informed investment decisions. 

For example, if a mutual fund has a high expense ratio, it can eat into your overall returns over time. It's important to compare fees across different funds to find the one that aligns with your investment goals and offers good value for your money.

5.Exit Load

When you invest in a mutual fund, you may come across a concept called "exit load." An exit load is a fee that is charged by the mutual fund company when you sell or redeem your investment before a specific time period, known as the exit load period.

Let's say you invest in a mutual fund that has an exit load of 1%. If you decide to sell your investment within the exit load period, such as one year, you will be charged 1% of the amount you're selling. This means that if you're redeeming Rs. 10,000, you will have to pay a fee of Rs. 100 as an exit load.

Checking the exit load of a mutual fund is crucial because it helps you understand the costs associated with selling your investment prematurely. By being aware of the exit load, you can make informed decisions about the timing and potential impact on your returns.

6. Diversification

Consider the fund's diversification strategy. A well-diversified fund spreads investments across different assets, sectors, and geographies and allows you to capture the potential upside of different areas of the market while mitigating the risk of being too heavily reliant on a single investment. Remember that all investments carry some level of risk, and past performance is not indicative of future results. Hence, it is prudent to diversify your portfolio to ensure your investment strategy aligns with your long-term objectives. 

In short, "don’t put all your eggs in one basket."

7.Active and Passive Funds

The decision between active and passive mutual funds is an important factor to consider before making an investment. 

  • Active mutual funds are managed by a fund manager who actively selects and manages the portfolio of securities, aiming to outperform the market. 

  • On the other hand, passive mutual funds aim to replicate the performance of a major market index, such as the S&P 500, by holding a diversified portfolio of securities that mirror the index's composition.

For example, let's say you have a long-term investment horizon and prefer a more hands-off approach. In that case, a passive mutual fund may be suitable for you. By investing in a passive fund that tracks a broad-based index, you can gain exposure to the overall market and potentially benefit from its long-term growth. On the other hand, if you believe in the expertise of a skilled fund manager who can actively identify investment opportunities and generate higher returns, an active mutual fund may be more appealing to you.

8. Read the Prospectus

Carefully read the mutual fund prospectus, which provides detailed information about the fund's objectives, strategy, fees, and risks.

9. Fund Size

Let’s understand this with the help of an example. 

Assume that you're considering two funds: 

  • Fund A, which has a small fund size of 10 crore rupees.

  • Fund B, which has a large fund size of 500 crore rupees.

In the case of Fund A, the smaller size might indicate that it is relatively new or hasn't attracted significant investor interest. A smaller fund size can mean limited resources, potentially impacting its ability to efficiently manage investments, research opportunities, or maintain liquidity during market volatility.

On the other hand, Fund B's large fund size may suggest that it has attracted substantial investor capital. This can provide advantages such as access to expert analysts, better research capabilities, and potentially greater bargaining power when buying or selling securities. Moreover, larger funds may also benefit from more stable cash flows, ensuring easier transaction processing.

However, it's essential to note that fund size alone is not a definitive indicator of performance. Smaller funds can often be nimble and have the opportunity to generate higher returns through focused investments, while larger funds might face challenges in maintaining their historical performance due to increased institutional constraints.

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