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Selecting the right mutual funds is crucial for achieving one’s financial goals. To make informed decisions, investors often rely on a set of criteria tailored to their individual needs. This list of criteria serves as a guiding framework, helping investors assess various mutual fund options based on factors such as performance, risk, fees, management, and alignment with their investment objectives. By carefully evaluating these criteria, investors can build a well-diversified portfolio that aligns with their financial aspirations.
Table of Contents
Reasons for Choosing Mutual Funds
The mutual fund industry provides investment solutions for investors of all ages. One can choose a mutual fund for wealth creation, children’s higher education, vacation planning, property purchase, or income generation during retirement. Nevertheless, the most important question that arises is how one can select mutual funds based on one’s investment goals. To understand how to choose mutual funds, one needs to be aware of the following three things:
Financial Goals
Define different financial goals before preparing an investment plan. Lay out all goals in stages of life, considering inflation, to create a clearly defined action plan. Then, select mutual funds that align with these goals.
Risk Appetite
The concept of risk refers to the probability that one’s financial expectations are not met. Risk-taking capacity varies from person to person. The level of risk one is willing to take depends on the age, stage of life, personal circumstances, and financial situation. One can choose a mutual fund based on one’s risk appetite if the risk can be assessed.
Asset Allocation
The risk profile of different asset classes differs. For example, debt funds have a lower risk than equity funds. It is important to understand that risk and return are directly related. To achieve one’s financial goals, asset allocation aims to balance risk and return.
One can have a higher allocation to equities if one has a higher risk appetite and vice versa. For that, one needs to know how to choose mutual funds in accordance with the chosen financial goal and risk appetite.
Choosing Mutual Funds in India
Considering the criteria for selection of mutual funds below, one will know how to select mutual funds according to the financial goals, risk appetite, and asset allocation.
Goal Identification
Before investing in a fund, defining investment goals is crucial. Prioritise between present income and long term financial gains. Plan the amount, location, and duration of investment for each life stage, considering inflation. Once these goals are set, consider selecting mutual funds aligned with them. Mutual funds can be categorised into debt funds, equity funds, or hybrid funds, depending on the investment purpose.
Investment Strategy
Many investors ignore investing strategy when they identify how to select mutual funds. However, it holds a key place in one’s investment portfolio. Investment strategies are also called investment approaches. It is a method through which fund houses make all investment decisions. A conflict of interest will arise if the fund house’s investment strategy does not align with the investor’s goals. Ultimately, this may result in exiting investments at an unfavourable price.
Types of Mutual Funds
One will be able to build a portfolio that matches one’s financial objectives by understanding the different types of mutual funds. Depending on the investment objectives, one can invest in a particular fund type. For the portfolio, one can choose from the following types of funds:
- Mutual Funds For Growth: A growth mutual fund generally invests in growth stocks. As the name implies, growth mutual funds are intended to maximise capital gains. In addition, they have a high-risk rating and are not ideal for long term investments.
- Mutual Funds For Income: Fixed-income mutual funds include debt mutual funds. Various income assets are invested in these funds, including debt securities, bonds, and securities. The fund managers of income mutual funds ensure that capital is preserved while also generating a consistent income for investors. It is an appropriate investment for those who are risk-averse and want to keep their money for at least two to three years.
- Mutual Funds That Save Taxes: A tax-saving mutual fund, also called an equity-linked savings scheme (ELSS), invests in equity investments. Under Section 80C of the Income Tax Act, funds invested in these programs are deductible. In spite of their high risk, they can yield substantial returns if the fund performs well.
- Liquid Mutual Funds: In liquid mutual funds, the money is mainly invested in short term and ultra short term securities, such as commercial papers, certificates of deposit, treasury bills, and others. The primary purpose of liquid mutual funds is to provide liquidity. The risks are low, and the rewards are moderate. A liquid mutual fund is an excellent option for investors seeking short term investment options.
Fund Performance
Fund Performance matters when understanding how to select mutual funds. It should be considered within a reasonable timeframe. The purpose of this is to ensure that the investments have gone through multiple market cycles. Over time, this would enable consistent returns.
The fund might not be a good investment if it hasn’t been able to beat its benchmark over the last three, five, seven, or ten years. To evaluate a fund’s performance, research the fund manager’s or the fund management team’s performance. One would benefit from a strong, experienced, stable, and proven fund management team.
Expense Ratio
An expense ratio refers to the commission or fee investors pay for investment management. To ensure efficient management and performance across investments, all investors incur the fund manager’s fee.
An investor should seek out mutual funds with low expense ratios. The percentage may seem small, but when compared to the total size of one’s portfolio, it will have a significant impact.
Entry and Exit Load
An entry load is a fee that fund houses charge investors. An exit load is a fee charged when an investor exits a mutual fund scheme. This is charged only to investors who exit within a short timeframe. The goal is to discourage quick exits and immediate outflows of cash from fund houses.
However, the majority of fund houses have removed the entry load. An investor should look for mutual fund schemes with zero or minimal entry and exit loads.
Taxes
- As an investor, one’s investment returns are taxable under the Income Tax Act. Returns on equity fund units are taxable based on the holding period.
- Equity funds are taxed on long term capital gains (holding period of 12 months and more) at 10% over and above their ₹1,00,000 exemption limit. The tax rate on short term capital gains (holding periods less than 12 months) is 15%.
Direct Plans
In a mutual fund scheme, there are two types of plans: direct and regular.
- Direct investing allows investors to purchase NAV units directly from a fund house.
- Regular units have to be bought through a broker or commissioner.
Returns are slightly higher in a direct mutual fund since commissions are not incurred. Depending on the asset management company and brokerage firm, this commission varies from 1-1.25%.
In the case of regular mutual funds, the AMC (Asset management company) pays a brokerage firm a commission for increasing its clientele. In turn, this reduces the total return generated by the investment.
Conclusion
In selecting mutual funds in India, it is important to consider one’s financial goals, risk tolerance, and asset allocation preferences. To make informed investment decisions, know one’s investment goals, understand different fund types, evaluate investment strategies, and consider fund performance, expense ratio, entry/exit loads, taxes, and plan type. Share India provides a platform to explore and invest in diverse financial instruments, including mutual funds, empowering investors to make informed decisions.