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How Do I Select A Mutual Fund To Invest In?

Selecting a mutual fund is like selecting any other investment and you should follow an objective decision framework.

Selecting a mutual fund is like selecting any other investment and you should follow an objective decision framework. You should start by answering the following questions:

Step 1: Deciding on Equity funds vs Debt funds

This decision is essentially a decision to invest in Equities vs Debt rather than being a mutual fund selection. The key elements in this decision are:

What’ your investment objective?

Is it Income or Growth? If you’re looking for Income, then go for debt. For growth, you could choose either equity or debt depending on your investment duration & return expectation.

What kind of return do you want/need?

Your return could be in the form of a fixed returns or capital growth (with uncertainty). If you are looking for fixed returns, mutual funds are completely ruled out.

What’s your investment duration? How fixed is this investment duration?

Are you investing for 1 year, 5 years, 10 years or longer? Debt funds are better for shorter durations (5 years or less), Equity Funds for longer.

IMPORTANT: Do not confuse investment duration with review period. Choose the asset class based on when you will need the money (investment duration) for example: 20 years. However, you should review your specific investments within that asset class more often (Review period), say every year.

How much return do you expect? Does historical data justify it?

A number of investors choose an asset class with unrealistic expectations of 20% or 30% returns. The long-term average return for debt is in the region of 9% and equity is in the region of 16%. Each of these comes with varying degrees of uncertainty or risk.

What are the risks? Are they in line with your objective & return expectation.

The variation of return in debt is usually small. A long-term average of 9% implies a band of 8-10%. This means that there is a high degree of certainty that you’d get returns of near the long-term average. The risk of capital loss is also very low.

On the other hand equity returns vary in a broad range. The range narrows with holding period but there is always a wide band. There is also a high risk of capital loss due to this.

In a simplistic way the decision between equity & debt is the decision between almost certain 9% return and an uncertain 16% return.

What is the tax applicable on the return you get?

  • Interest is added to your income and gets taxed at whatever your tax slab is (10%, 20% or 30%)
  • Debt funds held for less than 3 years, the gains get taxed at your tax slab; for more than 3 years, gains get taxed at 20% with inflation indexation.
  • Equity funds held for less than a year get taxed at 15%; for more than a year have zero income tax.
  • Then there are Tax saving equity funds (ELSS), which have a lock in for 3 years, but save you tax in the year in which you invest.

(Note: This is a broad generalization of tax applicability and not tax advice.)

Step 2: Selecting a specific mutual fund

Understand the capability of the fund manager, their investment process and track record

The performance of a mutual fund is ultimately the outcome of the Fund Manager’s expertise and their investment process. The two are designed to complement each other.

All funds are required to publish the resume of the fund manager. The fund managers also write articles and give interviews that reflect their thinking and the investment process they follow. You can also understand this by evaluating the risk reward characteristics of the mutual fund and things like portfolio churn.

A good investment process is an indicator of repeatable performance.

Analyse performance over a reasonable period

Very often investors are misled by recent (usually last 6 months or one year) performance of a fund. You need to analyse performance over at least 4-5 years. Also look for consistency of performance by comparing different period returns. Always remember that past performance may not be repeated.

Decision on picking a thematic or sectoral fund vs diversified funds

Themes and sectors limit the universe of stocks available to a fund manager. Choose these if you fully understand the economic conditions and their applicability to a specific sector. You must also carefully watch for changes in these conditions.

Focus on facts and data rather than brand names

An investor must be diligent in researching and analyzing data. This also involves ignoring personal preferences, uninformed recommendations, advertising and brand names. Let the track record speak for itself.

We highly recommend using freely available data on websites like http://valueresearchonline.com or http://moneycontrol.com to do your research. You can also use the pre-selected portfolio of funds by services like Scripbox.

Step 3: Re-confirm that you understand how your specific chosen mutual fund works.

  • Read the offer documents
  • Understand investment/ redemption limitations if any
  • How can you invest? How can you withdraw?
  • Cost and load structure- A load is a percentage charged by the fund to recover distribution costs. This may be charged at entry (Entry Load), exit (Exit Load) or over the life of the investment.

Next: How do I invest in mutual funds? How much does it cost me?

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