For many investors, especially those who are new to the world of finance, choosing a mutual fund to invest in can be a truly challenging task. The key to success in the mutual fund game lies in knowing yourself, in understanding your financial goals, your risk appetite, and your investment time horizon.
In this blog, we will help you understand what mutual funds are, how they work, and what steps you need to take before investing.
Table of Contents
What are Mutual Funds?
A mutual fund pools money from multiple investors to invest in a diversified portfolio of stocks, bonds, or other securities. While diversification is simple fundamentally, executing it effectively can be challenging for individual investors.
Individual investors generally cannot manage a mutual fund directly; it’s always managed by fund managers. These managers make all the key decisions regarding the fund’s investments and do all the necessary buying and selling.
Mutual funds are a managed and accessible investment avenue, professionally done in most cases. They offer three things that most investors want: diversification, liquidity, and regulatory protections. This makes mutual funds an interesting investment option for many investors.
How to Choose the Best Mutual Funds
Finding the best mutual funds to invest in can help you reach your goals faster. But, before investing in mutual funds, you need to understand the various types of funds that are available, how to evaluate them, assess fund managers’ performance, and develop strategies for diversification.
Step 1: Choosing the Right Type of Mutual Fund
Different investment goals and risk appetites classify the various kinds of mutual funds. Here are the main types:
1.1 Equity Funds: These funds historically offer higher long-term returns but carry higher risk. Primarily investing in equities, these funds can be further divided into large, mid, and small-cap funds based on the company size they invest in.
1.2 Debt Funds: Investors who do not want to take much risk with their money and also want to generate decent returns prefer debt funds. These primarily invest in fixed-income securities like bonds and treasury bills and are also known as fixed income mutual funds.
1.3 Hybrid Funds: Hybrid funds invest in a mix of equity and debt, but the ratio varies. Some funds favor equities for higher growth, while others lean more toward debt for stability. Understanding a fund’s allocation helps match it to your risk tolerance and investment goals.
1.4 Index Funds: These funds track the performance of a given market index. They usually have lower fees and are appropriate for investors who want a simple, low-maintenance portfolio.
1.5 Sector Specific Funds: These funds invest in specific sectors of the economy, such as healthcare, fintech, etc. Their returns depend on how well the sector performs, but they are riskier because the funds are not well diversified.
When judging a mutual fund, a crucial element to consider is how well it performs. There are a number of ways to assess this:
2.1 Past Performance of the Fund: You need to check the fund’s performance over the past 1, 3, and 5 years. Simply measure the fund’s returns against benchmarks and compare with other mutual funds.
2.2 Fund Performance: Whether the fund has consistently outperformed its benchmark and competitors throughout the years or not, it is important. It doesn’t need to outperform every year, but consistent returns indicate a strong fund.
2.3 Expense Ratio: The expense ratio covers a fund’s operating costs, but it does not include entry loads, exit loads, transaction costs, or taxes. Lower expense ratios are generally better, as high fees can decrease returns over time.
2.4 Risk-Adjusted Returns: Just choosing a fund because it generates regular returns is not enough. You must also consider the level and type of risks taken to achieve those returns. You can use performance measures like the Sharpe ratio, which is a common tool to evaluate how well your portfolio is doing relative to its level of risk.
Step 3: Consider Fund Managers’ Expertise
A fund manager plays a key role in evaluating a fund’s performance. When selecting mutual funds, a prudent first step is to evaluate the manager’s skill level.
3.1 Fund Manager’s Experience: Learn about the background of the fund manager and the time they spent managing funds. It is really important to understand how much experience the fund manager has in managing funds.
3.2 Performance History: You need to check how well the fund manager has managed other funds, too. If the manager has headed several successful funds, it shows their skills are pretty great in leading a fund.
3.3 Philosophy of Investment: Know about the investment philosophy made by the fund manager. Their approach should align with your investment goals. You can directly connect with them to ask investment-related questions.
3.4 Management Team: Each mutual fund is run by a group of fund managers. The team should have expertise in managing a fund to generate good returns.
Step 4: Diversification
Diversification remains a crucial factor to consider in mutual funds. It is the spreading of investment amount among different assets, which reduces risk. Instead of putting all your money into one mutual fund, spread it across regions, sectors, or asset classes. And if one type of investment performs poorly, you have other investments that might balance out your returns.
Step 5: Tax-Efficient Investing
Some mutual funds are more tax-efficient than others. For example, Equity-Linked Savings Schemes (ELSS) offer tax benefits under Section 80C in India. Having a good knowledge of the tax implications of each fund can help maximize your net returns. And when it comes to taxes, mutual funds can create tax liabilities even if you don’t sell the fund. You could remain liable for taxes if the fund sells bonds or shares and realizes capital gains.
How to Monitor and Optimise Your Investment Portfolio
1. Review Portfolio Regularly
Prioritise reviewing your portfolio regularly to ensure it is still aligned with your investment goals. Check the mutual fund’s performance, stay informed about the recent changes in the market, and analyse whether your investment strategy meets your financial requirements.
2. Rebalancing Strategies
Rebalancing your portfolio means returning it to the asset allocation you have chosen. Some investments may grow faster than others over time, and the construction of your portfolio may start to look quite different from the desired mix.
Suppose you want to continue performing at the same level of risk and return, essentially to stick to your plan. In that case, it could be a smart decision to sell some of the best assets and buy more of the underperforming assets that you have a valid reason to hold.
How Mutual Funds Work
1. Pooling of Funds: Investors buy shares in a mutual fund, putting their money into a collective pool of capital. The fund is managed by the mutual fund company, also known as Asset Management Companies (AMC).
2. Investment Strategy: The fund manager creates a strategy for investing, based on the fund’s goals (e.g., growth, income, or balance). The strategy essentially tells the fund manager how to distribute the fund’s assets among a variety of asset classes.
3. Net Asset Value (NAV): Each share is valued by the Net Asset Value (NAV) in the mutual fund. NAV is calculated by dividing the total value of the fund’s assets by the number of shares that are outstanding. A fund’s assets are divided among its investors according to their share of the fund.
4. Purchasing and Selling Securities: The fund manager purchases and sells securities on behalf of the investors. The return of the mutual fund is directly linked to the return of the portfolio’s underlying securities.
5. Returns to Investors: Investors make money in two ways, capital appreciation and dividends distributed by the fund. Firstly, earning money is very straightforward. Capital appreciation is when the net asset value (NAV) of their investment increases and through which investors earn returns. The increase in NAV suggests that an investment is doing well. However, remember that not all investments increase in NAV, especially in the short term.
Benefits of Investing in Mutual Funds
Putting money in mutual funds provides numerous advantages. Here are some:
1. Diversification
Mutual funds collect capital from several investors and invest in equities, bonds, or other types of securities. This variety means that the risk seen by any one investment’s poor performance is diffused across all the investors in the fund. If one of the investments the fund holds performs poorly, it will likely be offset by the better performance of another investment the fund holds.
2. Professional Management
Mutual funds are run by experienced fund managers who have the expertise to identify good investment opportunities. They also know how to manage a portfolio, which means a collection of various securities. If they are genuinely professional and actively managing the fund, investors can expect better returns and careful risk management.
3. Liquidity
Investors can buy or redeem shares in mutual funds (almost all) on any business day, making them a liquid investment. This means that when compared to other investment options, like real estate, mutual fund investors can get their cash with greater ease and speed.
4. Affordability
A large number of mutual funds need only a minimum investment. This low barrier to entry allows a fund to pursue a very broad array of individuals who can become its shareholders.
5. Multiple Options
There are a variety of mutual funds available in India, such as bond funds, index funds, equity funds, and balanced funds. So many choices allow investors to pick funds that fit their financial plans, ability to tolerate risk, and investment time frames.
6. Supervision and Control
Mutual funds are kept in check by governmental agencies, which gives investors an added measure of safety. These authorities enforce the rules that keep mutual funds in line. They ensure that funds do what they say they will do and that they invest in the way that they are supposed to.
7. Automatic Reinvestment
A number of mutual funds present an option of automatically reinvesting dividends and capital gains. This facility benefits the investors as they avail the opportunity of compound growth over a reasonable time.
Understanding the Risks Associated with Mutual Funds
Investing in mutual funds can be a great way to build wealth, yet they are accompanied by certain risks. Some of the primary dangers are:
- Market Fluctuation: The value of a mutual fund depends on the market; in a downturn, a fund’s worth can decrease significantly.
- Business Risk: A mutual fund’s performance is directly proportional to the businesses it invests in. If the business runs into financial trouble, the mutual funds also get affected.
- Interest Rate Risk: When the rate of interest rises, the market value of bond funds declines, directly impacting the NAV of bonds.
- Liquidity Risk: While most equity mutual funds are easily tradable, some debt funds or private market funds may hold illiquid assets. This can delay access to your money or affect the price at which assets are sold.
Conclusion
Remember, you can make important decisions that match your investment objectives when you understand mutual fund types, assess their performance, and review the expertise of mutual fund managers. Also, nowadays you can easily check an investment’s performance with the help of a mutual fund calculator.
You just have to put basic details like investment amount, expected return, and tenure on a mutual fund return calculator, and it will calculate the returns and future value of your investment. Once you do all the research, you will have a clear picture of which fund to invest in.
How to Choose the Best Mutual Funds in India – FAQs
Q1: How do I pick a mutual fund?
While picking a mutual fund, you should keep in mind what you are trying to achieve with your investments, the fund’s performance history, how much risk you are ready to take, and its fees.
Q2: Is it possible for me to incur losses with a mutual fund?
It is certainly within the realm of possibility. Even the best mutual funds in India can lose value, and they can lose it fast, especially in the kinds of markets where mutual fund managers can have little or no control over the fund’s performance. And, of course, there’s always the important risk factor to keep in mind: the risk of not doing anything but just holding that fund.
Q3: How frequently should I assess my mutual fund portfolio?
You should examine your investment portfolio at least once a year, or more frequently if the market takes a downturn.
Q4: ETF vs Mutual Fund, which is better?
Exchange Traded Funds (ETFs) track a market index and trade like stocks on an exchange, allowing real-time pricing and liquidity. On the other hand, mutual funds are priced once a day based on Net Asset Value (NAV) and aim to outperform their benchmark through active management. ETFs typically have lower expense ratio and more tax efficiency compared to mutual funds. Choosing between them depends on your investment style, risk appetite, cost sensitivity, and trading preferences.
Q5: How to invest in mutual funds?
To invest in mutual funds, first you have to:
Set an investment aim,
Select the type of mutual fund,
Research and compare funds,
Open a Demat Account,
Invest in the fund you choose through a platform,
Track and monitor the fund’s performance.