10 rules to select right Mutual Fund

Flummoxed with the variety of choices in picking a mutual fund? Fret not, here are tips to selecting the one that is right for you.

1.    Does the fund match your ‘financial profile’?

Mutual funds offer a whole bouquet of products such as aggressive equity funds, index funds, gilt funds, income funds, liquid funds, gold funds, thematic funds, etc. – the list is quite exhaustive.

But beware! You don’t have to buy all these types of funds.

As you would observe, all funds have a specific objective, a specific risk profile, a specific liquidity profile and a specific time profile. Hence, it is not possible that all funds will match your needs, risk-appetite, investment horizon etc.

Therefore, you must first decide on the types of funds that would suit your needs. Only then should you start selecting the best funds within those categories.

2.    Past performance

The past performance of the fund is one of the most important criteria in fund selection.

It is true that a fund’s good performance in the past does not guarantee that in future too it will do well. However, history also shows that funds with consistently good performance – good here means in the top quartile and not necessarily the top performer – can be expected to be among the top in their category in future too.

Similarly, a fund with poor performance will find it extremely difficult to move to the top quartile and remain there.

Therefore, don’t chase the top performers of the year. Instead, focus on funds that have delivered good returns consistently.

3.    Portfolio characteristics

Characteristics of a portfolio will also play an important role in fund selection.

For example, the percentage of top 5 or 10 holding will determine how diversified or concentrated a particular fund is. If about more than 60-70% of the corpus is invested in just 5 shares or bonds, the portfolio would be comparatively riskier than a fund with just 20-30% corpus in 5 scrips.

Typically, an aggressive equity fund would have higher turnover ratio. Comparatively speaking this is perfectly fine. But an index fund with a higher turnover ratio vis-à-vis its peers could be a cause for concern.

4.    Is the AUM appropriate?

There is, of course, no mathematical rule that would suggest the best size for a given mutual fund. In other words, there is no guarantee that if a fund’s Assets under Management (AUM) is less (or more) than a specific level, only then will it perform well.

Having said that, AUM could be an important factor in the fund’s overall performance!

In all probability, a very small fund will not be able to diversify itself reasonable well. It will also find it difficult to make the best of the investment opportunities available. As such, the performance could be very erratic — one year they would be the best performers and the next the worst. It would be preferable to avoid them.

A fund too large could also be an issue. Since a fund cannot invest more than 10% of its corpus in one company, a very large fund would invariably have too many companies in its portfolio. This could affect its overall performance.

5.    The fund house/fund manager

Investment is both a science and an art. Good research teams i.e. the science part of investing, are necessary in identifying the opportunities available in the market. 

However, if you give the same set of scrips to two different people, they could deliver vastly different returns. This means that apart from knowing what the good stocks are, you need something more. This ‘something more’ is the art of investing.

When to buy/sell/hold; how a fund manager reacts to market volatilities; how s/he responds to the pressure of performance; and such other psychological aspects have a very important role to play.

As such, you have to consider the fund manager’s past performance before investing.

That apart you should also evaluate the particular fund house – how many funds does it offer, how many of these are good performers, how much AUM does it manage, what are the service standards, etc.

6.    Risk parameters

Two funds may deliver the same returns. But the better of the two would be the one that does so:
–    By taking lesser risk (i.e. it has a higher Sharpe Ratio)
–    More consistently (i.e. it has lower Standard Deviation)
–    With less volatility than the market (i.e. it has a lower Beta)

Therefore, after you have short-listed the funds based on the performance, portfolio, fund house etc., check the risk parameters and opt for those that tend to deliver good returns despite taking lesser risks.

7.    Annual Recurring Expenses

The expenses that will eat into your returns in an MF would typically include management fees, custodial fees, marketing & selling expenses, trustee fees, audit fees etc.

But before you get worried, you will be glad to know that the Association of Mutual Funds in India (AMFI) and SEBI have simplified the issue of expenses. They have specified the maximum limit that a fund can charge as overall expenses by whatever name it may be called.

For example, the maximum expense ratio for an equity fund is fixed at 2.50%, for debt funds at 2.25%, for index funds at 1.5%, for Fund of Funds at 0.75%, etc.

It goes without saying that lower the expenses the better it is. But beware! Don’t give too much weightage to the expenses. Other parameters, discussed above, are far more important than expenses that anyway are quite reasonable.

8.    Entry / Exit Loads

Entry load: As per the recent regulation, SEBI has mandated that with effect from August 1, 2009 there will be no entry loads for all mutual fund schemes.

Exit Load: This is the load payable when you sell of your MF units. The exit load is generally payable only if you fail to satisfy certain pre-specified conditions. Therefore, in most cases you may not find a compulsory exit load, but what is termed as ‘Contingent Deferred Sales Charge’ (CDSC) and payable:

•    If you sell a debt fund before 6 months or some such period
•    If you sell an equity fund before 1 year or some such period

A lower load is better. However, since the load is nominal, sometimes even paying higher loads may be alright if the fund’s performance and other factors are very good.

9.    NAV is a meaningless number

The NAV of the fund has no impact on the returns it will deliver in the future.

Let’s assume you plan to invest in an index fund and you have two choices – Fund A is a new fund with an NAV of Rs. 10, which will mimic the Nifty and a Fund B, which is an existing Nifty index fund with an NAV of Rs. 200.

Suppose you invest Rs. 10,000 in Fund A and Rs. 10,000 in Fund B. You will get 1000 units of Fund A and 20 units of Fund B. After 1 year, the Nifty has appreciated by 25%, which means that both funds would have also appreciated by 25%, as they are a replica of the Nifty.

So after 1 year, the NAV of Fund A would become Rs. 12.50 and that of Fund B Rs. 250. But what is the value of your two investments? Fund A would now be Rs. 12,500 (1000 units * Rs. 12.50/unit) and Fund B also would be Rs. 12,500 (20 units * Rs. 250/unit).

The bottom line is that don’t bother about the NAV of a mutual fund, as you might do for the price of a share.


10.      Dividend or Growth? 

Like NAV, it is immaterial whether you choose the dividend option or growth option as far as the performance of the fund is concerned. In fact, even though you have different options, the underlying fund is the same. As such, the basic returns from all the three options i.e. growth or dividend payout or dividend reinvestment will be the same.

However, the final returns in your hand could be different due to taxation.

Tax rates are different, depending on whether you get this return in the form of dividend or capital gains. Therefore, the post-tax returns in your hand may vary depending on your tax profile. As such, you have to choose the option from the point of view of where your tax will be minimal and not from the point of view of the returns.

To keep things simple, just remember to opt for growth option if your investment horizon is more than 1 year and dividend option for less than 1 year (assuming you are in the highest tax-bracket).

Author: admin