A mutual fund is an investment vehicle that pools money from multiple investors and invests in various financial instruments. There are many types of mutual funds in the Indian market that invest in different asset classes. With so much variety, investors need to learn how to choose mutual funds based on their own financial needs.
Before investing in any mutual fund, you must decide on the category. Then, you need to consider various parameters to decide if it’s the right investment choice for you. This article will cover the crucial factors for choosing mutual funds.
Also Read: Share Class: Meaning, Types, Merits & Demerits
Types of Mutual Funds
Based on the asset classes they invest in, the following are the various types of mutual funds in India:
- Equity funds: These types of mutual funds invest mostly in the shares of listed companies. Their returns are linked to stock market performance and thus, subject to higher volatility. Equity funds are a good investment if you have long-term goals and high-risk tolerance.
There are many types of equity funds based on market capitalisation (large-cap, mid-cap and small-cap funds), investment style (value funds, growth funds), etc.
- Debt funds: These funds invest in debt instruments such as corporate and government bonds and treasury bills. They are considered low-risk investments and usually act as a stable source of income. Debt funds are usually preferred by conservative investors.
They are further categorised into liquid funds, credit risk funds, and overnight funds, among others.
- Hybrid funds: These funds invest in both equity and debt instruments. The balance of investment between these two depends upon the fund strategy and the fund manager. They are further categorised into various types like balanced funds, aggressive funds, multi-asset allocation funds, etc.
Knowing the types of funds is useful for understanding how to select the best mutual funds.
Also Read: Benefits of Investing in Mutual Funds in India
A very basic step in selecting mutual funds is to define your financial goals. There is no single fund which is the best for everyone, so the choice will depend on your goals.
Financial goals can include retirement planning, paying for a house, children’s education or international travel. Such goals can be short, medium or long-term. For example, you wouldn’t invest in the same fund to get money for a holiday next year and also for retirement planning.
Investing in mutual funds without proper planning and goals could result in unexpected losses and unpredictable returns. It is helpful to list your goals, lay down an appropriate investment plan, and invest accordingly.
Your Risk Profile
It is important to analyse the risks associated with mutual funds before investing. As an investor, you should also assess the amount of risk you are comfortable taking.
A person’s risk appetite depends upon multiple factors such as lifestyle, financial standing, age, personal situations, etc. Some people have the ability to take more risks than others. For instance, a person in their 20s with high income usually has a higher risk tolerance than someone with low income in their late 30s.
Once you understand your risk profile, you should pick a mutual fund that aligns with it. To minimise risks, it is a good idea not to put all eggs in one basket. Diversifying investments into different types of asset classes helps to mitigate risks.
Thus, assessing your risk tolerance is an essential factor in deciding which mutual fund to invest in.
Also Read: How Mutual Funds Work in India – Basics of Mutual Funds
Knowing the time period across which you want to invest is also important while choosing mutual funds.
Different mutual funds work well for different investment horizons. For example, equity funds are more volatile and are affected by market fluctuations. These types of funds are suitable for a long-term investment horizon of 5 years or more.
On the other hand, debt funds are more stable but have lower returns than equity funds. An investment horizon of less than a year is suitable for short-term debt funds like liquid funds and ultra-short-duration funds. For short-duration funds, the investment horizon should be 1-3 years.
While learning how to pick mutual funds, you should know about the payment modes. For example, you can invest in mutual funds by investing lump sum or by SIP (Systematic Investment Plan).
SIP allows you to invest in mutual funds periodically. By investing via SIPs, you can benefit from the power of compounding, and it also lets you invest in smaller sums. This makes SIPs a viable option for many people.
However, if you have the funds ready, you can invest in a lump sum as per your choice.
Direct vs Regular Investment Plans
Direct and Regular Investment Plans are two types of plans available for mutual funds.
In direct plans, as an investor, you can directly buy fund units from the Asset Management Company (AMC). However, in the case of regular plans, you have to purchase them via a broker.
Direct plans deliver slightly higher returns than regular plans since no commissions are involved. In contrast, in case of regular plans, AMCs pay commissions to brokers to increase their client base. The total returns are reduced due to this, as the brokerage is paid from the principal amount.
Read More: What Are Overnight Mutual Funds? How Can You Invest in Overnight Funds?
Fund’s Past Performance
A fund’s past performance is an important factor in judging the fund. Consistency is the key. Some investors evaluate a fund based on its one-year performance. However, it’s important to analyse its performance in the longer time frame. This is a very important process in choosing mutual funds.
You should look at the 3 and 5-year returns to understand how consistent the fund is. For instance, Fund X may have a one-year return of 20%. However, its five-year return can be 5%. On the other hand, Fund Y may have a one-year return of 15% but a five-year return of 12%.
A smart investor should weigh more on stability than on high returns. A strong and stable fund may not seem to give very high returns in 1 year, but it is a sound investment in the longer run.
Also Read: Tax Harvesting: How to Save LTCG Tax on Mutual Funds?
When learning how to choose mutual funds in India, you also need to learn about their taxation. Taxes are applicable on both dividends and capital gains from mutual funds.
- Taxation on dividends: Since the Union Budget 2020, dividends offered on mutual funds are taxed based on the income tax bracket of the investor. Earlier, dividends were tax-free as companies used to pay dividend distribution tax before giving the profits to the investors.
- Taxation on capital gains: The taxation of capital gains depends upon the holding period and the type of mutual fund. The holding period refers to the time period between the date of purchase and the date of selling of the units.
For equity funds, short-term capital gains (STCG) are taxed at a flat 15% rate for a holding period of fewer than 12 months. Long-term capital gains (LTCG) tax is applicable at 10% over a tax-free limit of Rs. 1 lakh.
STCG from non-equity funds is taxed as a part of an investor’s taxable income for an investment of fewer than 36 months. For a longer holding period, LTCG tax is applicable at 20% with indexation. FoF(international funds) are considered as non-equity funds
Fund Manager’s Track Record
An important step in learning to choose mutual funds is assessing the background of the fund manager. As the fund manager plays a key role in a fund’s performance, it is essential to check their past record. A few things to check are:
- Whether the fund manager has delivered consistent results
- The volatility of the fund they manage
- Unusually high turnover of the fund
These factors give an idea of how the fund manager performs in certain market conditions. Some other things to check are how much experience they have in investing and the number of years they’ve spent in this role. The greater the success rate of fund managers, the more reliable they are.
Read More: Top 10 Multi Asset Allocation Funds to Consider in 2022
Costs Associated with Mutual Funds
The primary costs associated with mutual funds are expense ratio and exit load. As an investor, you should check these factors to see whether they align with your financial goals.
Every mutual fund charges an expense ratio, a consolidated fee for its management, administration and promotion. The lower this fee, the higher will be your net returns.
An exit load is usually charged when investors want to take out their money before a specific time. It depends on a particular mutual fund.
Mutual funds are a popular investment choice these days. Choosing the perfect mutual fund may seem intimidating. However, after conducting some research and understanding your goals, it becomes significantly easier. Therefore, evaluating all these factors on how to choose mutual funds is vital before selecting a fund.
What are the types of mutual funds?
Mutual funds can be divided into many types depending on a number of factors like structure, asset classes, investment goals and fund management. For example, equity funds, debt funds, hybrid funds, solution-oriented funds and index funds/funds of funds are the different types of mutual funds based on the asset class.
Are there any fees applicable for buying units of a fund?
No, entry loads (fees applicable for entering a mutual fund investment) are not applicable in India. In 2009, SEBI (Securities and Exchange Board of India) banned the practice of charging fees for investing in mutual funds.
Which asset class carries the highest risk?
The equity asset class carries the highest risk. However, it also offers the highest potential returns. Aggressive investors with a long-term horizon can invest in equities to create wealth.