Which mutual fund is right for you?

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First started in 1924 by three Boston money managers, the mutual fund industry has grown into one of the biggest industries in the world. Not only in size, but also product offerings have gone up. This has led to confusion in the mind of investors on how to select the appropriate mutual fund scheme. In this article, though not comprehensive we provide a good starting point from where a person can increase her/his awareness about how to pick mutual funds.

To start with one must first decide on the financial goals and asset allocation. Once this is clear, he/she can then decide on where to invest and how much amount to allocate for mutual fund

Must do: It is essential to read the offer document before investing. In fact, all mutual fund distributors and financial planners are required to give their clients a copy of the same before the investor signs the application form. One can even go through the Key Information Memorandum (KIM) of the fund as the offer documents tend to be exceedingly lengthy.

Investment objective or scheme philosophy: This explains the scope or mandate of investment. It outlines the debt-equity mix and the type of instruments that the fund would invest. It indicates where your money will be invested by the fund manager, i.e., whether large, mid- or small-cap specific, the level of diversification, the option to the fund manager to invest overseas etc. While selecting the schemes, the investor should keep in mind his financial goals. Also one must keep in mind the risk appetite. Funds that have a high concentration in particular stocks or sectors tend to be very risky and volatile.

For example: HDFC Equity fund has the objective to achieve capital appreciation, while the investment objective of HDFC Infrastructure fund is to seek long-term capital appreciation by only investing predominantly in equity and equity related securities of companies engaged in or expected to benefit from growth and development of infrastructure. (Source: HDFC Mutual Fund)

Type of fund: Whether the fund is open- or close-ended? Open-ended schemes are available for subscription and redemption on an ongoing basis. They usually do not have a fixed maturity period. The units can be bought and sold any time during the life of the scheme at NAV related prices.

In case of close-ended mutual fund, the schemes have a stipulated maturity period. It is bought and sold just like the shares of a regular stock as it is listed on the stock exchanges. Generally the close-ended schemes trade at a discount to NAV; but closer to maturity, the discount narrows. In case of investing in a close-end fund, the lock-in period, liquidity window and repurchase options should be considered.

Risk: Each type of fund has a risk associated with it. For e.g.: scheme having large cap exposure is less risky than one with more mid cap stocks. Risk is normally measured by Standard Deviation. Higher the Standard Deviation, higher the risk taken by the fund to earn returns.

For example, if scheme A generates a return of 12% while scheme B generates a return of 10%, it would appear that the former is a better performer. However, the risk associated with scheme A is higher than B. Then it may actually be the case that scheme B has a better risk-adjusted return.

Let us assume that say that the risk free-rate is 6%, and scheme A's portfolio has a standard deviation of 7%, while B's portfolio has a standard deviation of 5%. The Sharpe ratio for scheme A would be 0.5691 while scheme B's ratio would be 0.6581, which is better than A. Based on these calculations, B was able to generate a higher return on a risk-adjusted basis. The fund's performance is better if the Sharpe ratio is better.

To give you some more insight, a ratio of 1 or better is considered good, 2 and better is very good, and 3 and better is considered excellent.

Performance Returns: While past performance may not get repeated in the future, it is always an important tool to select a mutual fund. This indicates the fund's ability to earn returns across market conditions.

Further, in case of a well-established track record, the likelihood of it performing well in the future is higher than a fund which has not performed well.

One also needs to compare the fund with its benchmark index and its peers as in isolation the performance do not give a meaningful insight.

However, care has to be taken to compare similar funds. For example, large cap funds to be compared to large cap funds and not small cap funds. While returns are an important measure of evaluation, it is not the only parameter. Importance to the other factors particularly to the risk should be also considered.

Cost of investing: This becomes a crucial factor when investing for a long term. If the fund is incurring huge expenses, it may not be worth investing in that scheme. Investors should look at the following important costs before deciding.

Expense ratio: Expense structures like costs of running the fund, including salaries paid to the fund manager are declared by the fund each year. Expense Ratio is the percentage of assets that go towards these expenses. Also higher churning by the fund manager increases the cost, as he pays a brokerage fee, which is ultimately borne by investors in the form of an expense ratio.

Further, if the churning is on the higher side, higher is the volatility. The fund incurs costs every time it buys and sells stocks hence the longer a mutual fund holds on to a stock, the lower will be the expense.

Exit Load: While SEBI has done a good move by removing the entry load, exit load still continues to exist. An exit load is charged to investors when they sell units of a mutual fund within a particular tenure. Generally it is charged if the units are sold before a year. It is a part of the NAV, thereby reducing your returns.

Studies have shown that over time, virtually all of the difference in return between funds is attributable to the higher costs.

Other important factors such as minimum initial investment, methods of purchasing, redeeming and making additional investments and the time taken for redemption, so forth and so on should also be looked upon.

While these tips may help one in easing the process of selecting a mutual fund, one must always keep a track of the investments on a regular basis depending on one's risks and needs. It is recommended for investors to have a long term horizon while investing in equity oriented funds. While there is no set of directions that are likely to beat the market using mutual funds, one must choose a fund that will stand by you in sickness and in health.

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