How to choose the right mutual fund?

Five parameters that will help you make a winning decision

If you are looking at investing in a mutual fund (MF) the good thing is that you will be able to find an option that matches your needs but the bad thing is that there are so many companies, each with so many schemes that finding the one that matches your requirements can be a difficult journey. In the following discussion we will try and focus on a few parameters that can help in choosing the right mutual fund for investment depending on an individual's requirements.

Identify the objective

Like stated before there is a right kind of mutual fund for everyone and every need. So the first thing one needs to do is identify their objective for investing in the mutual fund. This can be based on the timeline for investment (short or long term) or the financial goal. Asha is looking to invest in a mutual fund to save tax; an equity linked savings scheme (ELSS) will suit her requirements while Amol is looking for a regular flow of income so for him a monthly income plan (MIP) is required.

So the first step is to be sure about the reason for investing in a MF so that you can focus on that segment and choose a scheme that suits you best. You can have multiple funds to satisfy one objective or different funds to meet different kinds of goal.

Asses your risk appetite

Mutual funds are managed by professionals and generally these professionals base their decisions on extensive research. However one cannot forget the MFs are market linked products which means they are susceptible to market risk and they do not have guaranteed but have indicative returns.

So before choosing a scheme it is important to understand if it matches your objectives and whether it matches your risk appetite also or not. Equity funds are high risk and high returns, while debt funds lie on the other end of the spectrum.

Balanced funds as the name suggests lie somewhere in between. Generally those in advanced years do not prefer equity oriented schemes while the younger investors can afford to invest in equity funds and take some risk.

Focus on history

As stated earlier MFs are market related instruments so there can be no guaranteed returns. Even for debt funds the returns are indicative; so how does an investor decide if the fund will deliver what it promises in terms of returns? This can be assessed to an extent by looking at the past performance which can be indicative of the expected future returns but again there is no surety that in the future also a similar pattern will be followed.

Looking at the past returns can help in assessing a trend that a mutual fund follows in terms of returns.

Use statistics

Apart from returns, certain other numbers are also important when choosing the right mutual fund. Alpha is one such indicator; it is a measure of MF's performance on a risk adjusted basis and as compared to the benchmark. A positive alpha indicates that the fund is doing well.

Beta is the measure of fund's volatility as against the benchmark. It measures the fund's sensitivity to changes in the market.

For an investor with low risk appetite a fund which has a beta value less than one is the right choice and the opposite is true for those are willing to have a bigger risk appetite.

Standard deviation in terms of a MF will indicate its volatility; SD is how much the returns deviate from the expected returns calculated based on the past performance. An investor should also keep an eye on the various costs that s/he incurs as these costs ultimately impact the overall profitability of a mutual fund.

Pedigree is important

Another factor that one should focus on while selecting a mutual fund is the fund house that is promoting it and who the fund manager is. Choosing a well known and experienced fund house will ensure that they will not indulge in unethical practices or will go bust while leaving you in the lurch. A fund manager decides which instruments or securities to invest in so an experienced and knowledgeable fund manager will ensure that you get good returns on your investments.

Being preemptive and not reactive is what distinguishes a good fund manager from an average one.

The above factors can hopefully help you in choosing the right mutual fund for yourself which not only helps you in meeting your financial goal but is also a safe and profitable investment.

Illustration: Dominic Xavier/Rediff.com

The author is Co-founder and Director Credit Vidya.