12 things to know before investing in a mutual fund.

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A mutual fund is an investment scheme that pools money collected from the investors to invest in stocks, bonds, money market instruments, and other assets to earn returns on the invested amount over a period of time. It is managed by professional fund managers and people can invest in them to achieve goals in life like children’s higher education, vacation planning, and purchase of a vehicle or even create an income to be used during retirement. There are many mutual funds available in the market and the following factors can be taken into consideration before selecting a mutual fund for investment:-

1) Goals and Investment time Horizon:-

Every person has certain goals in life that he would like to achieve for himself and his family. It could be the higher education of his children, purchase of a house, or even retirement. The goals can be short-term or even long-term. The time frame is important for the type of returns that you expect to achieve and accordingly right funds can be selected.

Depending on the goals and the time horizon a person can invest in an equity mutual fund, debt fund, or a hybrid fund. Some people have an objective to get good returns and for others, it may be tax saving. If you require funds in the near term, mutual funds have certain sales charges that may lower your returns a bit on sale; so to minimize the impact the time horizon is also important in selecting the fund.

2) Risk Tolerance:-

A person should be aware of the risks associated with his investment before putting his hard-earned money on the table. The risk-taking ability depends on age, stage of life, and the financial condition of a person. If you can’t tolerate the volatility and the swings in your portfolio then you should go for debt mutual funds. These funds are stable but give lower returns than equity mutual funds and are suitable for conservative investors.

The equity mutual funds are more volatile but give higher returns than debt funds. They are for aggressive investors with a longer time horizon. Risks and returns are proportional so an investor can balance his aspiration of returns with his risk-taking ability.

3) Understand the types of funds:-

There are hundreds of equity mutual funds and a person should know the difference and risks associated with each of them:-

Large-cap Funds- The funds that invest a larger part of their portfolio in companies with large market capitalization are the large-cap funds. Large-cap companies are the top 100 companies by market capitalization on the stock exchange in India.

Mid-cap Funds- The mid-cap companies lie in between the large-cap and small-cap companies and ranked from 101 to 250 in the rank of companies by market capitalization in India. They have evolved from small-cap to midcap and are trying to become large cap over a period of time.

Small-cap Funds- The fund manager in a small-cap fund invests at least 65% of his portfolio in small-cap stocks. These are the companies below the top 250 companies on the stock exchange in terms of market capitalization.

Multi cap Funds– These are funds that invest in stocks across market capitalization and their portfolio has large-cap, midcap as well as small-cap funds.

Growth funds– The objective of the growth fund is capital appreciation and they invest in companies that are growing very fast. These companies have a higher price-to-earnings ratio.

Value funds– The value fund invests in stocks undervalued in quality due to various reasons. These companies have a very low price-to-earnings ratio.

4) Past performance of the fund:-

Evaluating the past fund performance is important and it should be done over a longer time frame, through many market cycles. It should be checked that the returns have been consistent and the fund has been able to beat its benchmark over a number of years like three, seven, or even ten years. The other thing to check is the volatility of the fund as compared to its benchmark and a higher stock turnover will impose costs on the investors. The performance of the fund manager and the management team should be checked; a good performance track record will instill confidence in the investment.

5) Expense ratio:-

The expense ratio is the annual fee that an investor is charged for the management of his fund. The asset manager manages the fund with a team of analysts and they manage all the risks. The higher the asset under management the lower would be the expense ratio and if the fund is small; the expenses are met from a smaller asset base, so the expense ratio can be high. A person should select a fund with a lower comparable expense ratio.

6) Load Costs:-

It is good to be aware of fees charged by the fund house and some funds have an entry load in which the fee is charged from investors when they enter their scheme. Exit load is the fee charged by the fund house when the investors exit the mutual fund. The entry load has been removed by most of the fund houses while the exit load is still there. Different fund houses have different exit loads and the aim is to discourage persons from the exit and reduce the number of frequent withdrawals. There are some conditions under which an exit load will be charged before a certain time limit.

7) Size of the fund:-

Many investors believe that the size of a fund is important but there is no reason for this belief. If a smaller fund has a better track record than a larger fund of the same type then the investors should pick the smaller fund.

Mutual funds grow in two ways; when there is a strong performance of stocks in their portfolio and the other way is when there is a continuous inflow of money from the investors. When more investors join a fund there is pressure on the fund manager to deploy the cash as soon as possible.

Size is not a problem for index and bond funds but could at times become a problem for small-cap funds as the fund manager has to purchase thinly traded shares without driving the prices too much upwards. Performance can slip when the fund manager struggles to pick new stocks. When the market conditions are bad these funds may suffer from fast-declining prices and poor liquidity.

8) Direct Vs. Regular Plans:-

Mutual funds have two types of plans – the direct and the regular. In the direct plan, the investors can purchase the units directly from the mutual fund while in the regular plan they go through a broker or an agent. Higher returns are generated when a person invests directly in a mutual fund as there are no expenses concerning the brokerage fees. In the regular mutual fund scheme, the Asset Management Company (AMC) gives a commission to the agents to bring in additional clients. This reduces the amount invested and thereby the returns generated. There are many platforms on the internet which a person can refer for making an investment thereby eliminating the role of the agent and in turn not losing the money to be paid on commissions.

9) Active Vs. Passive Funds:-

You can decide if you want to invest in active or passively managed funds.  In the actively managed funds the portfolio managers decide which securities and assets are to be included in the fund and for doing this they have to do a lot of research on the sectors, companies, and macro factors. As compared to this the passively managed funds have the same composition as the index, track the performance of the benchmark index. The expense ratio of the passive funds is much less as compared to the active funds as they simply have to copy the index and they don’t change their assets unless the composition of the benchmark index changes.

10) SIP Vs. Lumpsum investment:

An investor can benefit by investing in mutual funds either through a Systematic Investment Plan (SIP) or lump sum amount. The only difference is the frequency of investment. Investment in the mutual fund can be done daily, weekly, monthly, quarterly, or half-yearly through a SIP while the lump sum investment is a one-time bulk investment in a scheme. If you are salaried, with a small amount to invest; but can invest regularly then SIP is the most suitable investment option while if you have a big investment amount and can tolerate the risks involved then lump sum is more suitable.

11) Taxation-

You should be aware of the tax implications of the assets where you invest. In the equity mutual funds, Short term capital gains(held for less than 12 months) are taxed at 15% while the long-term capital gains(held for more than 12 months) are tax-exempt up to Rs 1 lakh and above that are taxed at 10% rate. In the non-equity mutual funds, short-term capital gains (held for less than 36 months) are added to your income tax as per your income tax slab and long-term capital gains (held for more than 36 months) are taxed at 20% after indexation benefit.

12) Customer Service:-

How is the customer service of the mutual fund that you selected? Is it easy to get in touch with them? How often do they send the portfolio update and the newsletter? How long does the payment take to arrive? These are important questions that should be kept in mind.

There are many mutual funds that provide solutions for liquidity needs, financial goals, and investment tenures A little research into the mutual funds will make it easier to select them and make informed decisions. In the short term, you may lose some money but if your investment horizon is long enough, with the help of experienced fund managers you can make good returns. The present bank interest on savings is very low therefore the mutual funds are becoming a preferred source of investment for many investors, providing sufficient returns to beat inflation.

dbssethi

After working for many years in the Marine industry it was becoming clear that I was filled with an entrepreneurial spirit and wanted to pursue my own passions and dreams.
Over the years of studying and dealing with my own finances, I wanted to share my experiences with other people. Personal finance is something that excites me the most and I am very passionate about it.
Entering the stock markets during the Harshad Mehta heydays and then the collapse of the market led me to search for answers and I read a number of investment books and with time was able to identify multibagger stocks. Along with my job I was also working as an insurance and mutual fund advisor but managing both was proving difficult. As I had saved sufficient money I thought of taking early retirement and here I am to talk about my financial experiences.

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