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How to select a suitable fund to invest in

Much like everyone else, you too would have, felt this when you stepped into an ice cream parlour. Just a glance at the menu card or the variety at display is enough to send you into a tizzy; flavours galore with choices of cups, cones and sticks. And all of them look so lip-smacking that you keep changing your mind almost every second.

Well, you may feel, the scenario in case of mutual funds too is quite similar. There are a few thousand funds in the dozen or so broad categories that they are classified into. It looks like a maze for the new entrant and even some old timers. If you too are unable to decipher the maze, the best option would be to seek professional help from a competent and trusted advisor. However, if you want to attempt finding suitable investments on your own, here are some pointers that would help you zero in on the fund of your liking.

  1. Identify your investment horizon: When you have some funds to invest, you would normally have a plan about how you want to utilize it ultimately. For instance, you may want to save up for the down payment of your dream home in two years’ time or put it away for your retirement which is fifteen years away. Knowing your investment horizon would be the first step in selecting a suitable investment.
  1. Identify your investment objective: While investing, your objective could be to aim for:

Growth of capital, if your financial goal is a long term one. An example would be the retirement goal identified above.

Preservation of capital, if your goal is short term like the down payment goal identified above.

Generation of regular income, if you are investing a lump sum with an aim of drawing it down over a period of time. An example of this would be a retired person wanting monthly cash flows for his living.

Objective, in some cases, could also be tax saving or even generating a particular rate of return without going through the above process elaborately.

  1. Know your risk profile: This has three major components.

Risk requirement: What is the extent of risk that your financial position forces you to take? This depends on the gap between where you are and where you want to go. If the gap is large, you may need to take higher risk and vice-versa.

Risk tolerance: What is the extent of risk that your present financial health allows you to take? If you are too deep in debt, you may not afford to take much risk.

Risk appetite: What is the extent of risk that allows you to have a good night’s sleep? If you do not have the stomach to tolerate the gyrations, you would do well to alter your investment strategy accordingly.

Each of the following fund categories exhibit different characteristic suitable to different kinds of investors:

Type of fund

Risk category

Suitable time horizon

Suitable objective

Liquid funds

Low

Few days to few weeks

Capital preservation

Ultra-short term funds

-do-

Few weeks to months

-do-

Short term funds

-do-

Few months to couple of years

-do-

Gilt & bond funds

Medium

Few years

Income generation with capital preservation

Monthly Income Plans (MIP)

-do-

-do-

-do-

Balanced funds

High

Above 5 years

Capital growth

Equity funds

-do-

-do-

-do-

  1. Pick the right category: Your investment horizon and risk profile play a very important role in this regard. You need to match your horizon and risk profile with the fund category. Typically, more volatile funds like equity funds are suitable for long term investing. But if you pick such a fund for the short term, any temporary erosion of capital could impact your financial goal. Similarly, if you pick a short term debt fund for a long term horizon, you may be compromising on the growth potential of your investment because such funds are typically suitable for the short term with lower risk. Similarly, your risk profile plays a very important role in selecting the fund category. If you do not have the risk tolerance, picking a volatile category like equity could cause you discomfort and panic, leading to unexpected outcomes.

Pick the right fund: Once you have understood your investment requirements reasonably well and picked your fund category, you need to identify the fund house and the schemes that suit your needs. You may rely on websites that enable you to compare various schemes. They also offer a rating on schemes which you may take as the starting point for your further research. You may also visit the websites of the fund houses to gather data on their schemes. You would do well to dwell into the following aspects while picking a fund:

Pedigree of the fund house: A reputed name with goodwill in the investment arena would do you good. The size of the fund house is not as much a criterion as its competency. A small fund with a good track record should rank equal with a large fund and similar track record.

Performance consistency: It would not be prudent to go by the most recent performance of a fund as it could be misleading. Sporadic bouts of good performance are possible by luck too. But to deliver good performance over an extended period requires skill and robust processes. Check how consistently the fund house and schemes have performed. While comparing performance in terms of returns, you would also do well to consider the risk taken by the fund. This is because a fund may take on disproportionate risk to generate just a little outperformance which may not always work favourably. You would do well to consider risk adjusted returns while comparing funds. There are ready metrics like Beta, Alpha, Sharpe ratio, etc. which are available publicly for you to analyze this. You may compare it with its benchmark or with its peer group.

Expense ratio: If the scheme spends too much, even the best investment returns could be frittered away. Check how the scheme stacks up against its peers.

Mutual funds facilitate a wide range of investment goals and objectives. You only need to be diligent in picking the right fund that suits you.

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Mutual fund investments are subject to market risks, read all scheme related documents carefully.