One thing that goes without saying is, to save your money against inflation, people need to invest. Depending solely on the primary source of income to sustain one’s lifestyle can often lead to unnecessary compromises.
While there are multiple approaches to investing, the highest suitability for the everyday investor lies with equity investment. Real estate might have high returns but is usually not the most affordable, and while gold has stability favouring it, its returns could be better.
For the sake of diversification, it is advised to invest in multiple instruments. However, this rule of diversification applies to a person’s equity portfolio as well.
The equity market can be accessed by investing directly in stocks, but for the uninitiated, the stock-picking process can often be a bit difficult or even confusing. This is where mutual funds enter the game as life savers.
Mutual funds allow investors to buy stocks based on various parameters that best suit their investment needs. It allows investors to hold earning rights from stocks of multiple companies without having to necessarily engage a large sum of money from the get-go.
The workings of mutual funds are pretty well known to the masses. However, the selection process is still a bit of a mystery. So let us demystify the mutual fund selection process a little.
Factors to consider when Selecting a mutual fund
To better understand the suitability of a fund for an investor, a two-way approach needs to be taken into the research process. The two-prong approach includes:
Personal analysis: Under this aspect of research, the investor first understands themselves in order to better find an appropriate fund. The steps under this analysis method are:
- Investment Objective: investment objective decides the end goal that you want to achieve with the investment. It could be the marriage of your child or sibling, a vacation, or the purchase of a house or vehicle.
Based on the necessity of your investment goal, the flexibility of your investment changes. The establishment of an emergency/retirement fund will be less flexible than, say, a vacation fund.
- Time Horizon: The time horizon of your investment is decided by the urgency of the goal you want to achieve with the investment. This helps decide the duration for which you will stay invested in the fund and the returns for the said duration will matter to you.
Going with the above example; for a 25-year-old, the retirement fund will have an approximate time horizon of 30 to 35 years. For the same individual, the vacation fund will have a shorter time horizon.
- Risk Appetite: Various investment instruments and strategies have a varied amount of risk associated with them. Based on your risk tolerance, your choice of mutual fund will change, too, as different mutual funds invest in different businesses, employ trading or holding strategies, and more.
Investment objectives and time horizons combined help a person decide how much risk they can take in relation to certain investments. The long time horizon of a retirement fund allows it to be somewhat risk-friendly, but the importance of the investment goal takes down the risk quotient a little.
With your investor profile established, if you still need some direction with selecting a mutual fund for you, Finology’s Recipe has a mutual fund recommendation that has selection of mutual fund recommendations based on your profile.
Based on your profile, Recipe also has recommendations on asset and capital allocation as well as buy, hold and sell times.
Fund analysis: Once you are done with creating a profile that helps you identify your investment needs, you may want to learn how to analyse funds to be better able to pick mutual funds for yourself. A little DIY can go a long way in helping you learn.
When looking to buy into a mutual fund, here are some of the aspects of the fund that you might want to look into:
- Expense Ratio: Mutual funds are organisations that manage a pool of money collected from a large number of investors. Since the interest of the masses is involved, not any average Joe can be handed the reins of this money. Thus, fund managers are elected to properly allocate the pool of funds collected.
Now, these managers need to be paid, and there are other expenses related to investing that the fund house needs to bear. These expenses are charged by the fund houses against the investors. The percent of charges payable by the investor against the assets in the fund is known as the expense ratio of a mutual fund.
Currently, the expense ratio for mutual funds is capped at 2.25% by the market regulator SEBI.
- Performance Analysis: The ultimate goal of investing in mutual funds, or investing in general, is to generate returns. However, returns alone are not enough. Investors need to study and find out if the returns generated by the fund are sufficient.
A mutual fund should be able to generate returns in line with or more than the average return of the segment it invests in. If the returns cannot keep up with the standards, then the fund management has been so poor that it could not generate the return that even a normal investor could have, interacting with the same stocks.
A comparison must also be made with similar mutual funds by other fund houses. Is your money better utilised with the mutual fund by the organisation you are investing with? Or does a competitor make better returns in the same category?
- AMC: Another measure of a mutual fund is the organisation involved with it. Also known as a fund house, the asset management company collects money from investors to invest in various stocks.
When assessing an AMC, a few things that investors need to look into are the consistency of performance and the fund manager’s performance. You want the fund to be consistently performing well instead of experiencing abrupt spikes in earnings. As for the fund manager, you want to learn their history with other funds. A fund performing well after a change in management could be a result of the actions of the previous manager.
- Entry/Exit Load: Entry and exit loads are charges levied by the fund house against investors when they buy shares with the fund or exit the fund by selling their holdings.
While entry loads are removed from most mutual funds, investors still need to ensure that if their mutual fund charges one, it is as minimal as possible.
Exit loads are levied to deter investors from selling the mutual fund units too quickly. The highest exit load is levied on the first year of buying into the fund, with the rate going down as time passes. Investors should seek low exit loads to ensure they are not charged too steeply in case they want to exit early due to a liquidity crunch.
- Taxation: Returns generated from investments are subjected to taxation based on the period for which the investment is held or the amount of dividend received against the funds.
Dividend received in up to ₹10 lakh do not attract any dividend distribution tax (DDT) in the hands of investors. However, if the dividend received is greater than ₹10 lakh, DDT at 10% is attracted on the dividends received.
Capital appreciation on equity based funds held for less than 12 months are considered short term capital gains (STCG) and for debt based funds, STCG is attracted for capital appreciation of funds held for less than 36 months. For funds held longer than the aforementioned periods, capital appreciation is considered as long term capital gains (LTCG).
While STCG is taxed at 15%, LTCG is exempt up to ₹1 lakh. LTCG over ₹1 lakh attracts a tax rate of 10%.
As mentioned above, DIY can help you learn the ins and outs of the process in a more personal manner. However, to set off on your learning journey, Finology Quest’s course, The Academy of Mutual Funds has two chapters on the basics of mutual funds as well as techniques to analyse the performance and other significant aspects of a fund.
What’s more, the course has a BSE certification which allows you to further pursue a career in financial analysis and have a concrete proof of the time you invest in learning about mutual funds.
Beginning investing can be a somewhat daunting affair. However, everyone who wishes to future-proof their funds needs to begin somewhere.
Mutual funds offer the benefit of diversification to investors as well as affordability to bring the equity markets to everyday investors. The stock market is neither a gamble, not an HNI exclusive playground.
Believe the cricketers when they say, “Mutual funds sahi hai.”