CHOOSING MUTUAL FUNDS TO INVEST IN

Before we get into how to choose a mutual fund to invest in, we need to understand what a mutual fund is and a few basic terms regarding the working of a mutual fund. Mutual funds are basically a single portfolio that contains investment funds from multiple investors, i.e. a pooled investment. Each investor in a particular pool will have ownership of a particular portion of the overall profit. One of the most important terms that we need to keep in mind is the NAV- Net asset value.

NAV= Total net value of the assets in the pool

Number of shares issued

There are 2 kinds of mutual funds, differentiated on the basis of their operations, namely; Open- ended funds and Close- ended funds. With an Open-ended fund an investor can buy newly issued shares at NAV and also redeem the money at the NAV. Additional management fee is charged as a percentage of the NAV. The investor can invest at any time and redeem his investment at his choice too. This is where a Close – ended fund is different. They are professionally managed pools of investment that do not take new investments once the money has been invested and also doesn’t allow redemption before the specified time.

The management of the mutual funds can also be separated into 2 types; actively managed funds and passively managed funds. Actively managed funds refer to funds where the management will select individual securities and their main goal in doing so is producing returns which are higher than those of their benchmark index. Passively managed funds (index funds) are portfolios which are constructed to match the performance of a particular index. The annual management fees are higher for actively managed funds but so are the returns. This in turn leads to a greater tax liability.

There are many types of mutual funds to choose from. A few of them are:

1. Money market mutual funds- very low risk, short term debt securities.

2. Bond mutual funds – investing in fixed income securities, high yield.

3. Stock mutual funds

4. Index funds etc.

There are a few things that should be decided prior to choosing the mutual fund that the investor want to invest in. The amount of risk aka the risk appetite, the time horizon for which the investor wants to invest their money, what kind of returns is the investor looking for? Answers to these questions should be fixed before going any further as this helps build a roadmap to the perfectly suitable mutual fund.

Now, we need to understand the methods in which we can compare two funds so that we can choose the one that is most appropriate and suitable to our needs. Mutual funds have certain measures by which analysts or anyone looking to invest in them, judge their performance:

1. Alpha- It is the measure of portfolio’s return when compared to a specific benchmark and it is also adjusted for risk. When the alpha is more than 0, the return per unit of risk is also more. And when the alpha is negative then it is an underperforming portfolio/ fund

2. Beta- This is the systematic risk which can never be eliminated. It is the measure of the stock’s volatility with respect to the overall market.

3. Standard deviation- this is the measure of volatility of asset price and interest rate.

There are a few ratios that help us in determining which mutual fund is better than the other. The first one is the Sharpe ratio. Sharpe ratio is the excess returns per unit of portfolio risk. A higher ratio indicates a better risk adjusted portfolio/ fund. In simple words, the Sharpe ratio is the measure of the portfolio’s returns versus a risk-free return. This ratio accounts for the total risk rather than just the systematic risk.

Sharpe ratio= Return on portfolio/ fund- Risk free asset

Standard deviation of the portfolio/fund

The M-squared ratio produces more or less the same rankings as the Sharpe ratio but in percentage terms.

The Jensen’s Alpha and Treynor measure both take into consideration only the systematic risk i.e. the Beta of the fund or portfolio, the former being the percentage form of the latter.

Treynor measure= Return on portfolio/fund- Return on risk free asset

Beta of the portfolio

The main rule for investing that we need to keep in mind is “more the risk, more is the return”. There are certain risks that a mutual fund carries. These include:

1. Interest rate risk- this is the sensitivity of bond prices to the change in the interest rate. As the interest rates go, up the bond prices go down.

2. Credit risk- this is the risk of the bond issuer being unable to make a payment because of various reasons like the bond rating being lowered etc.

3. Pre-payment risk- this is the risk of the issuer of the bond, paying back the owed money at an earlier date so as to be able to issue another bond at a lower interest rate, thus making more profit.

4. Default risk- this is the risk of the bond issuer failing to pay the coupon payments or the full money at expiry.

Before making a purchase, it is very essential to understand all the charges and fees that are associated to it. So, mutual funds companies make the most amount of money by charging the customer a certain amount of money as fees. Some mutual funds charge a fee known as load. This load can be of 2 types; front end load and back end load. Front end loan is charged during the initial investment when we buy the shares. The back-end load is charged on redemption of the money before the expiry date. This charge is usually kept in place to deter the investors from trying to redeem their funds earlier than the expiry date. Expense ratio is the annual maintenance charge which is levied by the mutual funds and it depends on the size of the mutual fund. Around 0.5% to 0.75% is a good expense ratio for an actively managed fund; anything more than 1.5% is considered very high.

Investing a big sum of money anywhere should be done after a lot of research into the person or organization that will be handling the money and so keeping this in mind, the track record of the fund and also the record of the managers of the fund should be researched by the investors. A few questions like;

Was the fund at par or more volatile than the index which it resembles?

How and what was the turnover and how will it affect the tax liability?

Were the returns given, consistent with what the other similar funds have shown?

Before buying the fund, the investment literature should be given a read. The fund’s prospectus should give us the idea of its holdings, sectors or companies it invests in and any other trends in the market that may affect the performance of the fund.

The amount of risk-taking capacity you have will decide the kind of mutual fund that would be optimum for you. If an individual has a high-risk taking capacity then, Mid cap and Small cap funds would be the most appropriate. Similarly, for medium risk-taking capacity, Multi- cap funds and for low risk-taking capacity, Large- cap funds.

Another more important part is the Tax aspect that every investor should take into consideration when investing in a mutual fund. Most mutual funds are very efficient in terms of post-tax return. For the equity funds, long term capital gain is taxed at the rate of 10% over and above the exemption given to 1 lakh rupees. Whereas, short term capital gains are taxed at 15%. The holding period of the fund decides whether the fund is short term or long term. Holding period is the amount of time that the investor holds the investment.

There are 2 types of plans that are available for mutual funds; regular and direct scheme. In a direct scheme, the investor can directly buy the required NAV units from the concerned asset management company. In a regular scheme, the investor has to go through brokers to get the NAV units and in that process incur a brokerage fee or commission. Initially when mutual funds were introduced, people didn’t have enough knowledge to choose on their own and so the regular scheme made sense, but now that so many resources are available, a direct scheme makes much more sense.

So, to understand the whole process, lets take an example. ABC is a 50-year-old man and he wants to invest in a mutual fund. First of all, he lists down what his time horizon is, which in this case is 10 years as he needs this money as a part of his retirement fund. The second thing that he would look into is the amount of risk he is ready to take, which is moderate to low as he doesn’t want to mess up the calculations of his wealth which he needs post retirement. And he also needs tax benefits along with this. After going through all the above-mentioned steps, he chooses to go for an ELSS, Equity Linked Savings Scheme, which are close ended (with a lock in period of 3 years minimum). They are also offering tax benefits under the new Section 80C of the Income tax act, so that criteria is fulfilled too. Here the risk is low too as the investment capital is protected and the rest of the money is invested in equity which is slightly riskier. Hence this way, ABC avails of a suitable mutual fund after putting in some effort.

In conclusion I would like to say that due diligence is the most important thing that all of us need to indulge in while choosing which fund to invest in. having a mind map or a road map written down, specifying your goals and needs would be an essential tool to choosing and investing in an appropriate mutual fund.