How to select Mutual Fund – Detailed Information | Master Mutual Fund Selection in Just 3 Easy Steps

To cultivate your capital you have always listened or been referred to invest in the stock market, mutual fund, ETF, debt fund, bold, real estate, forex, cryptocurrencies, fixed deposit, etc these are all the investment instruments in which you can invest to grow your wealth or so-called capital.

In this article we are basically going to focus only on mutual funds, types of mutual funds, how to select mutual fund best returns.

So before starting directly for how to select mutual funds we should know what is a mutual fund?

What is a mutual fund

Whenever a group of investors wants to invest their capital in investment instruments they have to do a lot of research analysis of particular instruments. If an investor is capable of analyzing the financial data of a company then it is more likely that the investor will invest himself.

But in another case, if the investor does not know the financial World he cannot effectively analyze the instruments that are shared for debt funds or bonds he/she will hire someone to manage investments on behalf of him/her. 

Excepting some handful of investors, some so many investors need someone to manage their fund in the equity or debt market to grow it. Here comes the role of the fund manager. Fund managers basically manage investors’ funds by choosing the right securities like stocks, bonds, golds, etc to invest in. 

This fund manager charges some fees to manage the fund and the returns generated from that fund are paid back to the investor as per their investment.

This is how simple the process of mutual funds works. In a market where there are thousands of asset management companies and fund managers, it will be hard for normal investors to considered mutual funds.

Incorrect ways of selecting a mutual fund

whether you may have already invested in some kind of mutual fund or planning to invest in it, then the very first question that arises in your mind is in which mutual fund you should invest to how to select a mutual fund. An immature person is likely to consider these two ways of selecting mutual funds

Investing in mutual fund by referral of some friends or colleague who does not have financial knowledge.

Selecting mutual funds based on past 2 to 3-year performance. This is the most common mistake that new investors make while investing in mutual funds. 

Funds that were the best performing in past can be tomorrow’s worst performance fund. And vice versa.

But don’t worry! We are going to clarify the whole process of selecting mutual funds in a stepwise manner.

How to select mutual fund: Basic Terminologies 

Direct plan 

Choosing a direct plan while investing in a mutual fund means you are investing without any distributor or agent. In a direct plan mutual fund, you don’t have to pay any commission or fees to an agent or broker.

Regular plan 

It means you are investing in that fund through the distributor. In such a case, you have to pay some fees to the distributor.

NAV (Net Asset Value)

It is similar to companies; as companies have their share, the mutual fund has its units. The price of a single share is called share price and the price of a single unit of MF is called net asset value off that asset management company or mutual fund.

Growth option 

While investing in mutual funds if you select a growth option then the profit generated from your investment will be reinvested in that fund.

Dividend option

IF you select the dividend option while investing in the mutual fund then the profit turn from your investment will be paid in your bank account on a monthly, quarterly, or yearly basis.

Category of mutual fund 

Basically, mutual funds are can be categories as equity end debt mutual fund

Asset size 

It is the total amount of funds that the AMC is managing. Larger the fund AMC is managing implies greater belief of investors in that AMC.

Expense ratio 

For managing your fund the AMC or fund manager will take some charge which is called the expense ratio. It is generally charged annually.

Benchmark 

To compare whether a mutual fund is performing better or not, it is compared relative to its benchmark. Ideally, returns of mutual funds should be greater or equal to their benchmark return. Generally, benchmarks are nifty 50, nifty 100, mid-cap, BSE 100, etc

Turnover 

It is represented on a percentage basis. This means, what percent of old holdings are sold and new holdings are purchased in place of that in the previous year.

Open-ended fund 

The fund in which investors can buy or sell units of a mutual fund at any given point in time is called an open-ended fund. 

Closed ended fund 

In a close-ended fund, you can only invest and exit at a specific time.

Exit load 

If you sell your equity mutual fund unit before one year then most of the mutual funds will charge a certain percent of your capital called an exit load.

How to select mutual funds

How to select mutual fund: Deciding your requirement

Before getting on to screening and technical aspects of mutual funds you must decide 

why you want to invest in mutual funds, 

how long you want to invest in mutual funds and 

amount of risk that you can bear while investing in a mutual fund.

Deciding your goal

Decide why you want to invest your money. It can vary from person to person, you can invest to buy a house, car, bike, educational purpose, retirement plan, or just grow your capital.

Defining time limit

According to your goal, you can decide the duration for which you will need to hold your investment.

The duration can either be less than three years, 3 to seven years, greater than seven years

Less than 3 years

If your time horizon is less than three years then it is highly advised to invest only in debt mutual funds. As they contain very little risk and guaranteed returns in short term. 

Debt MF is also divided into different types like a liquid fund, low duration fund, short term fund, the gilt fund (which deals only in government securities).

Greater than 3 years

If your time horizon is greater than three years and so on then you can consider equity funds like large-cap mutual funds, small-cap mutual funds, multi-cap mutual funds, hybrid mutual funds, etc

Understanding risk

Every investment comes with risk. While choosing any mutual fund try to look at 

Three factors for considering risk in mutual fund

Downside return 

Don’t just consider upside growth but also look for downside returns that the fund has given in any particular year in the past.

Returns consistency 

Some mutual funds make you extraordinary returns in some particular year and remain to underperform in the rest of the years. Try to stay or invest less in such a fund. Look for funds that are consistent in generating returns.

Fund manager 

Fund manager plays a very important role in any mutual fund. As he actively managing the fund the track record of the fund manager should be analyzed.

How to select mutual fund: Screening of mutual fund

Once you have decided your goal, the time duration, and the risk that you can take on your capital now it’s time to select a mutual fund that will be best suited for you.

For this purpose, the mutual fund is categorized into five different categories and their sub-categories so that it will be easy for you to consider mutual funds depending on every five parameters.

Market capitalization

In this category, the mutual funds are categorized based on the market capitalization of companies in which they invest. 

large cap mutual fund

Such funds invest 80% of their investment only in large-cap companies. Large-cap companies are the one feature in the top 100 of any index. Search funds are very stable, less risky, and give fewer returns compared to other funds.

If you are very conservative towards capital and want to take less risk then this type of fund is suitable for you. 

Mid cap mutual fund

This fund invests approximately 65% of its capital in mid-cap companies. Mid-cap companies are top 101 to 250 in the index. Such funds generate high returns than large-cap but also the risk increases.

Large and mid cap fund

 35% of capital is invested in large-cap companies considering low risk and 35% of the fund is invested in mid-cap companies for higher returns. If you want less risk but a higher return then such types of funds are suitable for you.

Small cap mutual fund

As the name suggests it invest 65% of their capital in small-cap companies. Any company beyond the top 251 is considered a small-cap company. Funds are  Highly risky but returns are also high.

Multicap mutual fund

65% of the capital is invested in large-cap mid-cap and small-cap companies. In such companies fund manager is very important. As he can change asset allocation as per his discretion. There is no exit load and taxes charge for shifting of asset allocation from large-cap to mid-cap or mid-cap to small-cap and vice versa.

Profit distribution and growth prospects Mutual Fund 

Dividend yield equity fund

Such funds are designed to pay dividends to its investors on regular basis. In this fund, 65% of investment is done in dividend-paying stock.

Value equity fund

The investment focuses more on underperforming shares or companies but with high future growth potential.

Growth equity fund

The investment is done only in high-growth potential companies with good corporate earnings. The profit earned is also reinvested. 

Mutual fund based on Investment strategy

Contra equity fund

AMC invests in the underperforming sector which is against the market trend. If the market is in uptrend or bullish the fund is allocated in the underperforming sector or a downtrend.

Focused equity

65% of the investment is done only in 30 or less stock. There is less diversification of stocks. Such funds can give high returns but are moderately Riskier. 

Sectoral/ Sector specific equity fund

As the name suggests 80% of the investment is done only in a particular sector. These funds are very risky if the sector remains to underperform and if the sector outperforms the market then the fund will also outperform. 

Mutual fund based on Management style

Active mutual fund

Only this type of mutual fund is actively managed by the fund manager directly. The fund manager generally charged a certain percentage of fees to manage the fund. The asset allocation is at the discretion of the fund manager.

Passive mutual fund 

Such funds mimic any particular market or index They are also called ETF exchange-traded funds. There is no role of the fund manager.

Mutual fund based on taxes

Equity link saving scheme (ELSS)

This fund invests 80% of its capital ininequitiesThe minimum locking period For such a fund is three years. If you withdraw after the lock-in period then according to Income Tax Act 80 see there will be tax relaxation of up to 1.5 lacs.

Non-tax saving equity fund

Any mutual fund that does not come under the category of ELSS is considered in this category. You will have to pay taxes for both long and short-term capital gain. 

Existing mutual fund or SIP

Exiting your position or profit booking is more important than investing in a mutual fund. As the market remains in an up and down cycle you have to regularly book your profit or exit your position if adverse conditions are likely to take place.

You can exit your position if your goal is achieved or the predefined time period is completed. 

Another way of exiting and reinvesting is through understanding the PE of the index that you are investing in. 

The below diagram shows a correlation between the pe ratio and the price of the index.

Relation between Nifty50 and PE of nifty50

How to select mutual fund: Summary

Before investing in a mutual fund first determine your goal, time duration, and risk that you can take on your capital.

Manage or invest in both equity mutual funds and debt mutual funds. Equity mutual funds will give you high returns while debt mutual funds will protect your capital.

To understand the diversification of mutual funds you can check out this video

Considered the above-mentioned 5 points for screening the best suitable mutual fund for you.

Exiting the investment or profit booking is more important than investment. 

Finally don’t be an immature investor who just invests on referral or considering past year performance.

Hope you have got some insight about selecting the mutual fund for at least screening the right mutual fund for you as per your need.

The above content is only for educational purposes and any investment regarding decision should be taken only after consulting your financial advisor only.

Happy trading and investing!

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Divyanshu Lad

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