Mutual Fund Investment: Step by step approach to follow before investing in mutual funds

Increased awareness about mutual funds has successfully increased the retail investor participation in the capital markets, bringing in a significant number of fresh investors from all age groups, geographies and income levels. However, with around 1,200 mutual fund schemes, 45 fund houses and 46 fund categories to choose from, selecting an appropriate mutual fund would be a daunting task for most of the fresh investors.

Here I will list a step-by-step approach for fresh investors to help in their fund selection process.

1. Align investments with your financial goals

Aligning your investment with a financial goal helps decide how much to invest and for what time horizon to stay invested in. Setting a time horizon for attaining your financial goals will help determine whether to invest in debt, equity or hybrid funds. For example, as equity can be very volatile in the short term while beating other asset classes like fixed income instruments over the long term, investments made for long-term financial goals can be made in equity mutual funds. Similarly, as fixed income investments offer greater income certainty than equities, debt funds would be more suitable for goals maturing in the short term.

2. Review investment objectives and strategies of funds

All mutual funds have to clearly state their investment objective and strategy, which reveals their broad fund management style and asset allocation strategy. Checking the objective and investment strategy of a mutual fund before investing in it will help you understand whether it would match your financial goals, risk appetite and investment philosophy, if any. Investors can find the fund’s investment objective and strategy in Key Investment Memorandum (KIM), Scheme Information Document (SID), product leaflets, product presentations and other product literatures.

3. Check the fund’s past performance

Ensure to compare the performance of selected funds with its peer funds and benchmark indices over several time periods, like 1 year, 3 years, 5 years, 7 years and 10 years. While the past performance of a fund doesn’t guarantee same performance in the future, comparing the past performances would help you to compare how the fund dealt with different economic conditions in the past vis a vis its peer funds and its outperformance of its benchmark index.

4. Factor in the fund’s expense ratio

Expense ratio refers to per unit cost incurred on managing a mutual fund scheme. It is obtained by dividing annual operating expenses as percentage with average daily net assets. The operating expenses involve investment management and advisory fees, commissions paid to distributors, transfer and registrar agent fees, audit and legal fees, fund administration expenses and marketing and selling expenses. As the expenses are met from assets managed by the fund, a lower expense ratio would mean that more of your money would remain invested in the fund for future compounding and growth. The importance of expense ratio becomes more crucial in short term debt funds as they have limited upside potential unlike equity funds.

Investors should prefer direct plans of mutual funds over its regular counterparts as the expense ratio of the former can be up to 1% lower than the latter resulting. The lower expense ratios of direct plans lead them to generate higher returns. While the outperformance in returns might seem marginal in the initial years, the difference can become substantial over the long run due to power of compounding.

5. Check the reputation and experience of the fund house

While many tend to give high importance to fund managers while evaluating the future potential of funds, the fund houses and their investment philosophies also play a crucial role in the future performance of their funds. Good fund houses lay more importance on building a strong organizational process and a good management team in place than on relying on just fund managers. Thus, even if a star fund manager exits a good fund house for better opportunities, the strong organizational process of that fund house will help in ensuring continued outperformance of its funds in the future.

Likewise, a fund house with a rich experience over all types of market cycles will be better armed to tide over future market volatility and economic uncertainties. Awareness of the reputation and experience of fund houses would also help you in evaluating their New Fund Offers (NFOs), which come with no historical data for the purpose of peer and benchmark comparisons.

(The author is Director, Paisabazaar.com)