How should you select mutual fund schemes

Mutual funds are becoming increasingly popular among investors in India. Mutual funds schemes offer a vast range of investment solutions for a vast range of risk appetites, investment tenures and income needs. There are large numbers of mutual fund schemes in the market and it can be confusing for the average investor to select a mutual fund scheme suitable for his or her needs. In this article, we will discuss how investors should select mutual fund schemes.

Financial planners suggest that investments should always be goal based. If you know why you are investing, you will be able to make the best investment decision. Investing, simply because you have some spare funds, without proper planning will lead to sub-optimal investments. Once you know the “why” part, you will be able to determine three important investment objectives:-

• The tenure of investment
• Your risk capacity
• Income or capital appreciation or both

Once you are very clear about your investment objectives, you can select mutual fund schemes that are suitable for your needs.

Mutual funds are financial instruments which invest in equity market, debt market and money market securities. Different securities have different risk / return characteristics and liquidity profiles. You need to match the fund characteristics with your investment objectives. Let us first discuss how you can select mutual fund schemes for different tenures.

The tenure of investment

Liquid funds, ultra-short term debt funds and arbitrage funds are suitable for very short tenures. If you want to park your funds for a few days to a few months (up to 3 months), liquid funds is the best choice. If you want to park funds for more than 3 months to up to a year, then ultra-short term debt funds is the better choice. The liquidity and risk characteristics of arbitrage mutual funds are similar to liquid funds and ultra-short term debt funds; however, arbitrage funds are more tax friendly than liquid funds because they are treated as equity funds. Short term debt funds are suitable for short investment tenures ranging from 1 to 3 years. Long term debt funds, monthly income plans and equity savings funds are suitable for medium term investments tenures ranging from 3 to 5 years. Hybrid funds and equity mutual fund schemes (including ELSS) are suitable for long investment tenures.

Read benefits of investing in Equity Linked Savings Scheme

Select schemes based on risk capacity

Let us now discuss how you can select mutual fund schemes based on your risk capacity or appetite. If your risk appetite is very low, then liquid, ultra-short term debt funds and arbitrage funds are suitable for you. However, these funds give lower average returns compared to other funds. Short term debt funds are also suitable for investors with low risk appetites. Investors with moderately conservative to moderate risk appetites can invest in long term debt funds, monthly income plans and equity savings funds. Investor with moderately aggressive risk appetites can invest in hybrid aggressive funds. Only investors with high risk appetites should invest in equity funds. Within equity funds, midcap funds have the most aggressive risk profiles but they also tend to give the highest returns; large cap funds, on the other hand, are relatively less risky but they give lower returns than midcap mutual fund schemes.

Income or capital appreciation or both

You should select the mutual fund scheme based on whether you need income or capital appreciation. If you want purely capital appreciation then you should invest in growth options of mutual fund scheme; if you need regular income from your investment, then you should invest in dividend options. Some mutual fund schemes offer multiple dividend option e.g. monthly dividends, quarterly dividends, annual dividends etc. Choose the dividend option based on your cash-flow needs.

Once you have narrowed down your mutual fund scheme selection based on your investment tenure, risk appetite and cash-flow needs, you should select schemes based on their (their fund manager’s) long term performance track record. You should consider at least 3 years performance for evaluating a mutual fund scheme. Ideally a 5 year performance cycle covering different market cycles (bull market and bear market) should be considered for evaluating performance consistency.

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