A Beginner's Guide to Select the Right Mutual Fund Scheme

You need to know about different types of mutual funds and their risk tolerance before investing. This article explains seven easy steps to select the right mutual fund scheme.

What Are Your Investment Goals?

Before understanding the steps to select the right mutual fund scheme, identify your investment goals. Investment goals imply what you are going to do with the amount you are investing and how much return you expect from that investment.

Whether you want long-term capital gains or immediate returns will decide the types of investment you should opt for. If you want a fund for your retirement that's many years apart, you should not invest in short-term funds. Whereas if you want to pay for your kids’ college expenses in the near future, then short-term funds are the best. Therefore, selecting the funds among many mutual funds will become easier if you know your goals.

How Much Risk Can You Take?

Now, you know your needs, so analyze your risk tolerance before following the steps to choose the right mutual fund scheme. Are you looking for a stable investment? Can you tolerate sudden fluctuations in the value? Your ability of risk tolerance will decide your returns as they are directly proportional to each other. Hence, you need to create a balance between a desire for returns with risk tolerance for choosing the right funds.

What will be the Time Duration?

You have already thought about a goal for your investment and analyzed the level of risk you can take. Finally, it's time to decide the time duration of the investment. You should anticipate and find out whether you will need liquid funds within this time period. If you plan for a very short-term investment, it will take a big portion of the investment as a sales charge. Ideally, you must choose to invest for at least five for better returns. Therefore, decide the time duration of investment before making an informed choice.

What are Different Types of Mutual Funds?

Capital appreciation funds

The main motive of any investment is capital appreciation. If you have a long-term goal and you can tolerate a fair amount of risk, go for long-term capital appreciation funds. However, these funds are risky as they tend to invest mainly in common stocks. Because the level of risk is high, you can expect higher returns over time. Usually, the time frame for these investments is more than five years.

Income appreciation funds

If you want regular income on your portfolio, then do not opt for capital or growth appreciation funds as they do not pay any dividends. In that case, an income fund is a better choice. Usually, income funds invest in bonds or debt instruments that produce regular interests. Therefore, before you follow the steps to select the right mutual fund scheme, you must know about the income funds.

Two common holdings in the income fund category are Government bonds and debt funds.

Government Bonds

 Often, the scope of these funds fluctuates depending on the time horizons, like short, medium, and long term. They are less volatile and mostly depend on the type of bonds available in the portfolio. They often have very little correlation with the stock market, so it helps to diversify the holding in the stock portfolio. Despite low volatility, it has some risks:

• Bond prices are sensitive to the changes in interest rates. When interest rates hike, bond prices rise, whereas bond prices also tend to fall when interest rates fall.
• If an issuer's credit rating falls then, that can affect the prices of the bonds adversely.
• When the bond issuer defaults on the debt obligations, then you may suffer from default. Hence, default risk is also there in the bonds.
• Sometimes bondholders pay the principal amount before the time to benefit from reissuing the debt at a low interest rate. Often investors fail to get the same interest rate or can't reinvest the amount.

Still, you must include a bond as a part of your portfolio whenever you plan to invest in a mutual fund. It is essential for diversification even though it comes with risks. For such investors who have a long-term goal but are not ready to take substantial risks, they must select a balanced fund. A balanced fund is the best alternative and serves the purpose completely as it invests both in stocks and bonds. In these funds, you can expect the best returns.

Seven Steps to Select the Right Mutual Fund Scheme

Investing in a mutual fund is a big decision. Before investing, make sure you identify the goals and consider personal risk tolerance. Apart from that, you know what different types of funds are and how long you want to hold the fund. These are seven steps to select the right mutual fund scheme:

Check the Offer Document

Every mutual fund has an offer document, also called a prospectus. You must check this document carefully. Reading the comprehensive fund documents carefully is the foremost step of selecting the right mutual fund scheme. It contains all the essential information about the fund that includes the scheme's type, objective, past performance, asset management company details, and everything that you must know before investing in that particular fund. In short, you need to begin the process of investing by reading and understanding the offer document.

Check the Objective

Each mutual fund comes with a different set of objectives. Before proceeding with the steps to select the right mutual fund scheme, you must check the purpose. Based on the specific objectives, different factors like allocation of the asset, dividend payouts, sector focus, risks, etc., are decided. Upon reading the offer document, you can check whether that particular fund's objective meets your goals regarding these factors. If you find that the objectives do not match your need, then that is not the right fund choice. In that case, try for another fund.

Check Charges and Exit Loads

Mutual funds charge an amount in the form of fees to offer services and meet various expenses like administration and operational costs, manager's fee, advertisement costs, manager's fee. The expense ratio can be as high as 2-2.5% for an active fund. Apart from some mutual funds charges when you invest or sell your shares. That means you have to pay a fee on entry load as well as on exit load. You can find all information regarding fees in the offer letter itself. Therefore, you should avoid such mutual funds that have high fees and loads. This decision will help you to avoid unnecessary charges that you have to pay for selling your shares.

Analyze the Fund's Past Performance

Even though a good past performance of a fund does not guarantee good performance in the future, still, it will provide an idea about the returns that you can expect. This analysis is one of the essential steps to select the right mutual fund scheme. You must invest in a particular fund only after analyzing its performance. Apart from that, always compare the performance with the benchmark.

You will certainly get a clear idea about the actual performance. On various financial websites, you can find information regarding any fund's past performance along with its benchmark. Always focus on long-term performance as short-term analysis will not give you a clear view.

Evaluate Portfolio

If you are going to invest for the first time without any investment knowledge, this step is a bit tricky. Even if you know the companies on which the mutual fund is investing, you can still not find out whether they are investing in the right holdings. Upon proper evaluation of the portfolio, you will get an idea about the securities and holdings on which the company is investing. The main objective is to find out whether the behavior of the securities matches your preferences

Suppose you want to invest in the automobile sector and then find out the mutual funds that invest majorly in automobile sectors' securities. You can learn whether the mutual fund is investing in sectors like energy, finance, infrastructure, or some other sectors only by evaluating the portfolio thoroughly. Hence, upon proper evaluation, you will have a clear idea about the right fund.

The process of evaluation may be troublesome. Often the holdings change because the fund manager decides whether to buy or sell the securities according to their analysis. In case you do not review the funds regularly, you may find the current allocation different from the time you investd. That's the reason you must review the fund every year after purchasing so that the fund fulfills your needs.

Review the Fund Manager's Credentials

The fund manager is a vital part of the mutual fund portfolio. They have the power to make all the decisions regarding the mutual funds on your behalf. Whether it is about purchasing decisions or about selling, they perform it all. Therefore, you must know about the fund manager. Many investors don't consider this step that important, but in reality, this is one of the essential steps among steps to select the right mutual fund scheme. After all, the behavior of the holdings of the portfolio depends on their understanding.

You must check their credentials and find out how well they have performed in the past. While you research the type of mutual fund, you must also check the fund manager's tenure. This process will provide you with a clear idea about the management skills of the manager. Besides that, check the other funds they are managing currently. If the funds they are managing now are doing well, then that is a good sign. Whereas only one fund is performing well while others are struggling, that will not be a good sign for your fund.

Check the Fund House Credentials

However, many people don't check the fund house's credentials before investing. But if you want to invest intelligently, then always go for the fund house with a good track record. Investing in a mutual fund is a prolonged affair. You will never want to get into trouble once you trust a fund house and make your investment. Therefore, if you don't want to face headaches in the coming years of your investment, always check the fund house's track record.

 New fund houses are coming in every day. In that case, you can't go through their track record. That doesn't mean you can't invest there. The majority of the time, these new fund houses provides you with exciting offers and meets the asset allocation plan you want. In that scenario, you can first invest a small amount and find out the track, and if everything goes well, then invest more.

The Bottom Line!

These steps to select the right mutual fund scheme are easy to follow for even a person who doesn't know anything about mutual funds. By following this procedure, you will invest in the right scheme. Always go for those funds that can fulfill all your requirements.