The best mutual fund for an investor is the one which suits his/her financial goals and risk appetite along with giving good returns.
Here are the parameters which help you to choose the best mutual fund for yourself.
Factors for choosing mutual fund category
1) Time Horizon
Time horizon refers to the time period for which you wish to keep your money invested in a mutual fund. It can be either as short as 1 day to as long as more than 5 years. Different fund categories work best for different time horizons. This is because some funds invest in shorter dated debt and others invest in longer dated debt. Equity funds should only be chosen if your horizon is more than 5 years. The market can be highly volatile in the short term but tends to move higher with earnings growth, over time. We provide you with a ready reckoner of fund categories for different time horizons below:
|Time Horizon||Mutual Fund|
|1 day – 3 months||Liquid Funds|
|3 months – 1 year||Ultra Short-duration Funds|
|1 year – 3 years||Short-duration funds|
|3 years – 5 years||Hybrid/Balanced Funds|
|More than 5 years||Equity Fund|
2) Risk tolerance
Risk tolerance refers to the amount of risk an investor is willing to take with his/her invested money. SEBI in 2015 made it mandatory for all mutual fund houses to display a riskometer which consists of 5 levels of risk associated with the invested principal amount. The 5 risk levels are – low, moderately low, moderate, moderately high, and high. The table below gives you the fund categories that are most suitable to different risk levels and time horizons.
|Time Horizon/Risk||Low Risk||Medium Risk||High Risk|
|Short Duration (up to 3 years)||Liquid Funds, Ultra Short-duration Funds||Short-duration Funds||Arbitrage Funds|
|Medium Duration (3 years – 5 years)||Short-duration Funds||Balanced Advantage Funds||Equity Hybrid Funds|
|Long Duration (5 years and above)||Large Cap Funds||Multicap Funds||Mid Cap Funds, Small Cap Funds|
Factors for choosing mutual fund scheme
After selecting the mutual fund category on the basis of your time horizon and risk tolerance, choose a mutual fund scheme within that category on the basis of the following factors:
1) Performance against benchmark
A benchmark index of a mutual fund scheme is a standard against which its performance and stock allocation are compared. The benchmark index mirrors the investment philosophy of the scheme. For instance, the benchmark index of a large cap mutual fund should be an index of large cap stocks and the benchmark of a mutual fund focussed on banking stocks should be a banking index. SEBI has also mandated that mutual funds use TRI or Total Returns Indices in their benchmarks. TRIs are built on the assumption that dividends are reinvested in mutual funds, as and when they are declared. In other words, the account for the fact that companies declare and pay out dividends. This makes them better benchmarks than just ordinary price indices.
2) Performance against category
It is equally important to assess how a mutual fund performs in comparison to its active peer group to get an holistic understanding of the fund’s performance. This comparison should only be among the same type of mutual fund schemes. For instance, a large cap equity mutual fund can only be compared with other large cap equity mutual funds and not against mid cap equity funds or debt funds. SEBI has defined different types of mutual funds in a circular issued in October 2017 and peer funds must be funds which fall within the SEBI-defined categories.
3) Consistency of performance
A good mutual fund is one which is able to generate good returns for its investors consistently over a period of time and not just whirlwind returns. The fund should be capable of providing consistent returns in both bullish and bearish periods of the stock market.
4) Fund Manager experience
Another important factor to be considered while selecting a mutual fund is the performance of its fund manager and how long he or she has been at its helm. For this, you should look at the fund manager’s experience with the fund in question and with other funds currently managed or managed in the past.
5) AMC track record (including AUM)
An Asset Management Company (AMC) is the company which manages a mutual fund. For example, HDFC Mutual Fund is the name of the AMC which manages schemes like HDFC Equity, HDFC Top 100 or HDFC Small Cap Fund. Many decisions are made at AMC level by the Chief Investment Officer (CIO) of the AMC. A poorly selected stock is often present in several schemes owned by an AMC, because the selection has been made at AMC level.
Also, check the Assets Under Management (AUM) of the mutual fund. In the equity category, especially in small cap funds, a large AUM can make it hard for the fund to enter and exit companies. On the other hand, size works in favour of the fund in liquid or short term debt funds. This makes the fund less vulnerable to redemptions made by large investors.
6) Expense Ratio
The expense ratio of a fund reflects the fee charged by an AMC for the administration, management, promotion and distribution of a mutual fund. All expenses incurred in the running of the fund are included in this figure. This figure is capped at 2.25% of the total fund assets by SEBI. Direct plans of mutual fund schemes have lower expense ratios than regular plans because distributor commissions are not paid in direct plans. In general, lower the expense ratio, higher are the net returns of a mutual fund scheme. You can find out more about this here.