How should you select mutual fund schemes for your investments
Mutual funds are becoming increasingly popular among retail investors in India as they offer a vast range of investment solutions for all kind of risk profiles, tenures and investment needs. As there are thousands of mutual fund schemes in India it can be very confusing for the average investors to select a mutual fund scheme which is suitable for his or her investments needs.
Therefore, let us analyze how you should select mutual fund schemes.
Most of the investment experts suggest that investments should always be goal oriented. Your investment goal could of few months to many years away from now. If you are investing on the basis of your goal, you will be able to make the best investment decisions. If you are investing simply because you have some surplus cash without proper planning, it will lead to sub-optimal return from your investments. Therefore, you should consider the following three important investment objectives before investing:-
- The tenure of your investment
- Your risk taking capacity
- You want income or capital appreciation or both
Once you are very clear about the above investment objectives, you can select the right mutual fund schemes suitable for your needs.
Mutual funds are financial instruments which invest in equity market, debt market and money market securities. As such different securities have different risk / return characteristics and liquidity profiles. As an investor, you need to match the fund characteristics with your investment objectives. Let us first discuss how you can select mutual fund schemes for different investment tenures.
Selection of mutual fund schemes based on investment tenure
Liquid funds, ultra-short term debt funds and arbitrage funds are suitable for very short term tenures. If you want to park your funds for a few days to a few months, say upto to 3 months, liquid funds is the best choice. However, if you want to park surplus funds for more than 3 months and up to a year, ultra-short term debt funds is a better option of investment. Read what are liquid funds
The risk characteristics and liquidity of arbitrage 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 from the taxation point of view. What are arbitrage mutual funds and how they work
Short term debt mutual funds are suitable for short investment tenures ranging from 1 to 3 years. Long term debt funds or income funds, monthly income plans and equity savings funds are suitable for medium term investment tenures ranging from 3 to 5 years. Please read what are mutual fund income funds and what are mutual funds monthly income plans
Hybrid equity oriented mutual funds or balanced funds and equity mutual fund schemes (including ELSS) are suitable for long investment tenures of minimum 5 years and above. Again among equity mutual funds, investors should have higher investment tenure for thematic and sectoral mutual funds. Read what are balanced mutual funds and what are diversified equity mutual funds
Selection of mutual fund schemes based on risk profile
Let us now analyze how you can select mutual fund schemes based on your risk profile 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 category of mutual funds. Short term debt mutual funds are also suitable for investors with low risk appetites.
Investors with moderately conservative to moderate risk profile can invest in long term debt mutual funds, monthly income plans and equity savings funds. Read what different types of debt mutual funds in India are
However, investors with moderately aggressive risk appetites can invest in balanced funds and large cap equity mutual funds.
Let us see the historical returns of large cap equity mutual funds
However, within equity mutual funds, there are mid and small cap funds, diversified equity funds and thematic/ sectoral equity fund categories which are suitable only for investors with high risk appetite. Large cap equity mutual funds are relatively less risky and therefore, generally they are suitable for moderately high risk takers.
To see the past performance of any category of equity mutual funds visit top performing mutual funds
Scheme and option selection basis you want income or capital appreciation or both
You should select a mutual fund scheme based on your investment needs which are - income or capital appreciation. If you want purely capital appreciation then you should invest in the growth option of mutual fund schemes. However, if your need is to get regular income from your mutual fund investments, then you should invest in dividend options. Some mutual fund schemes offer multiple dividend options e.g. monthly dividends, quarterly dividends and annual dividends etc. Debt mutual funds even offer daily dividend, weekly dividend or fortnightly dividends. Choose the dividend payout option based on your cash-flow or income needs.
Once you have narrowed down your mutual fund scheme selection based on your investment tenure, risk appetite and your cash-flow or future growth needs, you should select schemes based on their long term performance track record. You should consider at least 3 years performance for evaluating a mutual fund scheme. Ideally a 5 year performance period which can cover different market cycles, bull market and bear market, should ideally be considered for evaluating performance consistency of a mutual fund scheme.
We have discussed how the investors can select mutual fund schemes based on their investment objectives, risk profile and time horizon. Selecting the right mutual fund scheme and investing in it is just the beginning. Investors should also review the performance of their mutual fund investments from time to time, at least once annually, and ensure that their investments are in line with their investment objectives.