How to select Mutual Fund Scheme
Mutual fund scheme selection
The reason why an investor invests in mutual funds could be to earn higher return compared to fixed deposit rates. The investor could have an outlook over the interest rate to fall or participate in expected rally of equity market. He could have a positive view on gold or other commodities or global markets. Once an investor have a clear idea to invest, selecting schemes becomes a lot easier task.
When an investor wants to earn return higher than fixed deposits and expects liquidity as well as protection of capital then the investor can park his fund in cash funds or liquid funds that holds money market securities with maturity less than a year. On a tax adjusted basis also liquid funds earn higher return compared to fixed deposits.
When an investor expects that the interest rate is likely to fall then the option for investor to invest in government bonds or corporate bonds. The two main categories to invest in fixed income mutual funds are short-term income and gilt fund; long-term income and gilt fund. Investing in these funds gives market return or better than market returns.
When an investor expects economy to grow fast or corporate earnings to increase and is bullish on equities or particular sector or theme then he can invest in equity mutual fund schemes to take advantage of rising equity prices.
When an investor is bullish on any international economy, he can then participate in that country’s growth by investing in mutual fund schemes of international equities.
When an investor expects global growth or rise in global inflation or mismatch of demand and supply of commodities then the investor can invest in mutual fund schemes of commodities.
Mutual fund selection becomes lot easier if we have a view of the above factors. These factors along with investors risk appetite and future requirement leads to asset allocation framework.
Every investor has different risk appetite. If an investor has a conservative attitude towards financial markets he would construct a portfolio allocating into fixed income instrument whereas an investor having moderate risk appetite could also add equity exposure into his portfolio where as an investor seeking growth and has higher risk appetite for investing in financial market would allocate more of his funds in equities.
Risk appetite is very much dependent on the investor’s age. As life progresses asset allocation also keeps changing. At an early or young stage the investor doesn’t have much liabilities and his risk appetite is lot higher compared to an investor nearing his retirement.
When an investor has twenty years or more towards his retirement he invests more of his savings in equities (stock), as his objective is towards growth of his investment over the longer term.
As the investor nears his retirement age the composition of his asset allocation changes with respect to time as his risk taking ability also starts to diminish with time. Post retirement (usually after the age of 65) more of his investment proportion is allocated in fixed income (bonds and cash) and less in equities.
Rate of return are also subjected to time. Holding investment for short duration are subjected to higher volatility of return whereas if investments are held for long then negative returns are drastically reduced.
On an average Indian stocks (large) have returned a compounding return of 13.6% compared to average Indian bond return. Power of compounding is the key to holding investment for long term. Say for example an investor invests in stocks Rs. 1,00,000 for 20 years which is expected to compound at the same rate of 13.6% then after 20 years, Rs. 1,00,000 is turned into Rs. 12,81,052.
Before investing into a particular mutual fund scheme we need to address the cost involved in investing in a scheme and measure the fund manager’s performance as it greatly impacts our investment return.
The expense ratio measures the per unit cost of managing a fund. It is calculated by dividing the fund’s total expenses by its assets under management. A mutual fund recovers its fund management costs through its unit holders on a daily basis. The daily net asset values (NAVs) of a fund scheme are reported after deducting such expenses, though the expense ratio is disclosed only once every six months.
The market regulator, Sebi, has set a ceiling for the expense ratio. For an equity mutual fund, it cannot be more than 2.5% of its average weekly net assets. For debt funds, the ceiling is 2.25%, while for index funds and fund of funds (FoFs), the expense ratios are capped at 1.5% and 0.75%, respectively.
If you invest Rs 1 lakh in a mutual fund at a NAV of Rs 10 and the expense ratio is 2%, after one year, there is a gain of 12% on the NAV. So, the value of Rs 1 lakh has gone up to Rs 1.12 lakh.
However, after a deduction of 2% charge, the amount is reduced to Rs 1.09 lakh, which translates into a loss of Rs 2,240. Though it does not seem a big reduction, it could impair the value of investments over the long term.
The impact of expense ratio is greater in case of debt funds, which earn 8-9% on an average. For an investor of an equity fund, paying 2% from an average return of 15-20% may not pinch, but it will hurt to pay 2% in case of an 8-9% average return for debt funds.