Learn How to Choose Mutual Funds: Simple Guide for Smart Investors

The simplicity, diversification, and professional management of a mutual fund are the reasons it has become such a popular vehicle for investment. It pools together money from lots of investors into a diversified portfolio. Whether you’re an experienced investor or a starter, the decision of which one to choose really matters in determining your financial outcome.

With so many varieties, it might be confusing how to make a decision. Let’s walk you through the procedure of choosing a mutual fund from India, bearing in mind parameters such as risks, liquidity, expense ratios, and tax implications.

How to Choose Mutual Funds in India?

1. Determine how much risk you are willing to take. This will guide you toward the appropriate mutual fund category.
2. Look at the past performance of the fund, keeping in mind that past performance is not always indicative of future results.
3. Lower expense ratios can result in better returns over time.
4. Be informed of the investment strategy: Look at the fund manager’s strategy and make sure this shall happen in order to follow your goals and risk tolerance.

By following these steps and assessing the factors discussed below, you can make a decision as to which mutual fund best suits your requirements.

Factors Considered Before the Category of a Mutual Fund is Selected

Selection of the right category for mutual funds is very critical as it sets the base for your investment’s risk and return profile. Among the factors you need to consider when selecting a category are:

Risk Tolerance: Risk tolerance is a crucial factor in choosing a mutual fund. 

Time Horizon: Plan type-investment duration in which you foresee yourself staying as a shareholder could determine the fund’s category you could make a choice over. For objectives of less than 3 years, liquid/debt funds and objectives running for 5+ years may be more compatible with equity/ hybrid funds, respectively.

Tax Considerations: Taxation on various types of mutual funds is different. For equity mutual funds, the long-term capital gains tax applies if held for more than one year, whereas, for debt funds, it might be different. The tax treatment of a fund must always be considered before investing.

Factors to Evaluate Before Choosing Mutual Funds

1. Risk
Risk is an inherent part of investing in mutual funds. Every mutual fund comes with its own level of risk, and this is influenced by the underlying assets it holds. Here’s how to assess risk:

• Equity Funds: High risk. They invest mostly in stocks. 
• Debt Funds: Low risk. 
• Hybrid Funds: Medium risk. They invest both in equities and debt. It provides a balance between growth and safety.
  

2. Liquidity

Liquidity is the ease with which you can buy or sell your mutual fund units. Open-ended mutual funds generally offer higher liquidity, and investors can redeem units at any time.

• Equity Mutual Funds: Usually liquid, but the value may vary with market conditions.
• Debt Funds: Relatively liquid, but redemption penalties are attached depending on the type of fund.
• Close-ended Funds: The maturity date is fixed, and redemption is restricted.
• If you are investing for a short term or need easy access to your money, make sure that the fund you choose has the liquidity you need.
  

3. Investment Strategy

Every mutual fund has an investment strategy that decides how its assets are allocated:

• Growth Funds: These funds focus on capital appreciation by investing in high-growth companies or sectors.
• Income Funds: These funds aim to provide regular income through dividend payouts or interest from bonds.
• Value Funds: These funds focus on undervalued stocks with long-term growth potential.
• Index Funds: These mimic the performance of a market index, such as the Nifty 50 or Sensex.
• Select a mutual fund that has an investment strategy in line with your financial goals and risk appetite.
  

4. Fund Performance

The past performance of a fund is one of the important factors to be considered while selecting a mutual fund, though it cannot guarantee future performance. A fund that has been delivering consistent results, especially during times of market decline, maybe a relatively safer bet.

5. Expense Ratio

It is the annual management fees and operation, literally the cost of running the mutual fund, which will reflect a higher expense ratio over time, driving a dent in your returns. While evaluating a mutual fund, select the one with the low expense ratio, especially for the long term.

• Active Funds: Generally, their expense ratio is high because more effort involves manual management.
• Index Funds: These funds have low expense ratios because they are simply a passive tracking of an index.
• Low-cost funds may seem appealing, but they balance the expense ratio with the fund’s overall performance and strategy.
  

6. Exit Load

Exit load is a fee charged by fund houses when you redeem your units within a specified period:

• 1% exit load for redemptions within 12 months.
• No exit load for investments held beyond 12 months.
• Before investing, check the exit load structure and assess whether it fits your investment horizon.
  

7. Taxes

Taxes can significantly impact your mutual fund returns. Different mutual funds are taxed in different ways:

• Equity Funds: LTCG tax is levied if the investment is held for more than one year. It is 10% above ₹1 lakh in gains. STCG tax of 15% applies if the investment is held for less than a year.
• Debt Funds: The returns are taxed as per your income tax slab if held for less than 3 years (STCG). Long-term capital gains (LTCG) on debt funds are taxed at 20% with indexation benefits if held for over 3 years.

Always consider the tax implications of the fund you’re investing in to avoid unexpected tax liabilities.

8. Direct Plans

Direct plans have become increasingly popular because they offer a lower expense ratio compared to regular plans. In direct plans, no commission is paid to distributors, which results in reduced costs for investors. If you’re familiar with mutual fund investments and can navigate the process without assistance

Types of Mutual Funds

There are various types of mutual funds, categorized based on their asset allocation, risk level, and investment goals. Here are the main types:

• Equity Funds: Focus on stocks and are suitable for long-term capital appreciation.
• Debt Funds: Invest in bonds & other fixed-income securities, providing more stable returns.
• Hybrid Funds: Combine both equity and debt, offering a balanced approach.
• Money Market Funds: Invest in short-term, low-risk instruments such as Treasury bills.
• Sectoral Funds: Invest in specific sectors of the economy, such as healthcare or technology.
  

Consider Before Investing in Mutual Funds

• Financial Goals: What is your objective—retirement, education, buying a home?
• Risk Profile: Are you comfortable with high volatility, or do you prefer safer investments?
• Investment Horizon: How long do you intend to stay invested? Choose funds that are in line with your time frame.
• Track Record of the Fund Manager: The Experience and past history of the fund manager are a few things to consider.
  

Conclusion

You need to choose the right mutual fund according to several factors – such as your financial goals, risk tolerance, and time horizon. Remember that mutual funds are categorized into different types, so select one that best suits your needs. By following these steps, you can make informed decisions and grow your wealth through mutual fund investments.

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