How to choose the right mutual fund?

How to choose the right mutual fund that can generate the best returns is the most common question among investors. We often judge a mutual fund by its past returns. But that is not enough; you need to make sure the future returns from the fund are also lucrative.  

Mutual funds are of different types like large-cap, small-cap, and ELSS, among others. Once you have decided to invest, you must choose where to invest.

Knowing about the basic factors that shape investment decisions can help you decide which mutual fund you want to opt for. 

Two things you need to do to get started before you choose the right mutual fund

1. Setting a goal

One of the most significant aspects of investing is being clear about your goals. A goal can be anything – buying a car worth 5 lakhs, a retirement scheme worth 1 crore, or an apartment worth 5 crores. 

Any kind of goal requires a time horizon to function. Say, the goal of purchasing a car can be achieved within a time period of 5 years, or that of getting an apartment within 15 years.

Retirement plans have longer time horizons – almost 20 to 30 years.

Thus, while investing, you need to set a clear goal according to the time horizon for achieving it.  

2. Calculating risk appetite 

Once you have set your goal(s) and time horizon, the next thing that you need to analyze is your risk appetite. As the name suggests, risk appetite is your ability to withstand potential losses that might be incurred while investing.

Risk-taking is an important aspect of investment. Why? Because the higher the risk, the greater tend to be the returns. 

Time horizon becomes an important factor in calculating risk appetite. With a longer time horizon, the capacity to take risks also increases. This is because your investment return rates might decrease but they will still have a longer time window to recover. 

What is an equity mutual fund? 

Once you are clear about your goals and have calculated the time horizon and risk appetite, you can familiarise yourself with the different kinds of mutual funds so that you can choose the most suitable one for yourself.

The first type is called Equity mutual funds in which the basic idea is to invest in the shares of various companies. Here, the fund manager will put your money in the stock market to avail the best returns from it.

The returns from such investments depend highly on the market condition, thus, increasing the risk factor in equity mutual funds.

But since higher risks mean more returns, you can opt for equity mutual funds if your time horizon is more than 7 years to accommodate for increased risk.  

What are the different types of equity mutual funds?

Equity mutual funds can be of 4 types based on the level of risk and returns.

1. Large-cap mutual funds

The first one is called large-cap mutual funds. They invest in Indian companies that are considered to be in the top 100 in terms of their market value.

Here, you invest in shares of famous companies like Reliance, HDFC, and Infosys. The risk involved is moderate and the return rate is about 15%. This can be your go-to if you have a larger time horizon.  

2. Mid-cap mutual funds

Mid-cap mutual funds invest in Indian companies that are in the top 101 to 250 in terms of market value like Voltas, JK Cement, and Avenue Supermarts.

The risk involved in mid-cap mutual funds is higher than that of large-cap funds but the return rate is also more – about 17-18%. The time horizon for mid-cap mutual funds has to be at least 7-10 years to have a suitable risk appetite.  

3. Small-cap mutual funds

Small-cap mutual funds are ones that invest in companies that are beyond the top 250 in the country. This means that the amount of volatility is increased and so is the risk involved.

The bright spot here is that these mutual funds can also get you the highest returns which are at times over 25%.

4. ELSS mutual funds

Equity Linked Saving Schemes or ELSS is the third type. This scheme is a dedicated mutual fund allowing investors to save taxes. Here, you have the option to take a deduction of about 1.5 lakhs which will allow you to save almost 46,800 INR in taxes.

It, however, has a lock-in period of about 3 years, meaning you won’t be able to withdraw money from this fund for 3 whole years.

The purpose is to make you stay invested longer and receive higher returns – about 17-18%. The risk factor is higher than that of large-cap funds but ELSS is ideal if you’re looking to make long-term investments while also enjoying tax benefits. 

What is a Debt mutual fund? 

Debt funds invest in government securities, corporate bonds, treasury bills, and other such money-market instruments. Unlike equity funds, they do not get affected by market fluctuations and generate fixed returns.

If you are looking for low-risk investments, you can opt for debt funds. Since debt funds are low-risk investments, the time horizon required can be about 5 years. The expected return rate might range from 7% to 12%. 

A liquid debt fund is a kind of debt fund where you can put your surplus money. This can be utilized for short-term goals, say, for purchasing a laptop or planning a vacation.

These generate returns of almost 7% – 9% which is a huge improvement on the 3% – 4% that bank accounts can generate.

Liquid debt funds are also a brilliant way to save up for emergencies. One way to secure your equity investments as you inch closer to your goal is to move them to debt investments as debt funds have a low-risk factor. 

What is a Hybrid mutual fund?

As the name suggests, hybrid mutual funds are a combination of equity and debt funds. This fund is often chosen by low-risk investors because despite offering low risk, it generates better returns than debt funds. 

If you are insecure about the high risks involved in Equity mutual funds, you can opt for a hybrid mutual fund. It allows you to partially test out equity investments without being exposed to all the risks.

The return rates range from 13% – 14% and goals with shorter time horizons of about 3 years are ideal for this investment. 

What is the significance of the expense ratio and exit load? 

The expense ratio is the money charged to you by the assets management company for managing your funds. The higher the expense ratio, the lower the returns from an investment. Thus, it is wise to invest in a fund with a low expense ratio. 

Another thing you need to know while investing is the exit load or the sum you pay while withdrawing the money from the fund.

The purpose of exit load is to stop investors from exiting the fund prematurely. The exit load usually becomes nil after a year of investment. Thus, it is beneficial to be aware of the terms and conditions. 

Once you have considered things like goals, time horizons, and risk appetite, you can choose from the different types of mutual funds. Next, you can check out the expense ratio and exit load of the chosen scheme.

Good performance in the past might not be guaranteed the same in the future. Nevertheless, it is wise to check out the track record of the fund manager. 

A wise thing to do is invest your money in different funds instead of investing all of it in one. Once you have followed all these steps systematically, choose the right mutual fund.