How to choose a mutual fund

With so many categories of mutual funds, fund houses, and schemes available, choosing a mutual fund is not an easy task for many investors. The best way to begin is to decide on a method to narrow down on the right fund for you. Rarely do investors who do something else for a living employ a systematic checklist to evaluate a fund they are considering buying. Here is our blueprint for a structured approach to choosing a mutual fund. There are five areas that you must evaluate to decide whether a particular fund is a good investment.

The past performance of the mutual fund

Performance comparisons must be used only to compare funds within the same mutual fund category. They are meaningless otherwise. Only when used within the same category of funds do performance numbers tell you anything at all. By the time you reach the stage when you are comparing performance numbers of different funds, you should already have a good idea of how much you will invest in that mutual fund category.

Your risk appetite

Almost all investing is risky, at least those investments that get you any meaningful returns. In general, it is said that the riskier a fund, the more its potential for earning high returns. However, this is a simplified view that implies that a given amount of investment risk always gets you the same returns. This is simply not true because not all mutual funds are equally well-run.

The true measure of risk is whether a fund is able to give you the kind of returns that justify the risk it is taking on. Evidently, this is not as easy to measure as returns. There are a wide variety of statistical techniques that can be used to measure this. We distil a combination of performance and risk measurement into the Value Research Fund Rating. When we say that a fund has a five- or four-star rating, it means that the fund, compared to similar funds, performed better, given its risk level.

Construction of the portfolio

Unlike performance and risk, portfolio is one of the 'internals' of a fund. It is internal in the sense that the result of good, bad or ugly portfolios is already reflected in the first two measures and it's perfectly okay for you to choose a mutual fund on the basis of those two measures alone without actually bothering about what they own. Our basic analysis of portfolios measures whether a fund (we are talking about equity funds here) holds mostly large, medium or small companies. It also looks at whether a fund prefers companies that may be overpriced but are growing fast or whether it prefers low-priced stocks belonging to companies that are growing at a more gentle pace. For fixed-income funds, an analogous analysis tells one whether a fund prefers volatile but potentially high-return long-duration securities or stable and low-return short-duration securities. Also, one can analyse whether a fund prefers safer (lower returns) securities or riskier (higher returns) securities.

How well the mutual fund is managed

Fund management is a fairly creative and personality-oriented activity. This may not be true for some types of funds like shorter-term fixed-income funds and of course, index funds, but equity investing is more of an art than science. When you are buying a mutual fund because you like its track record (and unless you can foresee the future, that's the only way to buy a fund), what you are actually buying is a fund manager's (or sometimes a fund management team's) track record. What you need to make sure is that the fund manager who was responsible for the part of the fund's track record that you are buying into is still there. A high-performance equity fund with a new manager is like a new fund.

Low fund-related costs

While the above are the most important points on which to evaluate a fund, there is one more factor that is becoming increasingly significant, and that is cost. Funds are not run for free, nor are they run at an identical cost. While the difference in different funds' cost is not large, these can compound to significant variations, especially for fixed-income funds where the performance differential between funds is quite small to begin with. Even for equity funds, it may not be worth buying a higher-cost fund that appears to be only slightly better than a lower-cost one. Remember, there is no reason for one AMC to have much higher costs than others, apart from the fact that it wants to have a higher margin, or that it wants to spend more on things like marketing, which are of no relevance to you. If an AMC wants higher returns from its business, then it must justify it by giving you higher returns on your investments.

Also read:
What are mutual funds? A beginner's guide to investment
A beginner's guide to mutual funds

This article was originally published on October 29, 2021, and last updated on August 14, 2024.