Mutual funds: What are they and how do you choose the right funds?

By Angel Broking | Published on 5th October 2020 | 60

Mutual funds: What are they and how do you choose the right funds?

When you’re getting started with your investment journey, one of the first pieces of advice you’ll receive is to diversify your investment portfolio. Now, what better way to do that than to choose a financial product that is already diversified? Not sure what we mean? Well, we’re talking about mutual funds. These financial instruments have diversification at their core.

To understand this better, let’s begin at the basics.

What are mutual funds?

Mutual funds are a kind of financial product wherein the money invested by different investors is pooled together. These funds are then invested in various securities like stocks, bonds, money market instruments and other assets. So, you see, mutual funds spread your capital across multiple securities, thereby inherently achieving the goal of diversification.

To draw parallels with examples from life, investing directly in equity is like an à la carte meal, while investing in equity mutual funds is more like a buffet. There are more choices available, and your selection allows you to spread your investment risk. Now, there are different types of mutual funds as well. Let’s discuss some of them, so you can get to know your choices better.

What are the different types of mutual funds?

Depending on what kind of assets they invest in, there are different types of mutual funds available. Here’s a preview.

  • Equity funds:

These are funds that invest your money in stocks of different companies. Equity funds, as expected, carry a higher degree of risk.

  • Debt funds:

Debt funds are mutual funds that invest in fixed income securities like bonds, government securities, and treasury bills, among others. They carry lower risk.

  • Hybrid funds:

Hybrid funds invest in a mix of two or more asset classes – most often, stocks and bonds. The risk is more evenly distributed in these types of mutual funds.

  • Balanced funds:

Like hybrid funds, balanced mutual funds also invest in multiple asset classes – often stocks, bonds and money market instruments.

While these are the major types of mutual funds, there are many other subcategories too. For instance, equity funds can be small cap funds (that invest in the stocks of small cap companies) or large cap funds (that invest in the stocks of large cap companies).

How do you choose the right mutual funds for your investment portfolio?

Given that there are so many options, how do you choose the right mutual funds for your investment portfolio? Well, here’s where it becomes important to first know yourself as an investor. Here are three important metrics that you need to sort out.

1. Your investment objective

Here, you need to figure out what the real reason behind your investment is. It varies from one person to another. And it could be anything like taking care of your children’s education, buying a car or even owning a house. Depending on your investment objective or your financial goal, the ideal mutual fund scheme changes.

2. Your risk tolerance

Figuring out how much investment risk you can tolerate will help you understand if you are risk-averse or if you’re open to taking a good amount of risk. And accordingly, you can choose the right mutual funds for your investment portfolio. For instance, a risk-averse investor would do well to choose debt funds or hybrid funds instead of equity funds.

3. Your investment horizon

Here, you’ll get to identify if you’d like to keep your capital locked in for the short term or if you can afford to lock it in for longer. This factor also plays a key role in determining what the ideal mutual fund for you is. For example, you would do better to opt for an equity fund only if you’re investing for the long term.

Now, you know the three basic factors that help you understand your investor profile – your objective, your risk tolerance and your investment horizon. But is it enough to only look at these metrics? Not really. You also need to analyze other factors, many of which are beyond your control.

Here’s a sneak peek into some such factors.

  • The fund’s performance

While it’s true that past performance is no guarantee of future performance, it’s necessary, nevertheless, to study this factor. This way, you can get a better idea of what to expect in terms of performance. Performance can be analyzed against a benchmark or against other funds in the same category.

  • The fund manager’s experience

Fund managers are responsible for managing how the funds are invested, what assets they’re used to invest in, and when those assets are sold off. Since these experts are responsible for taking many critical decisions related to the fund, it’s important to look into the experience and the expertise of the fund manager.

  • The expense ratio

Managing a mutual fund is no easy job. There are many expenses related to the fund, like the salaries paid to the personnel, investment advisory fees, marketing and distribution expenses and shareholder transaction costs. So, you also need to look into this aspect. The expense ratio can help you here. Take a look at the formula.

Expense ratio = (Total expenses ÷ Total assets) x 100

Conclusion

Like this, there are some other factors to consider as well, like the investment philosophy of the mutual fund, the exit load and the scheme’s asset under management (AUM). Once you consider all of these factors, you’ll be in a better position to choose the right mutual funds for your investment portfolio.