Mutual funds have always been emphasized as a wealth creator in the longer run. Above all, mutual funds combine the best of simplicity, professional management, liquidity, wealth creation potential and the tax efficiency which is not available in most of the other financial products. Above all, mutual funds are extremely flexible and they can be easily adapted to the dynamics of your financial plan. But understanding mutual funds is one part of the story. The bigger challenge is selecting the right mutual fund. But the biggest challenge is to select the mutual fund that is exactly right for you. Let us look at both these aspects and how to go about it?
Selecting the right mutual fund
This is the first step in the mutual fund selection process. You need do zero on funds that you want to invest in. Here is a 6-step process that you can follow:
- Has the fund delivered above market returns? If you want to only earn as much as the index then you are much better off investing in an index fund. Why should you take the added risk of investing in equity diversified fund? The easiest way is to see if the fund is outperforming the index. One can argue about short term versus long term, but here is a simple test. Look at returns on 3 year rolling basis for 8 quarters. That will give you an idea of whether the fund is worth holding or not.
- It is not just about returns but also about the consistency of returns. You will prefer a fund that returns 15-16% annually compared to a fund that gives you phenomenal returns in the first year and negative returns in the next two years. Even if the wealth is the same at the end of 3 years, you prefer consistency as it is more predictable.
- Is the fund manager taking too much risk for the returns delivered? MF returns of 14% with 10% volatility are quite good. But returns of 16% with 35% volatility are not really impressive. That is why you have measures like Sharpe and Treynor which actually capture the returns per unit of risk. Focus on funds that give you positive returns on a risk-adjusted basis.
- Is the fund seeing too much swirl in the key personnel? If the CEO, CIO and the fund manager are constantly changing, you can be sure that there will be no consistency of investment philosophy or investment policy. That is not good news for the investor. You want funds where the core team sticks around for a long time.
- Is the fund size too large or too small? This is a key question because both the extremes are not good for the investor. If the fund size is too large then the fund loses out on flexibility and that impacts the performance. If the fund size is too small then it cannot be capitalized on all the opportunities present in the market. You need to get a middle path on this issue.
- Is the fund’s approach too much based on individual discretion or is the approach more structured. As an investor, you should always prefer a structured approach. Where the discretion is too high, there is too much accent on the decisions of the fund manager and that is not a great idea especially when you are looking at the long run.
Is the Fund right for me?
Once you have shortlisted the right funds under various categories and created your investable surplus then the next question is whether the shortlisted funds are right for you. That is when you come to the question of fitting these mutual funds into your goals. If your risk appetite is limited then a mutual fund that takes on too much risk is a misfit. Similarly, if you need to create wealth by the age of 45, then a conservative debt fund (however good) may not be your answer. That is where the difference between the right fund and (right fund for me) comes into mutual fund selection.
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