With ever falling bank deposit rates and taxes levied on them, fixed deposits fail to achieve the basic purpose of investing, that is beating inflation. If we look at the history, stock markets have been the best asset class giving highest return on invested capital. However, since most investors do not have the time or the knowledge to pick the right stock for their portfolio, it is always better to rely on market experts and let them pick the right stocks for you. One of the best and the most cost effective way to invest in stock is via mutual funds.
Mutual fund is a mechanism of pooling the resources and allocating it in a well diversified portfolio of stocks, managed by a professional. A well diversified portfolio, not only reduces the investment risk, but also improves the chances of above average returns. Every mutual fund has an investment objective which is mentioned in its offer document.To pick the right mutual fund for yourself, you must keep these points in mind:
Know your purpose of investment:
Before buying a mutual fund, you must understand your purpose of investing, that is what is your ultimate goal? Do you want to generate capital gains for your long term financial goal (such as retirement or your kid’s college education) or do you want a stable source of income (such as a pension after retirement). Understanding the purpose of investment will help you determine which type of mutual funds you should invest in. If your purpose of investing is to invest for capital gains, you should invest in equity funds. An equity fund invests major part of its funds in stocks in order to generate capital gains in the long term.
On the other hand, if you are looking to generate regular income from your investment then you should opt for monthly income plans. MIP or monthly income plans provide regular income to their investors in the form of dividend. MIPs invest mainly in debt instruments (such as corporate bonds, government bonds, debentures etc.) and a small portion is invested in stocks.The dividend paid is usually 8-10% of the total investment made by an investor.
Time horizon of investment:
The second point you should look at is the time horizon of your investment. As a thumb rule, you should stay invested in a mutual fund for at least 5 years. Longer you stay invested better will be your returns. When you invest in mutual funds for a long time, you let your money compound at a high percentage for a long period, giving you exceptional returns compared to other asset classes.
Mutual fund expenses are the charges levied by the fund houses, that an investor has to pay as a fee for investing in a fund and using professional services of the fund manager. It is thus very important to understand the charges you have to pay as they can substantially change your return on investment. The first expense that a mutual fund charges is called Total Expense Ratio (TER).
Total Expense Ratio (TER):
TER includes various operational costs such as investment management and advisory fees, sales/agent commissions and ongoing service fees, legal and audit fees, registrar and transfer agent fees, fund administration expenses, and marketing and selling expenses. TER is an annual charge which is a percentage of AUM (Asset Under Management). According to guidelines of SEBI (Securities Exchange Board of India), TER needs to be lower as AUM increases, and could go as high as 2.5% of total AUM.
Entry and Exit loads:
Other than this, there are two more charges a mutual fund can charge you, one is the entry load another is exit load. Entry load is a charge deducted on NAV at the time of investment in a mutual fund scheme. In August 2009, SEBI abolished all the entry loads from mutual funds.
Exit load is a charge levied by the fund when an investor wants to sell his investment in a short span of time from investments. Mutual funds charge exit load in order to discourage investors from frequently entering and exiting a fund without holding it for a sufficient period.
Some bonus points…
In addition to the points discussed above, you should also track the portfolio of mutual fund to check the quality of investments made by the fund as it determines the future potential returns of your fund. You should also keep tracking the performance of your fund frequently to understand if the goal for which you made the investment will be achieved or not.
Picking the right mutual fund is not complicated, with some common sense, and knowledge, you can choose the right fund that suits your needs and help you achieve your financial goals.
So what are your thoughts on picking the right mutual fund? Please do let us know in the comment section below