5 things you should know before investing in a mutual fund

I have often heard people complain about mutual funds, how they are unpredictable and an opaque investment plan. But let me assure you they could not be more wrong! Mutual funds are one of the simplest financial instruments. They give you the liberty to choose where to invest your money based on your risk appetite. There are five basic parameters based on which you can decide which fund to invest in:

1. Fund type: Often people associate mutual funds with high risk and equity. But this is not the case; mutual funds can be divided into three categories based on the risk quotient.

Now that you know the fund types, determine your financial goals. What should your mutual fund work towards — high returns, steady income with low risk, or just preserve your money?

2. Risk-Return equilibrium: A good mutual fund is one that offers higher returns than its peers for the same type of risk taken. That said, mutual funds are profitable when you invest for the long term. Start early when investing in mutual funds as amount of time you stay invested will give you better returns. Also, start by investing in equity funds as they will help you meet your current financial and retirement goals. Do note that investing in equity funds for the long term evens out the ups and downs of the market. But switch to debt funds as you near your retirement age, so that the money you have earned so far remains preserved.
3. Fund performance: It is important that you check a fund’s past performance before making your decision. Avoid funds that give high returns when the market is high and fall flat as soon as the market dips. You want a fund that is able to withstand market volatility to give you consistent returns. A good mutual fund consistently outperforms its peers over a 3–5-year range. Always study a fund’s performance over the long term, 5 and 10 years, and do not focus on the short term.
4. Expense ratio: If you are confused between similar funds, analyzing their expense ratio comes in handy. Expense ratio is the annual fees charged by all funds, comprising management fee and administrative costs. Schemes with lower expense ratios are better as they have higher assets. As the fund size grows, these expenses are spread out over more investors, thus reducing expenses. Consider this: Fund A has an expense ratio of 1.50% while Fund B has 1%. In effect, Fund A has to outperform Fund B every year by 0.5% to offer neck-to-neck returns. Maintaining this pace becomes more difficult when the market enters a lull, as higher expense ratio further drags down the fund performance.
5. Fund house experience: Before you decide the fund scheme to invest in, select the fund house you trust. Do some research, talk to investors active in mutual funds and identify fund houses that have a strong presence in the market. See if these houses have performed strongly and consistently over the years. Check the portfolio history of the scheme you are interested in and see how the fund has invested money historically.

- Naveen Kukreja is the Managing Director at PaisaBazaar.com

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