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10 Rules on How to Choose the Best Mutual Fund

1.  Does the fund match your ‘financial profile’?
Mutual funds offer a whole bouquet of products such as aggressive equity funds, index funds, gilt funds, income funds, liquid funds, gold funds, thematic funds, etc. — the list is quite exhaustive. But all funds will not match your needs, risk-appetite, investment horizon etc. Therefore, you must first decide on the types of funds that suit your requirements. Only then should you start selecting the best funds within those categories.

2.  Past performance
The past performance of the fund is one of the most important criteria in fund selection. History shows that funds with consistently good performance can be expected to be among the top in their category in future too. Similarly, a fund with poor performance will find it extremely difficult to move to the top quartile and remain there. Therefore, focus on funds that have delivered good returns consistently.

3.  Portfolio characteristics
Characteristics of a portfolio will also play an important role. For example, the %age of top 5/10 holding will determine how diversified or concentrated the fund is. If more than 60-70% of the corpus is invested in just 5 shares or bonds, the portfolio would be comparatively riskier than a fund with just 20-30% corpus in 5 scrips.

Or, an aggressive equity fund would have higher turnover ratio. Comparatively speaking this is perfectly fine. But an index fund with a higher turnover ratio vis-à-vis its peers could be a cause for concern.

4.  Is the portfolio size appropriate?
There is, of course, no mathematical rule that would suggest the best size for a given mutual fund. Having said that, AUM could be an important factor in the fund’s overall performance.

A very small fund may not be able to diversify itself reasonable well. As such, the performance could be very erratic. It would be preferable to avoid them. Too large a fund could also be an issue. It will have too many companies in its portfolio. This could affect its overall performance.

So average-sized funds usually offer the best opportunity.

5.  The fund house/fund manager
Investment is both a science and an art. Good research teams i.e. the science part of investing, are necessary in identifying the good opportunities. However, if you give the same set of stocks to two different people, they could deliver vastly different returns. This means that you need something more. This ‘something more’ is the art of investing. In other words, psychological aspects also have a very important role to play

As such, you have to consider the fund manager’s past performance before investing.

6.  Risk parameters
Two funds may deliver the same returns. But the better of the two would be the one that does so (a) by taking lesser risk (i.e. it has a higher Sharpe Ratio), (b) more consistently (i.e. it has lower Standard Deviation) and (c) with less volatility than the market (i.e. it has a lower Beta)

Therefore, after you have short-listed the funds based on the performance, portfolio, fund house etc., check the risk parameters and opt for those that tend to deliver good returns despite taking lesser risks.

7.  Annual Recurring Expenses
The expenses that will eat into your returns in an MF would typically include management fees, custodial fees, marketing & selling expenses, trustee fees, audit fees etc. It goes without saying that lower the expenses the better it is. But don’t give too much weightage to the expenses. Other parameters, discussed above, are far more important than expenses which are anyway quite reasonable and standardised.

8.  Entry / Exit Loads
Presently there is no entry load for mutual fund. And exit load is generally payable only if you fail to remain invested for a pre-specified period (which typically varies from zero days to 1 or 2 years).

A lower load is better. However, since the load is nominal, sometimes even paying higher loads may be alright if the fund’s performance and other factors are very good.

9.  NAV is a meaningless number
The NAV of the fund has no impact on the returns it will deliver in the future. Two similar funds (e.g. two Index Funds) will deliver the same returns whatever may be their NAVs. So don’t bother about the NAV of a mutual fund, as you might do for the price of a share.

10.  Dividend or Growth? 
Like NAV, it is immaterial whether you choose the dividend option or growth option as far as the performance of the fund is concerned. However, the final returns in your hand could be different due to taxation.

Tax rates are different, depending on whether you get this return in the form of dividend or capital gains. Therefore, the post-tax returns in your hand may vary depending on your tax profile. As such, you have to choose the option from the point of view of where your tax will be minimal and not from the point of view of the returns.

To keep things simple, just remember to opt for growth option if your investment horizon is more than 1 year and dividend option for less than 1 year (assuming you are in the highest tax-bracket). [UPDATE : Due to subsequent change in taxation, this simple guideline is no longer valid.]

Excerpted from the book 10/10 Now control your money…perfectly.

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