SELECT FUNDS WITH CARE

Over the years, mutual funds have emerged as an efficient investment vehicle that allows investors to allocate investments across different asset classes. This in turn helps them achieve a variety of risk/reward objectives, thereby reducing the overall portfolio risk. Therefore, a decision to invest in a fund or a combination of funds has to be well thought out and not based on some immediate urge. The key is to focus on fund selection. If you are invested in a good fund from a fund house with a proven track record, most of your worries are automatically taken care of. This decision itself will save you of a lot of botheration in the future and ensure success on an on-going basis. Let us analyze some of the important factors that can contribute significantly to your selection process:

Matching Objectives and Policies

The investment objective statement of the fund usually indicates whether it will be oriented towards capital gains or income or both. The fund manager also explains his approach to stock selection, risk assumption, and the anticipated level of portfolio turnover in the offer document. Besides, funds also mention internal investment restrictions that are imposed on the fund manager. Many a time investors face disappointment both in terms of performance and volatility because they do not match their own investment objective with that of the fund. Therefore, you must place greater importance on the fund’s investment objective and its investment policy.

Level of Diversification

Although mutual funds are diversified by nature, there are funds that follow a strategy of taking concentrated bets. The choice between a diversified and a concentrated portfolio will largely depend upon your risk profile. Remember, a well-diversified portfolio enables you to spread your investments across different sectors and market segments. The idea is that if one or more stocks do badly, the portfolio won’t be affected as much. On the other hand, if a few stocks do very well, the portfolio won’t reap all the benefits. A diversified fund, therefore, will be an ideal choice if you are looking for steady returns over a long term.

A concentrated portfolio works exactly in the opposite manner. While a fund with a concentrated portfolio has a better chance of providing higher returns, it also increases the chances of underperforming or losing a significant portion of the portfolio during a market downturn. Thus, you should opt for a fund having a concentrated portfolio only if you have the capacity to shoulder higher risk in order to improve the chances of getting better returns.

Past Performance

Though past performance has to be an important consideration in the selection process, it’s critical that you keep performance in perspective. No doubt, a fund’s successful track record can be a positive indicator, but it cannot be a guarantee for future growth at the same rate. While reviewing a fund’s performance, you need to not only look at performance relative to funds with similar objectives over a period of at least 3-5 years but also the risk taken by the fund to deliver those returns. In other words, the objective should be to select a fund that is managed well and provides consistent returns. Avoid those funds that show very high past returns but are inconsistent performers over different time periods. However, it may not be wise to depend entirely on past performance. It is equally necessary to have the right mix of funds in the portfolio. Therefore, you should first decide the allocation to each asset class and then select funds for each one of them. By investing in a haphazard manner you may end up having over-exposure to an asset class which may hamper the chances of success.

Tax Efficiency

Tax efficiency of an investment option considered for selection can be critical for the long-term success of a portfolio. As per the Income Tax rules, there are two types of funds i.e. debt funds and equity funds. Those funds that have an exposure of 65 per cent or more to equities are considered equity funds while all the others are categorized as debt funds. As regards equity and equity-oriented funds, tax efficiency comes into play when one has to rebalance the portfolio or redeem holdings within one year of making the investment. For debt funds, tax efficiency has a much bigger role to play in the selection process. This is because one has to consider short-term capital gains’ rate, dividend distribution tax as well as long-term capital gains for selecting the right option i.e. dividend or growth.