How to Choose Mutual Funds? - A Comprehensive Guide

It is always good when there are plenty of choices available before us.  But the problem arises when we have to pick up one among them.  When you choose one after some time the other will look better.  Coming to a conclusion is difficult at times.  There are numerous Mutual Funds are in the Market to choose from.  You may search in Google to find out ‘Top 10 Mutual Funds’, ‘Best Mutual Funds in 2013’ etc and find some of the top performing Mutual Funds tabled by many websites and offline Magazines.  You can choose the mutual funds that are placed in those lists but past performance of those funds may or may not happen in the future.  So it is important that instead of choosing the funds in these lists, you must have your own Investment objective i.e. Expected Rate of Returns, Stop Loss, Risk Appetite, etc.  Let’s discuss how to choose Mutual Funds.

Investment Objective:

You have to have an Investment Objective before you make any investment.  It means that how you want your money to be invested, how much return you expect and how long you are going to stay invested, etc.  In order to choose Mutual Funds you have to study and understand the following points:

Open Ended or Closed Ended: 

Mutual Funds give you two options are Open Ended Schemes and Closed Ended Schemes.  An Open ended scheme is that allows you to buy and sell the units of the scheme at any time during the business hours.  There is no restriction on the number of transactions at any time.

A Closed Ended Scheme is that allows you to buy units only at the New Fund Offer (NFO) i.e. when the units are offered for investment.  These schemes have fixed maturity period, only after that you can redeem their units.  But, they are listed in the stock exchanges after the initial offer where you can buy and sell the units. 

If you want to enter and exit any time in a scheme you have to choose Open Ended Schemes and if you want the scheme to allow the scheme to take its time and generate the returns as per its objective you can choose Closed Ended Schemes.

Equity or Debt:

A Mutual Fund can be either Equity oriented or Debt oriented.  An Equity oriented fund invests most of its fund in shares of the companies and Debt oriented funds invest in fixed income instruments like Bonds, Treasury bills, etc. 

If you want your money grow faster and ready to face downs you can invest in Equity oriented funds or if you want protection for your investment with little bit of return you can go for Debt Funds. (Read: How to Choose Debt Instruments?) (Also Read: What is Equity?)

Growth/Dividend Payout/Dividend Reinvestment:

You can choose how your investment money invested in any Mutual Fund.  Returns of Mutual Funds can be accumulated in Growth option.  If you want regular income you can choose Dividend Payout or if you want the dividends earned by the scheme to be reinvested, you can choose Dividend Reinvestment option. (Read: Growth, Dividend Payout, Dividend Reinvestment: What is What?)

Bench Mark:

Every Mutual Fund scheme has its own Benchmark by which it tracks the returns.  An index is the benchmark for a fund.   It invests in the companies indexed in that and tries to beat the Benchmark.  The main objective of Mutual Funds is to beat the Bench Mark otherwise you can simple invest in Index Funds where the expenses are less. (Read: Investment in Index Funds: An Introduction)

 

Past Performance:

Before investing in any Mutual Fund, it is necessary to have a look at its past performance.  The returns of the fund should be compared to the funds in the same category.  Mutual Funds issue fact sheets then and there you can find the performance of the fund by analyzing this sheet.  Though past performance may or may not indicate or guarantee future returns, it is essential to know if the fund has the capabilities to generate better returns.

Lump sum or SIP:

Investments in Mutual Funds can be made by Lump sum or through Systematic Investment Plan (SIP).  When you have lump sum money you can invest in Liquid funds and can use Systematic Transfer Plan (STP) to transfer the funds in small amounts from Liquid funds to other funds on a regular basis.  SIP method is the most effective way to accumulate money in the long run.  You can invest small amounts at regular intervals and average the price to get good returns.

                                                                                            

Expected Rate of Returns & Risk Appetite:

You must decide on how much return you expect from your investments.  Your expected rate of returns is based on the number of years you’re going to get invested.  You may need money after 5, 10, 15 years or you may want it for your after retirement life.   So you have to decide on number of years you need to get invested.  Investment made in Equities give better returns in the long run and if you want to fund your short-term needs you have to choose Debt funds.

If you can’t take too much of risk your exposure to equity should be lesser than Debt and if you’re ready to wait and never mind the market ups and downs you can invest in equities. 

Large Cap/Mid Cap/Small Cap/Sectors/Diversified:

The objective of all Mutual Funds is to generate returns by investing the money in various ways.  Mutual Funds invest in different segments like Large Cap, Mid Cap and Small Cap Companies.  They invest in different sectors and diversity the investments in order to reduce the risk.  Not all the Mutual Funds follow the same method.  So you have to decide where you want your money to be invested.  You can decide it before investment as you can find the objectives of Mutual Funds in their offer documents.   The method of investment will be well defined in the offer documents.  Though returns are slow large cap mutual funds give better protection during the downfall.  Mid cap and small cap funds can deliver higher returns with higher risk tag.  So your affordability of risk determines the segment in which your money to be invested.

Other Factors:

There are other factors which influence the returns of Mutual Funds are Expense Ratio, Mutual Fund Manager, etc.  The Expense ratio is the percentage of your invested money that goes for running the Mutual Funds, for example Salary for Staff, Administration expenses, Sales and Promotion expenses, etc.  If the expenses are higher the expenses you can expect only lesser returns.  If the returns justify the expenses, higher expenses are no matter.

The qualification and expertise of every Fund Manager is an important aspect of every Mutual Fund.  A well qualified and experienced Fund Manager is likely to manage your money effectively to generate good returns.  The expertise of the Fund Manager can be examined by other funds he/she manages, the returns of those funds, expenses ratio, etc. (Read: Benefit of 'Direct Plan' in Mutual Funds)

Conclusion:

Your Investment goal should be clear that how much can you invest, how long can you invest, how much you need and for what purpose.  Determination of the purpose of investment is very important as it is the one which decides everything said above.

Franklin India Bluechip Fund: An Introduction: A Fund A Week

This is an open-ended scheme from Franklin Templeton Mutual Funds invests in Large-cap Companies having very good prospects. Its objective is to provide long-term capital appreciation. 

The fund was launched on 1^st December 1993 and it is managed by two fund managers Mr. Anand Radhakrishnan and Anand Vasudevan. The fund’s benchmark is CNX Nifty.

The fund invests about 90% of its fund in Equity.  About 22% of its money has been invested in Banks, about 11% in Software Companies, about 10% in Pharmaceutical Companies and about 8% of its portfolio is in Telecom Companies.

The main companies in which the Fund invested are Bharti Airtel Ltd,  ICICI Bank Ltd, Infosys Ltd, HDFC Bank Ltd, Reliance Industries Ltd, ONGC .

Investment Calculations:

The fund has delivered Compounded Annualized Growth Rate (CAGR) of 22.92% since its inception.

If you’d invested Rs.10000/- in this fund from inception on 01/12/1993, the money would have grown to become Rs.5,40,643/-as on 31/03/2013.

If you’d invested in SIP of Rs.5000/- per month from inception for about 20 years, it would have grown to Rs.82,62,696/- (total money invested is Rs.9,30,000/-) on 31/03/2013 with Compound Annualized Growth Rate (CAGR) of 23.14% whereas CNX Nifty has delivered 12.81% return, which would have accumulated to Rs.30,44,961/-.

Details of the Fund

Date of Inception	1st December 1993
Benchmark	CNX Nifty
Entry Load	Nil
Exit Load	1% if the units redeemed within one year from the date of investment
Minimum Investment	Rs.5000/- and multiples of Re.1
SIP	Rs.1000/- p.m. for minimum of 6 months
Expenses Ratio	1.83%
Average Assets under Management (AAUM)	Rs.5110.90 Crores

Investors who is willing to stay invested for long-term and want to invest in Large-cap Companies can invest in this fund.  The fund has managed its investor’s money for two decades and given good returns.

Remember: Past Performance is not indication for future returns.

The above data given in the tables are as on 30/04/2013

Source: www.franklintempletonindia.com

Who determines the share price of a Company?

When a Company to expand its business, it issues shares in public and get money which is called Initial Public Offer (IPO).  Later the shares are listed in Stock Exchange Market where the shares are sold and bought by general public and it is called Secondary Market.

Also Read: What is Equity?

When a Company goes public for want of fund for its expansion it issues shares at the face value of Rs.10/- per share.  For example, if a Company needs Rs.10 Crores, it issues 1 Crore shares at face value of Rs.10/- per share (1 Crore shares x Rs.10/- = Rs.10 Crores). 

If the same Company performs well and earned good reputation and believes it will make good profits in the future, it doesn't want to issue the shares at the face value of Rs.10/-.  So, it adds premium to the share price.  The premium is determined by the Company with the help of Analysts who uses various formulas and techniques.  For example, if a Company performs well and determines its value more than Rs.10/-, it may fix the share price for Rs.100/- per share and Rs.90/- (100-10) is the premium for that Company and issues only 10 lakh shares to reduce the number of Investors.  Investors who believe that the Company would do well in the future and who are ready to pay the premium, may apply for the shares.

After IPO, if the company does very well and its value higher, the share price will go up.  Analysts determine the share price of a Company by using various valuation techniques.  They value the Assets, Liabilities, Revenue and Expenditure and its future prospects, demand for its products in the market and value the share price.  If they find the Company doesn't qualify for the higher share price they ignore its shares which automatically reduce the price.  It is just the demand and supply effect in the Share Market.  When more Investors are ready to buy the shares, the price will go up and when there is little demand for the shares, the price will go down for that Company.

Apart from the above, many factors like Economic Conditions, War among Countries; Government policies also affect the share price.  The price of the shares will increase of those Companies which are performing well and showing signs of good profits in the future and other Companies’ share price will decrease which fails to make profits and fails to satisfy the Investors.

SBI Emerging Business Fund: An Introduction: A Fund A Week

This is one of the best funds of SBI Mutual Funds which objective is to find and invest in Emerging companies and others which are export oriented and involving outsourcing business.

The fund is launched on 11^th October 2004 and it is managed by Mr. R. Srinivasan since May 2009 who has over 20 years of experience.  The fund’s benchmark is S&P BSE 500 Index.

The fund has invested about 50% in Mid-caps and 20% in Small-caps.  It has about 20% exposure in Large-cap companies.

Consumer Goods, Financial Services and Auto mobile companies are forming part of the total portfolio of about 19%, 16% and 11% respectively.

Investment Calculations:

If you’d invested Rs.10000/- in this fund from inception on 11/10/2004, the money would have grown to become Rs.44200/-as on 26/04/2013 with absolute return of 442%

If you’d invested in SIP of Rs.2000/- per month from inception, it would have grown to Rs.404,713/- (total money invested is Rs.206,000/-) on 26/04/2013 with Compound Annualized Growth Rate (CAGR) of 15.49%.

Details of the Fund

Date of Inception: 11/10/2004

Fund Manager: Mr. R. Srinivasan (since May 2009)

Benchmark: S&P BSE 500 Index

Entry & Exit Load: There is no Entry load and 1% Exit load is for the exits within One year

Minimum Investment: Rs.2000/- and Rs.500/- as additional investment  

SIP: Rs.500/- p.m for 12 months, Rs.1000/-p.m for 6 months and Rs.1500/- per quarter

Expenses Ratio: If you invest directly without through any distributor the ratio is 1.31% for others is 2.20%

Average Assets under Management (AAUM): Rs.1231.10 Crores

The above data are as on 28/03/2013

Source: www.sbimf.com

Investment in Index Funds: An Introduction

If you do not believe your Fund Manager would give you better returns than the market for what he is paid and charge many other expenses?  Then you can let him invest your money in Index Funds.  Index Funds are managed by Fund Managers whose responsibility is just to track the returns of the Benchmark Indexes.  Each Index Fund tracks the returns of its own Benchmark Index. 

There are various Benchmark Indexes are available for example in India, CNX NIFTY which comprises of 50 stocks and S&P BSE SENSEX comprises of 30 stocks based on their Market capitalization.  An Index Fund invests the money in those stocks in its Benchmark Index which it follows.  For example, an Index fund which has its benchmark index as CNX NIFTY invests the money in those 50 stocks in the same proportion and gives the same returns as CNX NIFTY gives.  There are various such Indexes in Stock Markets and S&P BSE Small Cap, S&P BSE Mid Cap, S&P BSE BANKEX are few examples available in India.

Index Funds are less expensive compared to other funds as they follow passive method.  Here the Fund Manager has very little job.  All he needs to invest the money in the companies as indexed in particular Stock Market.  Since there is no need of any Analysts, Stock pickers the expenses are less in these funds and also there is hardly any need to buy and sell the stocks very often which actually costs more in terms of capital loss and transfer costs, etc.

Advantages of Index Funds

Fund Managers follow simple method of investing in stocks and very transparent.

The expenses of Index funds are lower as they don’t require Analysis.

Disadvantages of Index Funds

The Index Funds may not be able to beat the market returns compared to Actively Managed Funds.  The Fund Manager performs lot of research, finds value in stocks and invests in them for better returns.

Index Funds are subject to ‘Tracking Error’. When the Fund Manager fails to match the returns with the Benchmark Index it is called ‘Tracking Error’.  Tracking Error may occur if the expenses of the Index Funds are increased.  The error is also applicable when the Index funds outperform its Benchmark Index.

The Actively managed Fund Managers have full freedom (within the rules and regulations) to pick up the companies in order to achieve the objective of the Funds whereas he has no control over selecting the stocks in Index Funds.

The main objective of the Index Fund is to give the returns as the Market give and lowers the expenses and minimize the ‘Tracking Error’ as much as possible.

Read also: Actively Managed Funds Vs Passively Managed Funds

Growth, Dividend Payout, Dividend Reinvest options: What is what?

When you put your money in Mutual Funds, at the time of filling up the form for the same, you must have noticed the following options:

• Growth
• Dividend Payout
• Dividend Reinvestment

You may have selected one among them for the sake of checking the box or just left the option non-filled.  Either if you have selected an option without any knowledge or left the option unchecked then read further.

Whenever you invest for the first time in a particular scheme you have to select one among the above mentioned options which is the direction of your invested money will go. 

Growth Option

In Growth option, your money gets appreciated over the long period of time.  All the profits, dividends, etc. are reinvested in the scheme which will compound over the years.  If you don’t need your invested money in the short-term you may opt for Growth option.  There will be no change in the number of units in this option.  Only the NAV of the scheme either will go up or down according to the Market conditions. 

Under the Growth option, say, if NAV of the scheme at the time of investment is Rs.15/- and after 3 years if the scheme delivers 20% return the NAV will go up to Rs.18/-.  If you invest Rs.10000/- at the NAV of Rs.15/- you would get 666.667 units and at Rs.18/- your money would have grown to Rs.12000/- (666.667 units x Rs.18/-).  So, the return from investment is Rs.2000/-.

Dividend Payout

Whenever the scheme performs well it declares dividend. The dividend amount will be paid out according to the number of units you hold.  In the above example, if the scheme declares dividend of Rs.3/- per unit you would get Rs. 2000/- (666.667 x Rs.3/-).  Since the amount is paid out, the NAV of the Scheme will remain at Rs.15/- and the Units will remain the same.

There is no Dividend Distribution Tax in Equity however you have to let go some amount when you invest in Debt Scheme.  Debt Schemes are subject to DDT when they declare dividends.  DDT will be paid by the Mutual Funds out the amount available in the scheme.  So the NAV of the scheme will go down in Debt schemes compared to the Equity Schemes.

Dividend Reinvestment

The declared dividend is reinvested so the units will be allocated equal the dividend amount.  DDT is applicable for Dividend Reinvestment option also.  Here the NAV will remain same but the number of units will be allotted equal to the amount of dividend reinvested.  In the above example, the units will be allotted for Rs.2000/- of dividend amount and you will get 133.333 Units (Rs.2000 / Rs.15/-) that will be added to have 800.000 units in total (666.667 + 133.333).  Remember the NAV will remain the same at Rs.15/- only the amount equal to Rs.3/- per unit will be allotted as Units.

And Finally

The return of all the options will be the same only the method of treatment is different according to the interest of the Investors.  If you want to grow your money over the years then select Growth Option.  If you want regular income, select Dividend Payout.  If you want more units then opt for Dividend Reinvestment option.

Actively Managed Funds Vs Passively Managed Funds

The Mutual Funds can be classified in one way that are Passively Manged Funds and Actively Managed Funds.  Let's find what is the difference between them.

Passively Managed Funds

• The funds which reflect the exact returns of a particular Market Index are Passively Managed Funds. 

• The Fund Managers of these funds have less work and they invest the money collected in those Companies that are indexed in different Stock Exchanges. 

• The Fund Managers are not taking any decision regarding the investment of funds.  They just invest in those stocks which forms part of the Index.

• Whenever the prices of the indexed stocks go up, the NAV of these funds also go up and comes down when the indexed stocks go down.  The returns of these funds are just the mirror image of the Index.

• Since there is no need of any big analysis and promotion, the expenses of these funds are lesser compared to the Actively Managed Funds.

Actively Managed Funds

• The Fund Managers of these funds are literally responsible for the better performance than their Benchmark Index.

• They have to beat the returns of their respective Index.

• The returns of Actively Managed Funds usually are higher than Passively Managed Funds.

• Since they do lot of researches, analysis to pick up the best stocks so these funds are expensive.

• The portfolio of these funds is being changed from time to time according the market conditions.

• Investments of these funds are the combination of both the stocks that are Indexed and others that Fund Managers find best.