You may know of several people who have lost their capital while investing in mutual funds. A common reason for this is that they tend to invest in the wrong funds. Furthermore, entering the fund and exiting at the right time to minimize losses is important.
Before you consider investing in such funds, you need to consider some factors. Assessing your age, risk profile, and investment goals will help you shortlist the appropriate mutual funds.
Let us first understand the five common types of mutual funds.
- Balanced funds
Such funds invest in equities as well as debt instruments. The proportions are diversified to minimize risk due to an adverse performance by a specific company or sector. Equity-oriented funds invest almost 65% of the money in equities. The balance is invested in debt instruments to reduce the performance risk due to the equity market volatility. If you are planning to invest in mutual funds for the first time, opting for such funds is advisable.
- Large-cap funds
Fund managers invest the money among the largest market capitalized companies. Over 80% of the fund corpus is invested in such companies. This reduces the risk because larger companies are stable when compared to small or mid-sized organizations. However, returns on these funds may not be very high.
- Index funds
Such funds invest only in stocks included in the equity indices. Generally, the percentage of investment is also distributed in the same proportion as the weight of the stock in the index. Such funds are managed passively and fund managers do not make any calls for increasing or decreasing holdings.
- Tax-saving funds
This type of fund is also known as an equity-linked saving scheme (ELSS). Investments in such funds are eligible for tax benefits under Section 80C of the Income Tax (IT) Act, 1961. You will need to remain invested in these funds for at least three years. Because the minimum lock-in period is three years, fund managers often invest the corpus in small and mid-cap companies. However, these companies may be volatile when compared to large-cap, which makes investing in these funds riskier.
- Monthly income plans (MIPs)
These plans are recommended if you want to invest a part of your retirement corpus. Most of these funds are hybrid schemes where almost 85% of funds are invested in debt and balance in equity. Such types of mutual funds offer periodic dividends, which makes these beneficial to earn regular income.
Having understood the different types of mutual fund investments, here are three factors to consider before investing in one.
- Determine performance
It is important that you consider the funds’ performances against their benchmark returns. If a specific mutual fund scheme has consistently failed to meet its benchmark return, you must not invest in it. Exiting such underperforming funds for schemes that deliver higher returns is also recommended. However, you must thoroughly analyze these funds before including them in your investment portfolio. Analyzing category average returns may help you identify funds that deliver higher returns than your current holdings within the peer group. This will help you make an informed decision.
- Review performance periodically
It is advisable that you periodically review the funds’ performances. However, you must avoid reviewing each time the market index significantly rises or decreases. Furthermore, if you invest in funds that are actively managed, the manager should be given time to earn returns. Although there is no specific benchmark on the periodicity, it is recommended you review the performance every 18 to 24 months.
- Analyze the factors
If you do not have the required financial knowledge, understanding the reason for poor performance of the funds may be difficult. However, a common reason for this could be changes in the portfolio holdings. Such changes may negatively impact the Net Asset Value (NAV) in the shorter period; however, the long-term returns may be higher. Making an investment decision solely based on the fund performance is not advisable. Analyzing the risk metric of the fund to make a decision is recommended. If the portfolio is modified towards high-risk instruments while returns consistently remain lower, you may consider shifting to another fund. Determining the risk-adjusted returns where potential earnings are determined based on the risk level is important to make the right decision. Several rating agencies provide information about risk-adjusted returns of various mutual fund schemes.
While periodically reviewing your mutual fund portfolio is important, you must be cautious to not make impulsive decisions. You must avoid making hasty decisions if the fund’s performance is not good in a particular month or quarter. The review must help you validate that your investments are according to your financial goals.