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Picking a fund

Mutual fund market has moved from traditional equity and debt schemes to specialised products like fund of funds, arbitrage funds and asset allocation funds. This variety often confuses the people to select a fund that suits their needs.

twitter-logoSameer Bhardwaj | Print Edition: October 16, 2008

The Indian mutual fund industry is growing at a phenomenal rate, with the assets under management increasing by 376.11% in the past 5 years. Besides, the investors are spoilt for choice as the market has moved from traditional equity and debt schemes to specialised products like fund of funds, arbitrage funds and asset allocation funds. This variety often confuses the people as they find it difficult to select a fund that suits their needs. To help pick the right fund, consider the following three parameters:

Investment objective and risk profile: The investment objective of the fund must coincide with that of the investors and includes tax planning, regular income, high returns and long-term planning like children's education. While equity funds are more tax efficient compared with debt funds, short-term debt funds aim at regular income, whereas closed-ended equity funds aim at long-term capital appreciation.

The fund chosen should also meet the investor's risk tolerance level. The Association of Mutual Funds in India defines three tolerance levels: low risk or cautious, moderate risk or cautiously aggressive and high risk or aggressive. Low-risk investors should consider debt funds, which invest in government securities or highrated debt papers. Moderate-risk investors should go for index funds, balanced funds and asset allocation funds, while the high-risk investors should look at equity funds, offshore funds and mid-cap funds.

Fund performance and management: Though a fund's past performance does not define its future, it's important to study it with respect to its benchmark or similar funds. Fund performance should be compared with the same category of funds. So the performance of a mid-cap fund cannot be compared with that of a largecap fund as mid-cap stocks are more volatile. The past performance also helps assess the quality of fund management and the skills of the fund manager. His stockpicking ability and market timing can be judged by comparing the fund's performance with its benchmark. If it does better than its benchmark, it's an outperformer, and if it yields less than the benchmark it's an underperformer.

Fund costs and loads: The operating costs of running a fund include marketing and selling expenses, audit fees, custodian fees, etc. These expenses can be gauged from the expense ratio, which is reported in the fund's annual report. This should be compared with similar funds; a high expense ratio impacts the long term investors due to the effect of compounding (see "Your Fund's Annual Cost")

Other important factors are the entry and exit loads, which are charged to recover the commissions of agents and distributors. The loads are deducted from the NAV of the scheme, which reduces the number of units for the investor. (In January 2008, Sebi scrapped the entry loads for those investing directly through fund houses, but not all fund houses offer this). The investor should compare the loads among similar funds. Due to the compounding effect, funds with relatively lower or no entry loads yield higher returns in the long run.

Previous instalment:Assessing Risk; Next issue: What's in a NAV?

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