4 point guide to pick a mutual fund – Questions you should ask before picking up a mutual fund

With a large variety of mutual funds available to choose from, you would have come across a situation many-a-times where all funds of a category seem very similar to you and you are left with no option but to turn a blind eye towards their innate differences and buy any one of them. Or else you would want to buy the same fund which your friend or neighbour bought. Here is an easy 4 point guide that would help you to pick the best suited fund.

1. Is the category right as per your goal?

Before acquiring share in any fund, you should first identify your goals and desire for the money being invested. Are long-term capital gains desired, or is a current income preferred? Will the money be used to pay for college expenses of your children, or to supplement a retirement that is decades away? Identifying a goal is important because it will enable you to shortlist mutual funds in the public domain.
In addition to this, you must also consider the issue of risk tolerance. Will you be able to afford and accept dramatic swings in portfolio value? Or, do you require a more conservative investment? Identifying risk tolerance is as important as identifying a goal. After all, what good is an investment if you have trouble taking all the risk required?

For capital growth, consider a fund that invests heavily in stocks. But keep in mind that the stock market goes up and down–and so will the value of your fund. The prospect of high returns comes wrapped in risk.
A bond fund will provide a steady stream of income. There can be fluctuations, but fixed-income investments are generally steadier than stocks and returns are often lower.

Investors seeking to preserve their principal should take a look at money market funds. Such funds are stable but typically generate less income than bond or growth funds. However, a short-term bond fund may generate more income without greatly increasing the risk.
Look for a fund that offers dividend distributions if you're after growth and income. Such funds typically invest in both stocks and bonds. In general, higher short-term income means lower long-term growth.

Apart from this, the issue of time horizon must be addressed. You must think about how long you can afford to tie up your money, or if you anticipate any liquidity concerns in the near future. This is because mutual funds have exit charges that can take a big bite out of returns over short periods of time.

2. Does the mutual fund add diversification to your portfolio?

Remember that diversification is a key to long-term success. For example, consider diversifying by including value and growth stocks, large- and mid-cap stocks. Diversification should smooth out the bumps in the market and will reduce the urge to chase hot funds. But do not dilute your opportunity for solid gains by putting a little money in a large number of funds across a broad range of sectors.
And time and market movements may change the balance of your fund portfolio between different sorts of funds. Review it at least once a year to make sure it still matches your goals.

In case you have most of the already made investments skewed towards a particular sector or a theme, try achieving that diversification through getting in a mutual fund which allows you to take exposure in sectors unrelated or little related to your ongoing investment avenues. If you are an avid investor, you will have to sit down to understand your prior investment, put to work your understanding of how fundamentals work and then decide your requisite course of action. And in case you are novice, take advice from your financial planner.

3. Does the mutual fund have a good track record?

Pick a mutual fund that has yielded good returns year after year. That indicates the fund can be successful under a variety of conditions. Also consider the efficiency of the fund manager. Managers determine when a fund's stock or bond should be bought or sold. Seek for his/her consistency and look for one who has longevity with the fund and company. Ask the experts. Search the internet for financial planners, investment advisors and mutual fund companies. You also can access information on all varieties of mutual funds and what experts consider to be the top picks. Review periodically. After you have selected your mutual fund, set up a regular review schedule-generally at the end of the year-to ensure its performance remains consistent with your investment objectives and level of investment risk. Although you should take a look at the fund performance, but keep in mind that history is not necessarily an indicator of future returns. The reason is simple: Hot funds, especially those investing in narrow sectors, can quickly go cold, the market can turn; a money manager can move on or simply have a bad quarter.

Read the prospectus and make sure the fund company is disciplined and sticks to its stated strategy for each fund. Chasing The Next Big Thing may produce a short-term pop, but won't generate steady, long-term returns.

If your fund will be actively managed, check the experience and performance of the managers. In case of passively managed and index funds, take a long, hard look. These funds track major indices and are not actively managed. This means lower fees.

Review the fund's volatility quarterly or annually. The net asset value (NAV) of a stock or bond fund routinely fluctuates with the market. Compare the fund's best years with its worst. If the ride is too wild, consider other funds. Also never forget to compare your fund of investment with the stated benchmark over different periods of time.

4. Does the mutual fund offer low fees and expense ratio?

Mutual funds make money by charging fees to the investor. It is important to gain an understanding of the different types of fees that you may have to pay when purchasing or even after purchasing a particular fund.

Some funds charge a sales fee known as a load, which will either be charged upon initial investment or upon sale of the investment. A front-end load/fee is paid out of the initial investment made by the investor while a back-end load/fee is charged when an investor sells his or her investment. Although entry loads have been abolished now-a-days, these charges would be adjusted in the NAV.

Still other funds charge fees for the fund for promotions, sales and other activities related to the distribution of fund shares. These fees come right off of the reported NAV and are not told separately to the investor. For overcoming this problem, one final tip is to go through mutual fund sales literature. The management expense ratio is revealed in this very document. In fact, that one number can help clear up any and all confusion as it relates to sales charges. The ratio is simply the total percentage of fund assets that are being charged to cover fund expenses. The higher the ratio, the lower your return will be at the end of the year.

You should not put your investments on automatic pilot. Keep a record of your fund's costs. You would not want to bounce from one fund to another on basis of a fancy, but if a fund underperforms or if its costs get out of line, dump it for a better candidate with more reasonable fees.

Picking up a mutual fund of your choice would never have been so easy for you earlier. But once you know how to differentiate among the shortlisted ones, you would necessarily earn the returns you desired from this investment and fulfill your goal unerringly.