Last few months have been difficult for equity investors in India and all around the world because of the rough weather and high volatility in the global as well as Indian markets. In times like this lot of investors, especially the lesser active ones, want to take advantage of the correction by investing in equity linked instruments like mutual funds. The decision of selecting mutual fund is based on sound underlying principles that it is a professionally managed, well diversified investment avenue to directly participate in the equity markets without worrying about timing the market.

In such difficult times we have to ask a few difficult questions to ourselves before committing our money to any mutual fund scheme. Here I give you three questions which you must contemplate on –

  1. Do I understand the risk associated with market linked instruments like mutual fund? It may be safer than direct investment in shares but it has got its own problems and risks. Because of enough diversification, stock specific risk might be reduced but the market risk still remains.
  2. How to make intelligent choices between different types of funds –balanced versus diversified equity (all stocks), open-ended versus closed-ended, SIP versus lump sum?
  3. What is the objective of buying the mutual fund? For tax saving you’ve tax saver funds (ELSS), if you are bullish on a particular sector, say pharma, you have sector specific funds like “Reliance Pharma Fund”, if you want regular cash flow from your investment, you can opt for dividend option of a fund.

4 mistakes mutual fund investors should avoid

  1. Not reading Offer Document Carefully: Don’t miss reading about the following things in the offer document (prospectus) of any mutual fund AMC
    1. Verify that you have received an updated version of the offer document. Otherwise, your decision will be based on out dated information, specially the historical performance of the fund.
    2. Investment objective of the fund. It can be – to generate regular income or long term capital appreciation or to closely match returns of a benchmark or something else.
    3. Risk factors should be properly evaluated against your own risk appetite. Credit risk, market risk, interest-rate risk etc. are all crucial and should be analyzed based on your expectations (protection of capital or regular flow of income or something else) from the investment.
    4. We’ve all heard that past performance is not an indication of future returns.  However, we must read the historical performance of the fund critically, looking at both the long and short-term performances.
    5. Fees and expenses include various commissions named as entry load and exit load. Though entry load is restricted by SEBI but there are certain adjustments with your NAV to compensate the middle-men. These are paid in the form of upfront and trailing commissions.
  2. Choosing sectoral funds without analyzing the sector: It is very important to understand the risk-return profile of a sector fund.  Investment in sector fund has to be timed very cautiously as the return will have the seasonality effect of the underlying sector. If you have entered into the right sector at the right time and if that sector performs, your investment in the fund will give you substantial return, most of the time more than market returns. For example Reliance Diversified Power Sector Fund gave handsome returns in the period 2004-06. Downside of sector funds is that individuals like us can seldom time the market properly.  If you have not seen 2-3 market cycles, then you should remain away from sector funds.
  3. Investing based on short term performance of the fund: Reading too much into 1 month, 3 months and 6 months performances, without checking the consistency of returns in longer terms like 3 years and 5 years can be very risky. Relying on researches like “last month, equity funds with higher exposure in defensive sectors like health care and FMCG, fared the best” can be misleading as the trend may be very short lived.
  4. Not knowing the underlying securities of your fund: Without knowing the composition of the portfolio of your fund, it is not possible to get the desired diversification. Take an instance where you invest in a few mutual funds to obtain a diversified portfolio. However, if all these funds hold same underlying shares, bonds, etc. you are not getting the required diversification. You must also know on what sectors your fund is overweight and on what sector it is underweight, which helps you map it to your risk appetite.

Related posts:

  1. Things you want to know about Exchange Traded Fund (ETFs)
  2. Mutual Fund Analysis-May 2010
  3. ELSS Mutual Funds