Questions To Ask Before Investing in Mutual Funds

Under the mutual funds umbrella, an investor has numerous options. It is not easy to select schemes to invest in. Here are a few questions to think about before selecting funds. 

What do the Key Numbers look like?

It would be good to fund out the values of key parameters of the mutual fund scheme. These include -

Returns – Check the returns of the MF scheme over different periods – 1 year, 3 years, 5 years. The long duration will negate the effects of short-term volatility. You can get an accurate picture of how the fund has performed. Past performance cannot guarantee future returns, but you will get an idea of its performance in different market conditions.

Expense Ratio – There are management fees and exit loads that once has to pay for mutual funds investments. Check these and compare them against other schemes in the similar category. There is no point of paying more for your hard earned money to be invested.

Suppose Scheme A charges 1% and Scheme B charges 2% as management fees. If you invest Rs. 50,000 in both and the annual returns are 13%. In Scheme A, you would get 12% and in Scheme B you will get 11% as it is more expensive.

Tax Benefits – Mutual fund investments offer tax benefits. Check the tax implications and the benefits that you would receive. For example, one can invest in an Equity-linked saving scheme (ELSS) to get tax benefits under Section 80C. You can invest up to Rs. 1,50,000 in an ELSS fund in one financial year to get benefit of deduction.

Does the fund fit my investment portfolio?

Each person has a different investment portfolio depending on need and ability. You have to check if the scheme you selected / recommended by financial planner is suitable for you. For example, if you will be buying a car soon, invest the cash in appropriate debt funds or liquid funds so that you can exit in a short time frame and get good returns. If you want to save up cash to go on a luxury cruise in your retirement, invest in large cap equity mutual funds.

How has it performed against similar mutual fund schemes or the average in the category?

Compare the returns of the mutual fund scheme with others in the same category. Check the performance against the average in the category. This will help you choose MF schemes with good potential.

Which option is better for me – Growth or Dividend?

Growth Options of MF schemes add returns to the NAV. Returns are accumulated and reinvested. This increases the NAVs. You will not get  regular returns. You earn when you sell for profits. This is good for long-term retirement goals.

In Dividend based mutual fund schemes, returns are in the form of dividends. You can get regular returns (not guaranteed). This is good for a regular source of income. But Dividend Distribution Tax (DDT) is paid by Debt Mutual funds which means there is less dividend to distribute. Moreover the NAV value keeps falling as value is returned to investors. Unless the investment amount is very large, dividend option does not make sense.

In Dividend Reinvestment Option, the dividends are used to purchase additional units. The number of units increase but NAV decreases. Dividend distribution tax is applicable for this option as well.

Your tax slab is  an important factor.

Equity MF schemes - Long term gains are not taxed. The type of fund does not matter.

Debt funds - Short term gains in debt funds attract a tax rate. If you are in the 10%  and 20% slab, invest in the grown option as the tax payable is DDT+Short term gains capital tax. This will amount to more than the income tax rate. If you are in the 30% slab, invest in dividend reinvestment option as the DDT is 28.33% which is less than the income tax rate.

In case of long-term gains, your gains will be taxed at 20 per cent with indexation benefit on your original investment. So you should invest in the growth option.

Before investing, research on the MF's and get answers to these questions. You will be able to make an effective Mutual Fund investment strategy.