Factors to keep in mind before choosing Mutual Funds
Amended as on Apr 1, 2023:
Please note that as per amendments in Finance Bill 2023, from April 1,
2023, profits made on investments in debt mutual funds are now taxed as
short-term capital gains if these funds invest <=35% in equities.
This means, debt mutual funds are now taxed as per the income tax rates
as per an individual’s income. Also note
that with effect from Apr 1, 2020, Dividend Distribution Tax (DDT) was
abolished, and mutual fund dividends were made taxable in the hands of
investors. Dividend income is now considered as ‘income from other
sources’ and investors need to pay tax on it as per their individual tax
slabs. Whether you’re a first time investor or an experienced one, mutual funds
are often considered by experts to be an investor’s best friend due to
their many advantages. But with so many different options available
today, how do you make the right choices for your portfolio?
Let us look at some of the key factors you should keep in mind while selecting funds:
- Investment Objective and Style
The investment objective of a scheme is what the scheme intends to
achieve through its investments. For instance, an equity diversified
fund may have the objective of investing in growth stocks to achieve
capital appreciation; a sector fund will have the objective to invest in
companies in the chosen sector to achieve capital growth and earn
dividends.
When you consider the investment objective, you will need to consider
whether or not it matches your financial goals and requirements. This
should also incorporate the timing of your financial goals and other
elements such as your risk profile (your ability to take risks and your
tolerance towards risk).
To make it easier to understand, consider a mismatch: Rakesh is retiring
and needs to secure his income; he invests in a sector fund with high
volatility because in the last 2 years, the fund has outperformed the
relevant sectoral index. Imagine that at the time when Rakesh needed the
income from the fund, there was a reversal in the fortunes of that
sector and the fund value fell. Rakesh’s income will dwindle. He may
also lose some of the capital that he invested at the outset.
Considering Rakesh’s life stage and risk profile, he would have been
better off investing in a low-risk income fund. Was the product the
problem or was the choice of product in the given circumstance the
issue?
You also need to consider your risk profile to identify how best to
build your mutual fund portfolio according to investment styles. For
example, you may choose to do this according to market capitalization
(small & micro-cap/ mid cap/ large cap) or according to fund
management style (seeking growth, discovering value, a blended approach
etc). All of this information is readily available on the asset
management companies’ websites and in the Scheme Information Documents. - Role of the fund
Different mutual fund products have different roles to play, just like
the characters on a chess board, or the members of a cricket team. Some
are meant to be aggressive, some are meant to be balanced and some are
meant to be conservative. Identifying what role a product needs to play
will keep your portfolio clean and well balanced. Think of teamwork every time you consider your portfolio and then
think of the reason why a particular fund is there in your portfolio. If
you cannot remember the reason why you bought a fund in the first
place, or you cannot understand why you’re adding a new fund to your
portfolio, it could be an indication of the need for you to rethink your
decision.
- Your time horizon and risk profile
The next factor to consider is the time horizon of your financial goal.
In general, the closer the goal is, the lower the risk you should seek
to take, especially if you are close to achieving the goal. For
instance, taking the above example forward, since Rakesh has reached
retirement, he should invest in a low-risk income fund. However, if
Rakesh was in his 20’s or 30’s, he could have invested in a high-risk
equity fund to build wealth for his retirement. Had Rakesh been in his
40’s, he would do well to invest in a mix of equity and hybrid funds
(which invest a part of its corpus in equity and the balance in debt). - Performance / track record
You should consider the following points while analyzing the performance of a fund: - Consistency: The fund should have
performed consistently in the past vis-à-vis its benchmark index and the
category average (the average returns of all schemes within that
category). The past in this case is not only the last 6 months, it
should include 1 year, 3 years, 5 years as well as since inception
comparisons
- Outperformance: A fund that
consistently outperforms its peers and its designated benchmark over the
short and long term is generally considered to be well-run and most
likely to bring you positive returns. However, as the famous saying
goes, there is no guarantee of this!
- Volatility, or variation in performance: The
volatility in returns of the fund should be in sync with its
objectives; for instance, if the fund is a high-risk-high potential
return fund, then volatility is a given; however, if it is a low-risk
fund, the returns should not be volatile. This can be checked with the
help of risk ratios published in the fund factsheets.
- Fund Manager: Assess the fund
manager’s track record – both in terms of his experience &
reputation and the past performance of the other funds under his
management. In general, a fund manager’s skills are visible across the
entire range of funds he manages.
- Size of the fund: Small is not, in
general, beautiful in the mutual funds’ world. While the largest fund
may not necessarily have the best performance or strategy to match your
goals, an optimal size would ensure your ability to cash in your
investment when you need it, and for the fund manager to be able to
execute his or her investment strategy. However, it is true that higher
the assets under management, higher the number of investors that trust
the fund manager in question.
- Fund expenses
All funds incur expenses to manage
the fund (fund management fees, administration charges, brokerage,
marketing and sales expenses, commissions, etc.). All of these expenses
are chargeable to the fund’s investors as a percentage of assets under
management, and are described as the “total expense ratio” or TER of a
fund. The lower the TER, the better the potential return on your
investment. - Tax impact
Different type of schemes of mutual funds are taxed differently. The
mutual funds schemes are predominantly divided into 2 broad categories
for the purpose of taxation.
i. Equity Oriented Funds: If you invest in an equity-oriented mutual fund (i.e. one whose
allocation to equity shares of domestic companies listed on stock
exchange is at least 65%) and hold your investment for more than 12
months, your long-term capital gains exceeding Rs 1 lakh per financial
year will be taxable at 10% (without indexation) as per the Finance
Bill, 2018 w.e.f 1st April, 2018. However, if you hold the same for less
than 12 months, it attracts tax at 15%
Note: Here, 12 months is the cut off time to be considered as ‘Long Term’.
ii. Non Equity Oriented Funds: Non equity oriented funds are further divided into two categories on the
basis of their allocation to equity shares of domestic companies
a. Specified mutual funds: Specified Mutual Fund" means a Mutual Fund by whatever name called,
where not more than thirty five per cent. of its total proceeds is
invested in the equity shares of domestic companies.
Finance Act 2023 has inserted Section 50AA in the Income Tax Act, 1961.
As per the said section, with effect from 1 April 2023, gains/losses
from units of Specified Mutual Fund would be deemed to be short term
capital gain/loss irrespective of period of holding and would be taxed
as per the slab rate applicable to investors. This is applicable for all
such units which are acquired on or after Apr 1, 2023.
Any investment in specified mutual funds prior to April 01,2023 would continue be taxed as per point b given below.
b. Non Equity oriented funds Other than specified mutual funds : The said category includes such mutual funds whose allocation to equity
shares of domestic companies is more than 35% but less than 65%.
If you held your investments in such non-equity-oriented funds for more
than 36 months, your capital gains would be taxed at 20% with the
benefit of indexation (which reduces the capital gains tax payable), or
at 10% without indexation if the units are unlisted which ever is more
beneficial to investor . Here, 36 months was considered as the cut-off
time for such investments to be considered ‘Long-Term’. However, holding
such investments for less than 36 months would attract tax at a rate
based on the tax slab your total income fell under.
If you are unsure of the tax implications of investing in the fund,
consult a financial advisor.
The factors mentioned above are all important indicators but you would
be best advised to not consider any one in isolation before choosing a
mutual fund for your portfolio. A professional financial advisor can
help you go about selecting the right funds for your portfolio in the
best possible manner.