How To Choose a Mutual Fund That Suits Your Financial Goal

Mutual funds are like a toolbox. They offer a range of options to suit your every financial goal. Your needs could be a short-term purchase, a medium-term milestone, or a retirement plan. There are several mutual fund categories in India, which means that there is likely a scheme that could suit all these and other goals.

This article tells you more about the different types of mutual fund schemes and the types of goals they may suit.

• Table of contents

1. Funds for different goals
2. How to choose the right scheme

Funds for different goals

Your mutual fund journey can start with three questions: what are your goals, how much time do you have to fulfil them, and how much risk you can tolerate? Accordingly, you should craft a well-balanced portfolio that seeks to balance risk and return and has mutual funds that suit these goals. Here is an overview of what sort of fund might suit different investment horizons.

• Emergency corpus (a year or under): For emergency expenses, you can consider highly liquid options like liquid funds, money market funds, overnight funds, arbitrage funds, and ultra-short-term or low-duration funds. These funds prioritise relative stability and easy access to your money (or liquidity). They also offer better return potential compared to savings accounts. Such funds may be good avenues to park surplus cash to build an emergency reserve.
• Short-term goals (1-3 years): A short-term goal could be to save for a vacation, make a big purchase such as a car, or create an emergency fund. Short-term debt funds may be suitable for these, especially if you are risk-averse. Such funds invest in debt securities and money market instruments. They tend to be more stable than equity investments and offer modest return potential, typically higher than that of traditional bank deposits.
• Medium-term goals (4-6 years): These could include saving up to start a business or to fund a higher education. Hybrid mutual funds that combine both debt and equity can be a good fit for medium-term goals. Such funds seek to balance growth potential with risk mitigation. The equity component lends growth potential, and the debt component seeks to provide relative stability to your portfolio. There are various hybrid funds with varying risk profiles, so both conservative and risk-friendly investors may find a suitable option.
• Long-term goals (7+ years): These could include retirement, funding a young child’s higher education, or buying a house. Equity funds can be a suitable choice for such goals for investors who are comfortable with some risk. Equity funds offer the potential to build wealth over the long term and tend to outperform fixed-income assets in the long horizon. A long investment horizon can mitigate the impact of short-term volatility on equity funds.

Conservative investors may also consider long-term bond funds or hybrid funds. Some hybrid funds for such long-term goals could be multi-asset funds (which invest in debt, equity and a third asset class, such as gold), and dynamic asset allocation or balanced advantage funds (which distribute their assets between debt equity).

How to choose the right scheme

Once you figure out which type of mutual fund suits your goals, the next step is picking the right fund within that broad category.

Here are some key factors to consider when choosing a scheme:

• Expense ratio: This fee, expressed as a percentage of your investment, covers the fund's operational costs. A higher expense ratio can eat into your returns.
• Past performance: Past performance is not a guarantee of future results, but it can offer insight. Analyse the scheme's historical returns and compare them to the scheme’s benchmark. Also look at the returns of other funds in the same category for a more comprehensive picture. This will help you understand if the fund manager's investment strategy has paid off.
• Investment style: Mutual funds can be actively managed or passively managed. The fund manager plays a large role in actively managed schemes, crafting and altering the portfolio based on market trends and their insights. The fund manager aims to outperform the market. Passively managed schemes, such as index funds and exchange-traded funds, track a specific market index. The portfolio comprises a proportionate representation of all the securities in that index. This can offer a diversified exposure to the market and the aim of the funds is to match market returns, subject to tracking error. Actively managed schemes typically have a higher expense ratio than passively managed ones. They may also entail more risk because the fund manager’s strategy and skill can influence returns.
• Exit load: Certain schemes may impose an exit load, a fee charged if you redeem your investment within a specified timeframe.
• Risk tolerance: The risk level of the scheme you choose must align with your risk tolerance.

Conclusion

There are many mutual fund schemes on offer in India, which means that investors with varying goals and risk appetites can find a scheme category that may be suitable to them. You may also craft a portfolio with a combination of various schemes for different goals and investment horizons. For example, a young investor could split investments into short-term funds for an upcoming down payment, a aggressive hybrid or dynamic asset allocation or balanced advantage fund for higher education costs, and equity funds for long-term goals such as retirement.
The percentage you allocate to each fund will depend on your goals, risk appetite and investment horizon.

FAQs

What are the main types of funds suitable for short-term goals?

Short-term debt funds may be suitable for goals that are 1-3 years away. This is because debt tends to be more stable than equity, with the potential to yield higher returns than traditional bank deposits.

How do medium-term goals impact fund selection?

A medium-term goal would require stability as well as growth potential. Aggressive hybrid funds or Dynamic asset allocation/Balanced Advantage could be suitable for such goals because they combine both debt and equity in their portfolios. The equity component lends growth potential, while the debt allocation seeks to lend relative stability to the portfolio in volatile markets.

Are there specific funds recommended for long-term goals?

Equity funds can be a suitable choice for long-term goals (of 7+ years) as they offer diversified exposure to equity that has the potential for capital appreciation over the long term.

Should risk tolerance differ across various goal-oriented funds?

Yes, your risk tolerance should align with every scheme you choose. Moreover, short-term goals may require more stable investment vehicles. Equity funds may be better suited to long-term goals. This is because they entail high risk, but the long investment horizon can potentially mitigate the impact of short-term volatility.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.