Guide to Selecting Mutual Funds

Investing in mutual funds is one of the best ways for investors to potentially beat inflation and build wealth over long run. However, choosing the right mutual fund for your goals can be daunting, with options galore. There are 1,566 schemes in the industry as of June 2024. (Source: AMFI) Whether you are a novice or an experienced investor, selecting the right mutual funds for your portfolio requires an understanding of various fund types and evaluating multiple factors to align with your financial goals. Let us begin by exploring the different categories of mutual funds.

Oct 2024 - 7 mins read

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Understanding Mutual Fund Types

Equity Mutual Funds

There are 11 categories of equity funds. Equity Funds primarily invest in a basket of stocks, offering the potential for beating inflation over long run. Equity Funds are ideal for investors with a long-term horizon looking to build wealth. Understanding different sub-categories such as Large Cap, Mid Cap, and Small Cap funds, Multi Cap, can help you tailor your portfolio to your risk tolerance and financial goals. Your portfolio should ideally have a mix of large, mid and small caps to capture opportunities in each segment of the market.

Debt Mutual Funds

Debt mutual funds invest in fixed-income securities like bonds and treasury bills. They are suitable for conservative investors seeking stable returns with lower to moderate risk. The credit quality of underlying securities and duration, among others, are crucial factors to consider when opting for debt funds. There are 16 types of Debt Funds, each carrying varying degree of risk-reward potential. Debt Funds can be used to park your short to medium term investments. Debt Funds are essential to help you diversify your portfolio.

Hybrid Mutual Funds

Hybrid mutual funds combine equity, debt, gold, silver or REITs providing a balanced investment approach. They are ideal for first-time MF investors looking to leave the asset allocation decision with fund managers. There are seven categories of Hybrid Funds - aggressive, balanced, and conservative, dynamic, muti asset, equity savings and arbitrage.

Other Types (Sector, Index Funds, etc.)

Besides the plain vanilla market cap based funds, Sector Funds help you get a dedicated and narrow exposure to a particular sector. Thematic Funds have a slightly broader investment mandate as they can invest in ancillary themes which are directly connected with a theme.

Passive Funds are broadly categorized into Index Funds and Exchange Traded Funds. They mimic a market index such as Nifty 50, Nifty 500, providing broad market exposure. Passive Funds help you get a broad exposure to different market capitalizations such as Large Cap, Small Cap, Mid Cap and sectors such as Healthcare, Defense, Industrials, Banks, Tourism, etc. and commodities such as gold and silver.

Equity Linked Savings Funds (ELSS) help you save tax on investments of up to 1.50 lakh under section 80C under the old tax regime.

By understanding these different types of mutual funds, you can begin to identify which ones align best with your financial goals and risk tolerance. This foundational knowledge is crucial as we move forward to examine the key factors to consider when choosing a mutual fund.

Before you shortlist funds, it is crucial to draw up your overall asset allocation - equity, debt, alternatives. After this is in place, you have to select the funds that suit your goals from each of these categories.

Key Factors to Consider When Choosing a Mutual Fund for Investing

Selecting the right mutual fund involves evaluating multiple factors to ensure it aligns with your investment goals and risk tolerance. Each factor plays a critical role in assessing the fund's potential.

Investment Goals and Horizon

The first step before you shortlist funds is to ascertain your life goals - short-term or long-term and select funds that align with your goals. For example, if you are saving for retirement 20 years from now, diversified equity funds are appropriate. This alignment is essential for achieving your financial objectives, as different funds are designed to meet various timelines and risk profiles.

Performance Metrics

Performance metrics, such as returns over different market cycles show how a fund has performed over long run. Look at rolling returns to check the consistency of the fund. When you are shortlisting active funds, check if the fund has been able to outperform its benchmark and peers over long run.

Simply chasing the best performing funds, entering and exiting funds, may not help you get the desired outcome. Instead, diversify your portfolio across different styles (value, growth, momentum) and fund managers so that you don’t miss out any themes and investment styles.

Expense Ratio

The expense ratio represents the cost of managing the fund, and can impact net returns. For example, if a fund has an expense ratio of 2%, it means that 2% of the fund's total assets are used annually to cover expenses. Lower expense ratios are generally preferable as they ensure more of your money is invested. Expense ratios across various categories are capped by Securities and Exchange Board of India.

That said, expense ratio should not the sole criteria to select funds. The expense ratio of equity funds (actively managed) tends to be higher as compared to Debt funds. Passive Funds (Index Funds and ETFs) charge lower as compared to actively managed equity funds as their sole objective is to mirror the underlying benchmark. Active Funds aim to outperform the benchmark and hence they charge a higher TER as compared to Index Funds and ETFs.

Fund Manager’s Track Record

Besides the past track record, fund manager can influence fund’s performance. Opt for funds managed by experienced and successful managers with a history of navigating market volatility. A skilled fund manager can make informed decisions that enhance the fund’s performance and mitigate risks. While each fund operates as per the investment objective, fund manager’s unique skills related to stock selection, sectoral rotation and being underweight/overweight on stocks plays a crucial role in generating alpha. It is ideal to spread your portfolio across different fund manager’s as each fund has a unique style of fund management and stock picking skill.

Asset Management Company (AMC)

Investing with AMCs known for strong governance, long track record of operations across geographies, adequately resourced team and performance history can provide additional confidence in the fund’s stewardship and capability in managing funds.

Risk Assessment

Understanding the various risks associated with mutual funds is crucial to making informed investment decisions. Here, we break down the primary types of risk you should consider.

Market Risk

Market risk refers to the potential for losses due to market fluctuations, which are impacted by sentiments as well as the potential of underlying companies’ future earnings and any geopolitical uncertainties. Equity funds typically carry higher market risks compared to debt funds as they are more sensitive to changes impacting equity markets. Understanding the volatility and market risks associated with the fund is essential to gauge your risk tolerance and investment horizon. Volatility is inherent in equities and you should have a longer time horizon while investing in this asset class. Short term volatility gives you an opportunity to buy into dips and accumulate more units.

Credit Risk

Credit risk is the possibility of a default by the issuers of the securities within a fund. In debt funds, considering the credit quality of the underlying securities is vital to avoid defaults. Higher-rated securities generally carry relatively low credit risk, making them a safer option for conservative investors. For instance, Gilt Funds, which invest in government securities, carry low credit risk but have a high interest rate risk.

Fund Size (AUM)

The size of a fund, measured by its Assets Under Management (AUM), often indicates its popularity among investors. Larger AUM can be a sign of investor confidence; however, it may limit the fund's agility in making quick investment decisions. A fund which gets regular investments from SIPs or otherwise can find new opportunities to deploy in the market. Balancing fund size with performance metrics is crucial, as both small and large funds have their advantages and disadvantages.

A small fund on the other hand, has agility, but it can have concentration risk, and its NAV might be impacted if gets large scale redemptions. So the best way is to find a middle path by investing in funds which have a decent AUM size and are getting regular cash flows from investors. Size may not be of so much concern in large cap funds but it does matter in the small cap category. Small Cap Funds which grow too much in size may not be able to deploy the inflows beyond a point and may temporarily suspend inflows.

Practical Steps to Choose a Mutual Fund

Now that we have understood key considerations for selecting the right mutual fund, you can follow these steps to ensure your choice aligns with your financial goals and risk tolerance.

Step 1: Define Your Financial Goals

Clearly outline your financial objectives, whether for retirement, education, or wealth accumulation. Knowing your goals will guide your investment decisions and help you select funds that align with your needs.

Step 2: Assess Risk Tolerance

Determine your risk appetite based on your financial situation and investment horizon. This assessment will help you choose funds that match your comfort level regarding risk. For example, a young investor with a long horizon may take on more risk than someone nearing retirement.

Step 3: Compare Mutual Fund Categories

Evaluate different fund categories such as equity, debt, and hybrid to find the one that best fits your risk tolerance and goals. Equity funds are ideal for growth, debt funds for stability, and hybrid funds for a balanced approach.

Step 4: Analyze Fund Performance

Use historical data to assess the fund's performance consistency and stability. Look for funds with a strong track record of delivering consistent returns. A fund's past performance, while not guaranteeing future results, can provide insights into its management's effectiveness.

Step 5: Review Fund Management

Investigate the fund manager's experience and the AMC's reputation. A skilled fund manager and reputable AMC are ideal.

Step 6: Final Selection and Investment

After thorough analysis, choose the fund that best meets your criteria and proceed with the investment. Regularly review your portfolio/asset allocation to ensure it remains aligned with your goals. Making adjustments based on performance reviews and changes in your financial goals is essential to maintaining a healthy portfolio.

Advanced Strategies

For investors looking to enhance their mutual fund investments, consider these advanced strategies:

Systematic Investment Plans (SIPs)

SIPs allow for regular, disciplined investing, averaging out market volatility and helping build a decent corpus over long run. By investing a fixed amount regularly, you can benefit from rupee cost averaging and compound interest. For any goal, if you know how much corpus you require, you can calculate how much you have to invest per month, assuming a rate of return in a given time frame, to achieve that corpus. You can use online SIP calculators to find out how much you need to save regularly. You can also increase your SIP amount by opting for Top Up SIP to achieve your goals faster.

Regular SIP

If you wish to accumulate a corpus of Rs 1 crore in 15 years, you have to invest approximately Rs 20,000 per month in equity funds, assuming 12% CAGR.*

Top up SIP

Assuming you can’t commit Rs 20,000 right away, you can still achieve the 1 crore corpus in 15 years if you increase your SIP commitments as your income grows. For instance, if you start with Rs 10,000 per month in equity funds for a period of 15 years with a top-up of Rs 2,500 every year, you will create a corpus of Rs 1.06 crore.*

Top up SIP
SIP Per Month	Rs. 10,000
Tenure in years	15
Yearly top-up amount	Rs. 2500
Total Value of Investment	Rs. 1,06,85,021
SIP Amount Invested	Rs. 49,50,000
Estimated Returns	Rs. 57,35,021
Return %	12%

*Past performance may or may not be sustained in future and is not a guarantee of any future returns.

Calculate your SIP top up investment by using our SIP Top-Up Calculator.

Systematic Transfer Plans (STPs)
STPs facilitate a gradual transfer of funds from one scheme to another, balancing risk and returns according to market conditions. This is useful for investors looking to switch from debt to equity funds or vice versa over time.

Systematic Withdrawal Plans (SWPs)
SWPs provide a regular income stream by allowing periodic withdrawals from your investment. This is suitable for post-retirement income planning, ensuring that you have a steady flow of funds while keeping the rest of your investment growing. While withdrawing, you have to keep in mind that your rate of withdrawal should not be more than the rate of return you get from your portfolio, as you run the risk of depleting your corpus early.

Conclusion
Selecting the right mutual funds is a journey that combines introspection, knowledge, strategy, and a bit of intuition. Beyond numbers and performance metrics, remember that each fund represents a vision for your future, whether it is securing your retirement, funding your child's education, or achieving financial independence. Stay curious, stay informed, and let your investment choices reflect your aspirations.

The right mutual fund is not just a financial decision; it's a step towards your dreams. When you are investing for your long term goals, your behavior plays an important role in the final outcome. You have to overcome your emotional biases like greed and fear and keep invested rationally. If required, take the help of a financial advisor in building your portfolio.

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