How to Pick the Right Mutual Fund
Investors need to examine the options and choose mutual funds that fit their risk profile, investment goals, and time horizon. There are no easy answers to picking the right mutual fund, and different mutual fund schemes are suitable for different financial goals and periods.
Equity funds offer higher returns and are best for long-term financial goals. However, they are not suitable for short-term goals as they are volatile. Debt funds provide reasonable and stable returns, which are ideal for emergency funds or short-term goals. Once an investor has narrowed down the categories, choosing a specific scheme from a mutual fund category becomes essential.
Parameters to Choose Mutual Funds
As mentioned below, investors can make an informed decision on choosing a mutual fund scheme by considering the following parameters:
1. Asset Class
First, one should consider the asset class in which they want to invest. Different asset classes, like equity and debt, react differently to the same macroeconomic conditions and act as a hedge against portfolio losses.
- Equity Funds: Volatile in the short term but have done well in the long term.
- Debt Funds: Provide stable but reasonable returns.
Investors can further narrow down their universe by choosing a specific asset category.
2. Investment Strategy
The chosen mutual fund scheme should match the investor’s financial and risk goals. If an investor wants to invest in a small-cap fund but doesn’t want its short-term volatility, that scheme can be ruled out in favour of other schemes that match its risk profile.
- Small-Cap Funds: Not the best for short-term goals.
- Multi-Cap and Large-Cap Funds: Good for the long term with lower risk.
- Liquid and Overnight Funds: Good for parking surplus funds for the short term as they have lower interest rates and credit risk.
3. Fund Performance
Investors often make decisions based on the recent performance of funds, a behaviour called recency bias. To make objective investments, one needs to focus on the long term and not the short term.
- Look at the performance of the fund across different market cycles, not just bull and bear markets, to check consistency.
- As per SEBI guidelines (Securities and Exchange Board of India), mutual funds are required to disclose their performance over different periods.
- Check the alpha generated by the fund by comparing its performance with the benchmark index.
4. Fund Managers
Professional fund managers supported by research teams make investment decisions for mutual funds. A fund manager’s strategy is what drives the performance of a fund which is also called alpha.
- Check the fund’s performance under the current manager.
- If a new manager has taken over recently, check the alpha generated by previous schemes.
5. Fund Size
Fund size can impact the portfolio stability.
- Significant Funds: Provide liquidity and may have consistent performance as they have a diverse portfolio.
- Small Funds: Performance can be heavily dependent on a single investment decision as they have a smaller base.
6. Portfolio Concentration
Portfolio concentration in equity or bond funds gives an idea about the investment strategy of the fund manager and the return that can be generated with the associated risks.
- Fund houses publish the scheme portfolio on their website and in monthly factsheets.
- A fund with high concentration may have higher risks, especially for debt schemes where credit downgrades and defaults can impact returns heavily.
7. Portfolio Overlap Analysis
Portfolio overlap analysis is also helpful for investors. This analysis checks the similarity of mutual fund holdings in a portfolio.
- High overlap may indicate concentration in specific funds or sectors, increasing risk.
- Diversify your investments across funds with different strategies and less overlap to reduce concentration risk and create a well-balanced portfolio.
8. Risk-Adjusted Returns
The fund factsheet gives you an idea of the portfolio composition and critical ratios.
- Check risk-adjusted returns by looking at the investment style and concentration risk across companies and sectors.
- This can be done by using key performance ratios like standard deviation and performance against benchmarks.
By checking risk-adjusted returns, you can find better funds.
Conclusion
Investing in mutual funds requires a thought-out strategy and understanding of asset class, investment strategy, fund performance, and fund manager expertise is key to making informed decisions. By evaluating these aspects thoroughly, you can find mutual funds that align with your financial goals, risk profile, and investment horizon. Also, checking fund size, portfolio concentration and risk-adjusted returns will ensure that your investment is diversified and robust to market volatility.
A holistic approach which includes checking portfolio overlap and understanding fund performance across market cycles, will give you the tools to create a balanced and sustainable portfolio. Monitoring and re-evaluating these parameters regularly will ensure that your investments are in line with your changing financial goals. In the ever-changing world of investing, a disciplined approach that considers both risks and opportunities will help you make smart decisions and achieve your financial goals with ease.
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