Chapter 9: How to Choose the Most Suitable Mutual Fund
The Indian mutual fund industry stands among the world’s finest, boasting over 40 asset management companies (AMCs) and a rapidly expanding array of over 1500 schemes. With such abundance, the challenge for today’s investors shifts from mere participation to prudent selection.
It’s widely acknowledged that mutual funds offer substantial potential for wealth creation over the long term. However, the critical question remains: which fund suits your unique financial objectives?
Navigating this decision can be daunting, as your financial goals hinge on the performance and suitability of your chosen mutual fund. To mitigate this complexity and reduce stress, a data-driven approach is indispensable. By leveraging factual insights and key parameters, you empower yourself to make informed decisions that align with your investment goals.
This chapter delves into the essential considerations and methodologies that will equip you to select mutual funds effectively, ensuring your investments are tailored to your needs and aspirations.
When selecting the optimal mutual fund tailored to your needs, the initial step is assessing its historical performance. However, since mutual funds are subject to market risk, past performance can never guarantee future returns, and therefore, only using quantitative data such as past returns of the funds is not enough.
Therefore, we must adopt a methodical, data-driven process for filtering the best mutual funds based on certain approaches.
The Dual Approach
A dual approach to analyzing qualitative data, such as the integrity of a fund house, the track record of the fund managers, and quantitative data of risk vs. returns, will equip you to make a superior-quality and well-informed decision.
The best part is that you can use these approaches every single time in your selection process. They will aid you in making superior-quality decisions that cater to your needs. Additionally, applying these approaches will help you identify and steer clear of funds that may raise concerns.
Let us explore them first and then look at how we incorporate these data points in our research and design a selection process to choose the Best Mutual Fund for You.
Quantitative Measures :
This encompasses analysing the past performance of the chosen scheme, the level of risk undertaken to achieve returns, and a thorough examination of the fund’s associated costs.
1. Historical Returns
Using Historical returns shows us how well a fund has performed over time. They are typically categorized into:
– Short-term returns (1-3 years)
– Medium-term returns (3-5 years)
– Long-term returns (5+ years)
While past performance doesn’t guarantee future results, it can indicate consistency and the fund’s ability to weather different market conditions.
2. Risk Metrics
Using risk metrics like the following will help you understand the volatility and potential downside of a fund:
- Standard Deviation: Measures the fund’s volatility. A higher standard deviation indicates greater fluctuations in returns.
- Sharpe Ratio: Evaluates risk-adjusted returns. It shows how much excess return you receive for the extra volatility of holding a riskier asset.
- Beta: Measures a fund’s sensitivity to market movements. A beta of 1 means the fund moves in line with the market, while a beta greater than 1 indicates higher volatility than the market.
When you combine past returns with risk metrics, you learn how much risk the same category fund managers are taking to generate returns on the fund. This information helps you eliminate funds and assess the caliber of the fund manager managing the fund.
3. Expense Ratio
It helps you understand how much money is being invested and what charges you pay to the mutual fund AMCs that manage your money.
The expense ratio represents the annual cost of operating the fund, expressed as a percentage of its assets. It includes management fees, administrative costs, and other operating expenses. A lower expense ratio means more of your money is invested.
4. Assets Under Management (AUM)
AUM is a key data point when analyzing a mutual fund scheme. It represents the total market value of assets that a mutual fund manages. While a large AUM can indicate investor confidence, it may limit a fund’s flexibility.
Conversely, a very small AUM might suggest that the fund hasn’t gained widespread acceptance or lacks economies of scale.
Using this in your research process and all the above data points can help you navigate and narrow down on funds for further research.
Qualitative Measures:
This involves evaluating the mutual fund house managing the schemes, including their track record, investment philosophies, management pedigree, and overall credibility. Once you have filtered out the funds based on quantitative analysis, you should use this approach to fine-tune your decision-making process.
1. Fund Manager Experience
Just as a captain of a ship knows how to manage his ship in all weather conditions and reach his final destination safely, a fund manager’s expertise, track record, and tenure are crucial to know while selecting a mutual fund. After all, your financial goals are aligned with the performance of the fund, and a fund manager is the captain of your ship who is responsible for helping you reach your goals.
It’s always better to seek a fund manager who has seen it all, as this equips him to make informed decisions, especially during turbulent times.
An experienced fund manager is better equipped to navigate various market conditions and make sound investment decisions, which could generate higher returns while also handling volatility.
2. Investment Philosophy
The Investment Philosophy in mutual funds refers to the guiding principles that shape the fund’s investment strategy. It could be value investing, growth investing, or a blend of styles.
Understanding the investment philosophy is crucial when choosing a mutual fund to invest your savings since your financial goals align with the mutual funds in which you choose to invest. Indeed, this helps ensure that the fund’s approach aligns with your investment goals.
It’s important to board a flight that reaches your desired destination, isn’t it?
3. Fund House Reputation
As we have learned, Mutual fund Houses, aka AMCs, are the trustees that hire mutual fund managers to invest money on behalf of the investors. The Asset Management Company’s (AMC) reputation can provide insights into its reliability, consistency, and commitment to investor interests.
Factors to consider should include the AMC’s history, regulatory compliance record, and overall performance across different fund categories. This builds trust and fuels the confidence to be associated with the mutual fund house for the long term.
4. Portfolio Composition
Once you have considered all the above data points, it’s also important to check the portfolio composition of the mutual fund schemes you choose to invest in.
Portfolio Composition refers to the mix of securities within the fund. It includes the types of assets (stocks, bonds, etc.), sector allocation, and individual security weightings.
The portfolio composition should align with the fund’s stated objectives and your risk tolerance. Any variance in the composition is a red flag, so it helps you eliminate the universe you discover from the quantitative data analysis.
Based on the above-discussed approaches to data, here’s a framework that integrates both aspects to guide your decision-making process effectively:
Actionable Steps for Choosing the Best Mutual Fund
1. Define Your Investment Goals and Risk Tolerance
- Clearly articulate your financial objectives (e.g., retirement, child’s education)
- Assess your risk tolerance (conservative, moderate, aggressive)
- Determine your investment horizon (short-term, medium-term, long-term)
2. Research and Shortlist Funds
Apply the above combination of approaches to filter out schemes that stand out.
You may use online fund screeners to filter funds based on your criteria.
After which, create a list of 10-15 funds that match your investment goals and risk profile
3. Analyze Historical Returns
Now Compare the shortlisted funds’ returns over 1, 3, 5, and 10-year periods (if available). Check how the funds have performed compared to benchmark indices and category averages.
Pro Hack
Look for consistency in performance across different time frames and look for funds that have managed to outperform the industry average returns in the same category.
4. Evaluate Risk Metrics
Compare the standard deviation of shortlisted funds with category averages. Assess the Sharpe ratio to understand risk-adjusted returns. Look at the beta to gauge how volatile the fund is compared to the market.
Compare them with the industry average and look for funds that have managed to get above-average returns, considering the risk taken to achieve those returns.
5. Examine Expense Ratios
- Compare expense ratios within the same fund category. You need an apple to apple comparison while looking at the options.
- Calculate the impact of expense ratios on long-term return. Consider whether higher expenses are justified by superior performance.
6. Consider Fund Size (AUM)
Check if the fund size aligns with its investment strategy. Further, consider the fund size to understand whether the sheer size does not impact the fund returns. For example –
For equity funds, ensure the AUM isn’t too large to become unmanageable. On the flip side, for debt funds, a larger AUM might indicate better negotiating power for good deals
7. Assess Fund Manager and Team
Research the fund manager’s experience and track record
Look into the stability of the fund management team
Check if the same manager has delivered consistent performance across different funds
8. Understand the Investment Philosophy
Read the fund’s factsheet and investor communications
Ensure the fund’s investment approach aligns with your goals and beliefs
Check if the fund has stayed true to its stated philosophy over time
9. Investigate Fund House Reputation
Research the AMC’s history and standing in the industry
Check for any regulatory issues or investor complaints
Assess the overall performance of other funds from the same AMC
10. Analyse Portfolio Composition
Review the fund’s top holdings and sector allocations
Ensure the composition aligns with the fund’s stated objectives
Check for any concentration risks (e.g., over-reliance on a few stocks or sectors)
11. Check for Consistency
Look for funds that have performed consistently across different market cycles
Be wary of funds that show extreme performance swings
12. Consider Tax Implications
Understand the tax treatment of different types of mutual funds. Factor in the after-tax returns when comparing funds
13. Read Scheme-Related Documents
Go through the Scheme Information Document (SID) for detailed information.
Review the Key Information Memorandum (KIM) for a quick overview
14. Start Small and Monitor
As a general practice, begin with a small investment to test the waters. Once you get comfortable with your choice of fund, scale up as per your budget. Regularly review the fund’s performance and rebalance as needed.
15. Seek Professional Advice if Needed
If you’re still unsure, consult a financial advisor for personalized guidance. Remember that professional advice can be particularly valuable for complex investment decisions
Following these steps, you can choose mutual funds aligning with your financial goals and risk tolerance. Remember, the key is to make informed decisions based on comprehensive research and to regularly review your investments to ensure they continue to meet your evolving needs.
With this, we come to an end! In the next chapter, we shall learn and decode how to start investing in mutual funds, discussing the eligibility, onboarding process, and ways to invest in SIPs, SWPs, and lump sums.