How To Pick the Right Mutual Fund (Kaun sa Mutual Fund sahi hai)
'Mutual Fund sahi hai' is the tagline of the season. Many new investors who have recently understood the power of equity markets by listening to success stories of their neighbors and colleagues want to hop on to the market story. This is a usual bull market scenario. Young professionals, just out of college, want to start their investing journey. In addition, there are those financial influencers who have created spreadsheets with goals, and nobody wants to miss those goals and select the right mutual fund.
The bottom line is, everyone is looking for a place to invest and grow their money quickly. Especially with raging bull markets, there is a sense of FOMO too. The question then is, which mutual fund to invest in?
Mutual Fund Fundamentals
Definition: It is a fund or a pool of money collected from investors and managed by a Fund Manager employed by a Mutual Fund House such as ICICI/HDFC/Kotak/Parag Parikh, among others.
Minimum investment amount: Investors can start with as little as Rs. 500.
Fund Manager's role and objective of fund: The fund manager is responsible for identifying investment opportunities and making investments. Each mutual fund has an investment objective based on the investor's return expectations and risk tolerance. Depending on the objective or fund, the fund manager invests the money in various types of assets such as equity, gold, debt, etc.
Diversification and market cap categorization of funds:
Keep in mind that a mutual fund is already a diversified investment vehicle on its own. Typically, a fund manager will have 30-50 stocks in their equity portfolio. A Flexi Cap fund for example, includes stocks from large, mid, and small cap categories. For beginners, Cap her stands for Market capitalization which is the market value of a business, for example if you want to own Reliance, you will pay Rs. 20 lac crore today and that is the market cap of Reliance. Further, large cap companies are the top 100 in terms of market cap or valuation, mid cap companies are ranked 101-250, and small cap companies fall below the 250 mark.
On recent small and mid cap returns:
Analyze the monthly timeframe chart to compare the Sensex, Mid Cap, and Small cap indices in the exhibit below. It is evident that all three indices showed similar returns during the initial 6 years on the 10-year chart. However, starting from 2020, there has been a significant breakout in the Mid Cap and Small cap indices compared to the Sensex, resulting in higher percentage returns. This partially explains the situation. Generally, all funds aim to surpass these benchmark indices. For novices, an index comprises stocks chosen by BSE in this scenario. The sudden surge lacks a specific rationale. Could it be due to a surplus of funds chasing limited assets? In summary, based on the past four years, small and mid cap funds have significantly outperformed large corporations in terms of returns.
Risks associated with small cap funds and equity in general:
If you define risk as potential capital loss, it's important to note that the risk only materializes if you sell the asset at a lower price. If you have a long-term investment approach and avoid selling in times of distress, the risk is limited. Small cap and mid-cap funds may not offer similar returns in the next 4-5 years, but over a 10-year period, they could potentially provide 10-15% CAGR returns. Therefore, the key factor is the duration of your investment in the market. Risk perception varies based on individual definitions. If you consider risk in the short term, such as the next 6 months, then it is indeed a risk. In general, it is advisable not to invest funds that may be needed in the next 6 months to 1 year in any equity asset. Fund Managers utilize diversification as a strategy to reduce risk.
Picking the right Mutual Fund
Having gained an understanding of the basics of Mutual Funds, let's explore the process of selecting a mutual fund from a wide array of choices. It is essential for investors to be aware of where their funds are being invested. Typically, investors tend to base their decision on the previous year's returns or the fund's rating. However, this approach should be avoided as past performance does not guarantee future results. While the market may have experienced exceptional returns in 2023-2024, this trend cannot be assumed to continue in the future. It is more probable that returns will be more moderate in the upcoming year. Over the long term, equities are expected to provide an average return of 12-15%. Therefore, assessing a fund manager based on their performance over the last five years may still be a valuable criterion.
Utilizing a mutual fund is an effective strategy for establishing an initial capital base before transitioning into wealth creation through the multiplication of that capital. Mutual funds offer disciplined investment options such as SIP/STP/SWP, which facilitate savings. While it is not advisable to go overboard in fund selection, investors seeking returns superior to those of an index fund should conduct thorough research to identify a suitable fund.
Therefore, investors should consider maintaining a portfolio consisting of a maximum of 3-4 funds diversified across equity and debt, including a mix of large, mid, and small-cap equities. Opting for a flexi cap or equity-oriented hybrid fund can generally fulfill this requirement. Alternatively, investors may choose to include a large-cap, mid-cap, and small-cap fund, along with some allocation to a debt fund for risk diversification. Analyzing the fund's portfolio is crucial in selecting the most suitable option.
6 Key Points to Consider when selecting the right Mutual Fund
- An effectively diversified equity portfolio strikes a balance between diversification and concentration. A fund manager with a moderate number of high-conviction bets, making up around 7-8% of the portfolio and not exceeding 30 stocks, showcases expertise and commitment compared to an inefficient fund manager who holds hundreds of stocks in the portfolio.
- Emphasize long-term returns over short-term performance indicators such as one-year returns.
- Most funds conduct quarterly reviews of their portfolios. Take advantage of these opportunities to comprehend the portfolio and the rationale behind a fund manager's investment choices. While this may be challenging for some investors, dedicating time to this practice can enhance your understanding of the stock market in general.
- Sectoral funds such as digital/infrastructure funds are not suitable for ordinary investors, and it is advisable to steer clear of them unless you possess expertise in the specific sector. Often, fund managers introduce sectoral funds when a particular sector is performing well, like the recent launch of PSU funds due to the sector's momentum. Ordinary investors are at risk of getting caught up in such trends, making sector funds unsuitable for them. This is a common mistake many investors make by investing in sector funds.
- Do not overly fixate on the expense ratio, as a competent fund manager may come at a higher cost, and sometimes it is acceptable to incur an additional 0.5-1% for better returns. If the fund is managed effectively, paying a slightly higher fee is justifiable.
- Opt for a direct fund over a regular fund to avoid paying a commission to a Mutual Fund distributor, provided you have a good understanding of the investment process. If you require assistance in fund selection, it may be beneficial to opt for a regular fund through a mutual fund distributor/advisor.
Conclusion
Pick the right Mutual Fund by thoroughly examining its portfolio, investment strategy, and other relevant factors. While diversification is important, avoid excessive diversification. Recognize the risks associated with equity investments, but do not allow fear to dominate your decision-making. To achieve returns that outpace inflation, accepting some level of risk is essential. Once you have a solid grasp of the fundamentals, consider taking calculated risks. Invest only funds that are not designated for emergencies in equity-based schemes. Lastly, exercise patience and stick to your plan, as long-term investment is your best defense against risk.
