Mutual funds are supposed to make investing easier, but picking the right one can often be a tricky task. Discover how to choose the best mutual fund in this article!
The Context
Investing in Mutual funds is easy nowadays and you can invest any multiples starting from ₹100 to infinity.
The first step and precondition to start investing in mutual funds is to become KYC (know your customer) compliant. Only after this can you invest in these baskets, as mandated by the Securities and Exchange Board of India (SEBI).
If you completely want to go paperless then you can download a KYC form from any of the mutual fund house websites and the rest of the process is pretty much DIY. Alternatively, KYC forms are also available on all intermediary websites for your disposal.
In India, Computer Age Management Services (CAMS) and Karvy are leading registrar and transfer agent companies that provide services to investors on behalf of mutual fund houses. In our personal opinion, they are doing brilliant work by adding sense to all of the financial chaos.
You can also go to the KARVY or CAMS website to read more about the KYC process. The biggest challenge that comes afterward is picking the right fit for yourself and with more than 2,500 options that all claim to be the best, this process occasionally comes to be a headache. This post will walk you through each facet you need to take into account when choosing the most qualified applicant.
So let’s start with the basics:
Types of Mutual Funds
Open-Ended Mutual Funds
1. Debt or Income funds
Debt funds are the least risky type of mutual fund investment, as the corpus is invested in government securities, debentures, and other debt-related instruments. This is a relatively low-risk and low-return investment and is ideal for those who are willing to accept minimal risks and earn a regular income.
2. Money Market or Liquid funds
Liquid Funds invest your pooled money in short-term financial instruments. These funds are ideal if you want to park your excess money in mutual funds that earn better returns than fixed deposits and savings accounts in the short term.
This allows you to earn returns in the interim period while awaiting worthwhile opportunities to invest across other asset classes like equities or gold. This can also double up as a means to park some of your emergency funds, yielding better returns than your savings account.
3. Equity / Growth funds
Equity funds are the high-yield and high-risk types of mutual funds. The accumulated corpus is principally invested in equities/stocks, thus creating a high-risk; high-return portfolio. This is the ideal investment if you want long-term capital appreciation.
Equity funds are further classified as below –
3.1 Index Scheme
Index funds that invest in indices such as the NIFTY 50 or SENSEX. These schemes adopt a rather passive investment strategy that performs in tandem with the movements of the indices. It’s a simple principle that states – if you can’t beat the market, you better move with the market. These are low-expense ratio funds as buying and selling are minimal. An index stock is sold only when it gets dropped from an Index.
3.2 Sectoral Scheme
Sectoral Mutual fund schemes invest in instruments of a particular sector such as pharmaceuticals, infrastructure, information technology, and others. Sector funds may also invest in companies with small, medium, or large market capitalization.
The risk involved is closely tied to the sector risks so only invest in these funds if they fall under your area of competence or understanding.
3.3 Tax Saving funds
Also known as the Equity Linked Savings Scheme (ELSS), this type of mutual fund has a three-year lock-in period and offers tax benefits. The fund corpus is invested in equity-related instruments and offers a long-term capital appreciation. As per Section 80C of the Income Tax (IT) Act, the investments made in ELSS funds are exempt from income tax with a 3-year lock-in
3.4 Balanced funds (Reader’s Bonus)
Balanced funds also called Hybrid funds are the seamless mix of equities and fixed-income securities as per a predetermined percentage (Debt + Equity). They enable you to enjoy growth and earn an income at periodic intervals. These funds are suitable for vigilant and aggressive investors.
Closed-Ended Mutual Funds
1. Capital Protection Funds
These funds focus on protecting your principal investments and thus invest primarily in high-rated fixed-income securities. A marginal component of the corpus is invested in equity. Thus, these funds have the potential to deliver realistic returns with low risk on your investments.
2. Fixed Maturity Plans (or FMPs)
As the name suggests, these schemes have a fixed maturity period and the corpus is invested in debt instruments that mature with the fund maturity. Such plans earn a fixed interest or coupon rate (*Coupon rate is the yield or return paid by fixed income security).
Since FMPs are passively managed, the expense ratio on these is lower when compared to actively managed schemes.
How To Pick The Best?
As most investors follow research ratings that simplify Mutual funds into Stars, it’s not always necessary that the fund will maintain a similar rating after you invest. Ratings simply reflect decisions that were historically made by a fund manager.
Rating agencies usually rate mutual funds based on the fund’s past performance, the fund manager’s skill, risk, cost-adjusted returns, and performance consistency which builds a good case for distributors to advise investments in Mutual funds to prospective investors.
This is analogous to driving a car while looking in the rearview mirror. So, here is a cheat sheet to help you out with this predicament.
A Checklist To Pick Winners
1. Focus on the Investment Objective
A mutual fund scheme’s goal and investing logic are determined by its investment objective. It could include long-term Capital appreciation, Regular monthly income, or Fixed returns. These objectives are mentioned in the Mutual Fund’s brochure.
If you plan to be a Smart Investor, read the objective and related risks before investing. This is a good practice to understand if it aligns with your investment philosophy as well.
2. Expense Ratio
The expense ratio is the annual operating of a fund and is the percentage of assets payable to the fund manager or the asset management company (AMC) as the maintenance fee. These charges may include fund manager perks, team management costs for the team that helps with analysis, and advertisement costs.
Small-size funds often have a high expense ratio as compared to large funds. This is because in large funds the same cost can be spread across a larger asset base while leveraging the same number of resources. For an investor, this is a lower the better metric.
The ideal fund ratio for equity investors should range between 0.5% to 0.8% and a higher ratio than this can only be justified if a fund manager is actively taking higher risks for better returns in comparison to similar funds.
3. Who is managing the Fund?
Making buy/sell decisions on a mutual fund’s underlying securities falls entirely on the shoulders of the fund management. Always maintain tabs on who is in charge.
Whether a fund is good for the long haul or is only getting lucky due to the predominant bull markets largely depends on the history and profile of the fund manager.
4. Review the Fund Alpha
Alpha is the measure of a portfolio’s return versus a relevant benchmark.
A relevant benchmark could be a composite criterion as the fund could be a complex mix of different stocks featured in multiple indexes (Like 10 stocks from NIFTY 50, 5 stocks from NIFTY NEXT 50, 3 stocks from NIFTY Pharma, etc.).
For instance, if the fund is entirely sectorial such as a Pharma fund, the benchmarking will be based on the Pharma index.
👉 An investment with an Alpha greater than zero has historically provided more return for the given amount of risk assumed.
👉 A negative alpha, less than zero indicates security that has underperformed the benchmark; it has earned too little for the risk assumed.
👉 You should look for high Alphas if your investment horizon is more than 5 years.
5. Take a close look at fund Beta
Beta is the measure of an investment’s volatility to another market index, such as the SENSEX or NIFTY. Volatility indicates how likely an equity instrument is to experience wide roller-coaster swings.
If the beta is 1, the investment moves in sync with the Index or experiences a measure of volatility similar to the index (moving with the market).
👉 If the beta is positive, the investment moves more than the index.
👉 If the beta is negative, the investment is less volatile than the index.
For example, a beta of 2 implies a movement twice that of the market (beware, that’s too much volatility). Assuming a market price change of 10%, the investment could move 20% up or down.
To lessen volatility in your portfolios, conservative investors should normally favor investments with low betas. On the other hand, if you’re a risk-taking investor, you might choose high-beta funds.
6. Compare R-Squared Value
The R-squared value is a measurement of how reliable the beta number is. It varies between zero and 1, with zero being no reliability and 1 being perfect reliability (it’s higher the better metric). This helps compare two timid funds that look similar owing to the same beta but one fair far better than the other in terms of volatility protection.
7. Review The Standard Deviation
While beta typically measures an investment’s movement against an index such as the NIFTY 50, the standard deviation measures the volatility of an investment in a different way. Standard deviation measures the dispersion of data from its mean.
Instead of comparing the investment’s return to a benchmark, standard deviation compares an investment’s returns (for example, the closing price each day) over a specific period relative to its average return over the same period.
The more individual returns deviate from the investment’s average return, the higher the standard deviation.
In simple terms, a greater standard deviation indicates higher volatility, which means the mutual fund’s performance fluctuated high above the average.
8. Validate Sharpe Ratio
Developed by Dr. William Sharpe, a professor at the Stanford Graduate School of Business and one of the recipients of the Nobel Prize for his contribution to the capital asset pricing model (CAPM). The Sharpe volatility ratio is a measure of a portfolio’s return versus a risk-free return.
The risk-free return most often used is the interest rate on a three-month government Treasury bill. The Sharpe ratio tells investors whether an investment’s returns are due to wise investment decisions or the result of excess risk.
Theoretically, the higher the ratio, the stronger the portfolio’s return relative to the risk taken.
👉 A ratio of 1 indicates that the return was what should be expected for the risk taken
👉 A ratio greater than 1 is an indication that the rate was better than expected
👉 A ratio less than 1 is an indication that the return did not justify the risk taken.
9. Independent Ratings
Because they are Free!
Companies such as CRISIL, ICRA, MorningStar, and ValueResearch have proprietary rating systems to rate mutual funds on a risk-adjusted performance basis.
Before investing in mutual funds, do look for these ratings to validate your assessments. The ratings may not be 100% accurate all the time, but they will help you validate your hypothesis.
Conclusion
Investing in mutual funds is a long-term commitment. While investing in mutual funds is as simple as it sounds, it does take adequate research and understanding to develop a sound consensus.
You can certainly utilize a top-down method to simplify this process by choosing funds with high ratings as reported by independent rating agencies, and then deconstructing them piece by piece to verify additional distinctions on risk and rewards.
This concludes the guide to picking the best mutual funds.
We hope that this information will equip you with the necessary diligence to choose the ideal mutual fund for your particular needs.
Frequently Asked Questions (FAQs)
1. What are the different types of mutual funds available, and how do they differ?
Mutual funds come in various types, including debt funds, money market funds, equity funds, and balanced funds, each with its own risk-return profile and investment strategy. Debt funds focus on low-risk investments like government securities, while equity funds aim for high returns through investments in stocks. Understanding these differences is crucial for selecting the right mutual fund.
2. How do I pick the best mutual fund for my investment goals?
To choose the best mutual fund, consider factors such as your investment objectives, risk tolerance, and investment horizon. Evaluate the fund’s investment objective, expense ratio, fund manager’s track record, alpha and beta values, standard deviation, Sharpe ratio, and independent ratings. This comprehensive analysis will help align the mutual fund with your financial goals and risk appetite.
3. What is the significance of the expense ratio in mutual fund investing?
The expense ratio represents the annual operating expenses of a mutual fund as a percentage of its assets under management. A lower expense ratio indicates a better value for investors, as it reduces the impact of fees on returns. Investors should compare expense ratios among similar funds to ensure they are getting the best value for their money.
4. How do I assess the performance of a mutual fund?
Assessing the performance of a mutual fund involves analyzing various metrics such as alpha, beta, standard deviation, Sharpe ratio, and independent ratings. Alpha measures a fund’s return compared to its benchmark, while beta indicates its volatility relative to the market. Standard deviation measures the fund’s volatility, while the Sharpe ratio assesses its risk-adjusted returns. Independent ratings from agencies like CRISIL and MorningStar provide additional insights into a fund’s performance.
5. Why are independent ratings important in mutual fund investing?
Independent ratings from agencies like CRISIL, ICRA, MorningStar, and ValueResearch offer valuable insights into a mutual fund’s risk-adjusted performance. These ratings help investors validate their investment decisions and provide additional information beyond the fund’s stated objectives. While not infallible, independent ratings serve as a useful tool for evaluating mutual funds and making informed investment choices.
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