How to Pick the Right Mutual Funds for Yourself?
Investing in mutual funds is a popular choice for those who want to grow their wealth over time. Mutual funds provide this opportunity as they are professionally managed and diversify your investment across different assets. However, with a plethora of mutual funds available in the market, selecting the right one can be daunting. This blog will guide you through the key steps and metrics to consider when choosing the best mutual funds for your investment goals.
Step 1: Assess your risk appetite
Before diving into the technicalities, it's crucial to understand your risk tolerance. Your risk appetite will determine the type of mutual funds that suit you best. Mutual funds are categorised based on the market capitalisation of the companies they invest in, namely large-cap, mid-cap, and small-cap funds.
Large-Cap Funds: These invest in well-established, financially stable companies. These funds are less risky but offer moderate returns. They are ideal for conservative investors with a lower risk appetite.
Mid-Cap Funds: These funds target medium-sized companies with growth potential. These funds carry more risk than large-cap funds but offer the possibility of higher returns.
Small-Cap Funds: These funds focus on smaller, emerging companies. They are the most volatile but can provide substantial returns if the companies perform well. They are suited for aggressive investors with a high-risk appetite.
Example:
If you are a conservative investor, a large-cap mutual fund like the HDFC Top 100 Fund might be a good choice. It has a history of stable returns with lower volatility compared to small-cap funds like Axis Small Cap Fund, which is better suited for those willing to take on more risk.
Step 2: Consider Thematic Investing
Thematic investing involves focusing on specific sectors or themes, such as green energy, technology, or healthcare. Thematic mutual funds can offer high returns if the sector performs well, but they also carry the risk of sector-specific downturns.
Pros: High potential returns if the sector thrives.
Cons: Higher risk due to the concentration in a single sector.
Example:
If you believe in the future of green energy, you might consider a thematic fund like the ICICI Prudential Green Energy Fund. However, if you prefer a more diversified approach with lower risk, an index fund like the Nifty 50 would be a safer bet.
Step 3: Analyse key metrics
Once you've assessed your risk appetite and considered thematic investing, it's time to dive into the metrics that can help you make an informed decision.
1. Rolling Returns
Rolling returns provide insight into the consistency of a mutual fund's performance over time. Unlike point-to-point returns, which only consider the start and end periods, rolling returns measure performance over multiple overlapping periods, offering a more comprehensive view of the fund's stability.
In this example, Fund B has more consistent rolling returns across different periods, making it a better choice for long-term stability.
2. Assets Under Management (AUM)
AUM refers to the total market value of assets managed by a mutual fund. A larger AUM generally indicates greater popularity and trust among investors. However, a very large AUM might also dilute the fund's returns if the fund manager struggles to deploy the large corpus effectively.
Example:
The ICICI Prudential Bluechip Fund has an AUM of ₹59,364 crore, signifying strong investor confidence. The large AUM suggests that this fund has a solid track record and is a preferred choice for many investors.
3. Expense Ratio
The Expense Ratio (ER) is the annual fee charged by the mutual fund company for managing your investments. A lower ER means that a larger portion of your money is being invested rather than being used to cover management fees.
In this example, Fund A with a lower expense ratio is more cost-effective, ensuring that more of your money goes towards investment rather than fees.
4. Exit Load
Exit load is a fee charged when you redeem your mutual fund units before a specified period. It's important to check the exit load, especially if you plan to liquidate your investment in the short term.
Example:
The SBI Bluechip Fund charges an exit load of 1% if redeemed within one year. Choosing a fund with a lower exit load can save you money if you need to access your funds early.
5. Sharpe Ratio
The Sharpe Ratio, developed by William F. Sharpe in 1966, measures the risk-adjusted return of a mutual fund. It helps investors understand the return they are earning for the level of risk they are taking.
Higher Sharpe Ratio: Indicates better risk-adjusted returns.
Optimal Range: A Sharpe Ratio between 1.0 and 3.0 is considered ideal.
Example:
If Fund A has a Sharpe Ratio of 2.5 and Fund B has a Sharpe Ratio of 1.2, Fund A offers better risk-adjusted returns, making it a more attractive option.
6. Beta
Beta measures the volatility of a mutual fund compared to its benchmark. It helps you understand how much the fund's price will fluctuate in response to market movements.
Beta > 1: The fund is more volatile than the market.
Beta = 1: The fund's price moves in line with the market.
Beta < 1: The fund is less volatile than the market.
Example:
If Fund X has a beta of 1.2, it is expected to be 20% more volatile than the market. On the other hand, Fund Y with a beta of 0.8 is less volatile, making it a safer option for risk-averse investors.
Step 4: Review the Fund's Fact Sheet
The fact sheet is a document that provides comprehensive details about a mutual fund, including its past performance, expense ratio, portfolio composition, and the fund manager's track record. Reviewing the fact sheet is essential before making any investment decision.
Example: The Parag Parikh Flexi Cap Fact Sheet
Step 5: Diversify Your Portfolio
Diversification is key to managing risk in your investment portfolio. By spreading your investments across different types of mutual funds (large-cap, mid-cap, small-cap, thematic, etc.), you can reduce the impact of any single fund's poor performance on your overall portfolio.
Example:
You might allocate 50% of your portfolio to large-cap funds for stability, 30% to mid-cap funds for growth, and 20% to thematic funds like green energy for high-risk, high-reward opportunities. This way, you balance risk and reward across different market segments.
Conclusion
Choosing the right mutual funds requires a thoughtful approach, taking into account your risk appetite, investment goals, and the key metrics that can guide your decision-making. By assessing factors like rolling returns, AUM, expense ratio, exit load, Sharpe ratio, and beta, and by reviewing the fund's fact sheet, you can make informed decisions that align with your financial objectives. Remember, diversification is crucial to managing risk, and staying informed about market trends and fund performance will help you adapt your strategy over time.
Investing in mutual funds can be a rewarding way to grow your wealth, but it's important to do your homework and choose funds that align with your goals. With the right approach, mutual funds can be a valuable component of your long-term financial strategy.
