INVESTING IN MUTUAL FUND - CHOOSING OF FUND (PART-5) - Smart Investor - An investment in knowledge pays the best interest

Saturday, September 9, 2023

INVESTING IN MUTUAL FUND - CHOOSING OF FUND (PART-5)

Greetings, dear readers! Welcome to the fifth and most pivotal instalment of our "Investing in Mutual Funds" series. Think of this segment as our grand finale. In the vast landscape of mutual funds, how do we navigate and select those that align perfectly with our financial objectives and risk tolerance?


Selecting mutual funds is no cookie-cutter task; your choices should be as unique as your financial circumstances and objectives. Armed with the right information and a strategic approach, you can make well-informed decisions that set you on the path to financial prosperity.


In our previous articles, we delved into the essential terminology and key performance ratios used in the world of mutual funds. In this segment, we'll transition from theory to practice, learning how to leverage these terms and ratios in the selection of funds that best match our financial goals and risk appetite.


This article aims to be your compass in the complex landscape of mutual fund selection. Whether you're a novice investor looking to start your investment journey or an experienced one seeking to refine your portfolio, we're here to guide you through the decision-making process.


so, whether your goals involve retirement planning, saving for a child's education, or simply seeking to grow your wealth, let's embark on this journey together to uncover the art and science of choosing the right mutual funds for your financial future.


But before we dive into the practicalities, let's rewind the key terms and ratios discussed in our previous articles (Part-1, Part-2Part-3 and Part-4).


Now, let's embark on the exciting journey of mastering the art of investing in mutual funds! 😁


For the purpose of illustrating our selection process, we'll use the "Quant Small Cap Fund" as our reference. Please note that this fund is not recommended by us.


To select any Mutual fund, the initial step is to define our investment objective and clarify the purpose behind our investment. Whether it's for retirement planning, education funding, home purchase, or any other financial goal, setting a specific time frame for achieving, is crucial.


For Short-Term Goals: In cases of short-term goals or emergency funds, consider money market funds or debt funds. These options offer stability and liquidity. They primarily invest in low-risk, highly liquid securities such as Treasury bills, government securities (G-secs), and bonds.


For Long-Term Goals (More than 5 years): For long-term objectives like retirement planning or wealth accumulation, it's wise to explore equity funds. These can encompass various types, including index funds, actively managed stock funds, and sector-specific funds.


Now, let's delve into the selection of equity funds. Equity funds tend to offer higher returns, albeit with higher risk, which often appeals to retail investors seeking substantial gains. However, within the realm of equity funds, there are different categories, such as Large Cap, Mid Cap, Small Cap, Sectoral/Thematic, and ELSS (Equity-Linked Savings Schemes), as we discussed in our previous article (Part-2).


To choose among these categories, it's essential to assess our risk tolerance. You might wonder why we need to evaluate risk when equity funds inherently carry a high level of risk. The reason is that risk tolerance varies among individuals, and understanding your comfort level with risk is key.


Consider how much risk you are willing to take with your investments. Generally, risk and potential returns are closely linked. Higher risk tolerance may offer the potential for greater gains, but it also carries the potential for more substantial losses. Therefore, careful consideration is essential at this stage of decision-making.


Here's a general guideline for risk levels within equity funds:

  • Large Cap/ELSS funds tend to be more stable.
  • Mid Cap funds are moderately stable.
  • Small Cap funds come with higher volatility.
  • Sectoral/Thematic funds require a deeper understanding of specific sectors, in addition to other evaluation criteria.

So, have you selected the type of fund that aligns with your goals and risk tolerance? If so, the critical part of the process has just begun.


Once you've identified the fund category that aligns with your objectives, you'll encounter numerous options offered by various Asset Management Companies (AMCs) falling under the same category. This is where the real work begins – selecting the fund within an AMC that consistently outperforms its peers from other AMCs.


Here are the criteria I've used to select a fund within the category we've chosen. (It's worth noting that I always recommend opting for the "Direct" option due to the differences between Direct and Regular, as explained in Part-2.)


  • Age of Fund: Consider the tenure or age of the fund. A longer track record can provide insight into how the fund has performed through various market cycles. I think, opting for a fund with a minimum age of 3 years is a wise decision.

  • Fund's AUM (Asset Under Management) / Size: The fund's AUM is an important factor. A fund with a substantial AUM may offer stability but could face challenges in deploying large amounts of capital effectively. Conversely, a small fund may be more nimble but might have liquidity limitations. So go for medium sized fund (500 Cr to 10000 Cr). 

  • Fund Manager Expertise: Assess the fund manager's experience and track record. A skilled and experienced fund manager can play a crucial role in a fund's performance. The duration of their association with the fund is also a crucial factor to take into account. When a fund exhibits strong performance but experiences a recent change in the fund manager, it raises questions about the likelihood of maintaining that performance. 

  • Fund Performance Over Different Periods: Examine how the fund has performed over various timeframes, such as short-term, intermediate-term, and long-term, in comparison to its peers. Consistency in performance is key. Compare on time-frames like 1M, 3M, 6M, 1Y, 3Y, 5Y etc.,

  • Ratios/Metrics Compared to Peers: Analyse key ratios and metrics of the fund, including expense ratios, Sharpe ratios, alpha, and beta, (refer Part-3, Part-4) in comparison to similar funds offered by other AMCs. These metrics provide insights into the fund's efficiency and risk-adjusted returns.


By considering these factors and conducting thorough research, you can make an informed decision when selecting a specific fund within your chosen category. Remember that past performance is not indicative of future results, so ongoing monitoring of your investments is essential.


Let's conclude here to keep this segment concise. The detailed illustration of the fund selection procedure outlined above will be covered in our upcoming article. We appreciate your patience and encourage you to stay with us to gain practical insights into the process. 


Share your selection of fund as per your financial goal and risk appetite in comments below.  🙏


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