Mutual Funds are broadly classified into five groups. There are cumulatively thirty-five plus categories under these five groups. And then, there are forty plus Asset Management Companies offering their schemes for respective categories. Coming straight to the point, as on 31st August’2022, there are 1156 open ended schemes to choose from. This is a perfect example of paradox of choice. Anyone can get confused.

Let’s try to build a basic framework of how to select a mutual fund.

Step 1: Choose the right category

The first thing you need to choose is the right mutual fund category. All the 35 plus categories of schemes have different characteristics and hence selecting the right category is paramount.

Let’s understand this by example, a corporate treasury that wants to park their surplus money from the current account would not like to take equity risk or be comfortable with credit risk / interest rate risk. Therefore, the category suitable for them will be either overnight funds (for 1 to 15 days of parking of funds), liquid funds (for 8 days to 3 months) or ultra-short-term funds (for 2 months to 6 months).

Let’s take one more example, a father wants to invest only for 17 years for his newly born son so that he can pay for his higher education. Considering the long-time frame in hand, it makes a lot of sense to allocate a significant portion of the portfolio to equities. Within equities, he can construct a portfolio tilted towards large cap with a flavour of mid and small cap. Otherwise, he can also invest the money in one or two aggressive hybrid funds.

If someone invests in the wrong category, an accident is just around the corner. Consider a situation, where a brother wants to invest for 1 year for sister’s marriage and invests the money in a small cap scheme. Now equities by nature are volatile, if the investor is lucky the marriage can be a gala event. On the contrary, if the bet goes wrong, marriage will be covid style (with limited gathering).

One more example, if someone wants to invest for the purpose of tax savings, ELSS is the category where one should invest in.

Following are the factors which affects the scheme category selection:

• Risk profiling (risk taking ability & willingness to take risk)

• Investment horizon

• Objective of investment (tax saving, wealth creation, preservation of wealth, etc.)

• Asset allocation of scheme

• Tax slab

• Capital market outlook (more in step 2)

Step 2: Decipher the Style, Asset Allocation Mandate & Security Selection Universe

Within the same category, there can be instances where mandates of the schemes are completely different. The investor needs to completely check whether the fund is true to label and the strategy matches with what he/she is looking for.

Examples:

• Most flexi cap funds are investing only in Indian Equities but there can be a fund which invests a portion of the portfolio in global stocks.

• Balanced Advantage Funds could be either following “buy low sell high” or “buy high sell higher”.

• Conservative Hybrid Funds – equity range of 12.5% to 25%.

• Equity Savings Fund – Different equity ranges for different schemes

• Dynamic Bond Fund or Floating Rate fund or Corporate Bond Fund – there can be roll down maturity fund in these categories (here, the intent of highlighting this is to make sure that if you want to choose a roll down maturity fund, it can be there in these categories as well)

Similarly, one needs to consider the style of the fund. A fund can be a top-down approach to select stocks (selections based on macros 🡪 industries 🡪 company) and another fund can be following bottom-up stock picking (selections based on company 🡪 industries 🡪 macros).

Different fund managers can be following different styles, he/she may be running a growth-oriented strategy, value-oriented strategy, a portfolio constructed based on quality stocks, or investing in a different geography, etc. or it could be a blend of all strategies, etc.

One should also check for security selection mandates. For example, debt funds within the categories may be having different mixes of credit rating securities.

To gather and analyse all this information, one needs to read the asset allocation section in the Scheme Information Document, brochure of the scheme and may be required to speak with the respective AMC representatives.

Step 3: Consistent Performance

Whenever looking for performance, never go for trailing returns or star ratings.

As per FundsIndia, if we start with top quartile funds based on three-year performance, only 27% of the funds, on an average, were in top quartile in subsequent 3 years.

Similarly, if we start with top quartile funds based on five-year performance, only 19% of the funds, on an average, were in top quartile in subsequent 5 years.

Based on the above data, one can say that scheme selection solely based on past performance (trailing returns) is not the ideal way. One should always analyse scheme selection (strictly after shortlisting the suitable category) based on rolling returns. Always look for funds which have consistently beaten the category average and benchmark on 3-years, 5-years and 7-years rolling basis. Other things which one can be considered are:

• Experience of fund manager

• tenure of the fund manager managing the respective scheme

• Pedigree of the Asset Management Company

• Expense Ratio

• Turnover Ratio

• Risk management policies adopted by the AMC