Why do people do mutual fund investments? The reason can be anything like wealth creation, regular income, diversification or expert portfolio management.
There are over a thousand mutual fund schemes in India and choosing a mutual fund for investment simply by looking at its past performance might not be the best way to invest for two reasons:
- Past performance may or may not sustain in future.
- Each investor has a different investment objective and risk appetite.
So how to choose the best mutual funds for investments that would suit your requirements?
Let’s start with determining the best mutual funds based on risk appetite and time horizon to narrow down our search:
- If the time horizon is short (up to 3 years):
Conservative risk-taking Investors: If your risk appetite is low. The best mutual funds in which you can invest are Liquid funds, Ultra Short-term funds and Overnight funds.
Medium risk-taking Investors: If your risk appetite is medium. The best mutual funds in which you can invest are Arbitrage funds, Low Duration funds, Short-term funds.
Aggressive risk-taking Investors: If your risk appetite is high. The best mutual funds in which you can invest are Credit risk funds, Floater funds.
- If the time horizon is medium (3-5 years):
Conservative risk-taking Investors: If your risk appetite is low. The best mutual funds in which you can invest is Conservative Hybrid fund.
Medium risk-taking Investors: If your risk appetite is medium. The best mutual funds in which you can invest are Balanced Hybrid funds, multi-asset funds.
Aggressive risk-taking Investors: If your risk appetite is high. The best mutual funds in which you can invest are Aggressive Hybrid funds.
- If the time horizon is long (more than 5 years):
Conservative risk-taking Investors: If your risk appetite is low. The best mutual funds in which you can invest are large cap funds.
Medium risk-taking Investors: If your risk appetite is medium. The best mutual funds in which you can invest are flexi cap funds, large and mid-cap funds, value/contra funds, focused funds.
Aggressive risk-taking Investors: If your risk appetite is high. The best mutual funds in which you can invest are sector funds, mid-cap funds, small-cap funds, international funds.
Once we narrow down the type of mutual funds for investments, we can further analyze the fundamentals of different schemes to identify the best mutual funds:
- Track Record of AMC and Fund Managers:
It is one of the most crucial parts of research to know the track record of AMCs and Fund Managers managing the fund. You can look at the total experience of Fund Managers, how long they have been handling a particular fund, and which other funds they handle at the time. The longevity and quality of AMCs in running their business is an important aspect too.
- Portfolio Turnover Ratio:
Portfolio Turnover Ratio shows how frequently the Fund Managers buy and sell assets in the portfolio. A higher portfolio turnover ratio would mean that the conviction of the Fund Manager in assets purchased are lower. A long-term investor should prefer mutual funds with lower Portfolio Turnover ratio for long term investing.
- Portfolio Concentration Ratio:
Portfolio Concentration Ratio shows the proportion of total funds invested in different companies, sectors and assets. A fund with high concentration in particular assets reduces the diversification and as an investor you should decide if lower diversification is what you require based on economic research.
- Standard Deviation:
Standard deviation shows the difference in current returns to average returns of a particular fund. You may have seen some mutual funds have performed extremely well in a year while its past returns were not so great or vice versa. As a long-term investor, you should look for mutual funds that offer consistent returns or have a consistent growth in returns instead of choosing funds having a higher standard deviation.
- Sharpe Ratio:
Sharpe ratio shows the returns adjusted to risk for different mutual funds. For example – If two mutual funds both have 10% returns in a year, it becomes hard to select the best mutual fund. However, if we say that one generates 10% returns by taking 10% risk and another one gives the same return by taking 20% risk then you can easily choose the first one. Hence, Sharpe ratio is an important comparison tool as it provides a detailed risk return trade off for mutual fund investments.
- Drawdown:
Drawdown shows the lowest point of fund value after its most recent highs. You can use drawdowns to identify the number of times a major drawdown was seen in a particular fund and how long it takes for a recovery.
Conclusion:
Finding the best mutual funds for investment and being invested for long term is important to gain significant returns from mutual funds, however, it is also important that you review and rebalance the Portfolio at regular time intervals which is the key element of aligning your investments with financial goals.
