Equity Mutual Funds: A Guide to Choosing the Right One

It is generally not a good idea to invest in a specific mutual fund based on its past performance, as past performance is not necessarily indicative of future results. Instead, it is important to consider your own financial goals, risk tolerance, and investment horizon when selecting mutual funds to invest in.

In our previous article, we discussed about the basics on equity mutual funds. If you’re new to investing or unfamiliar with equity mutual funds, we recommend checking out our previous article. In this article, we will be discussing how to study and pick a mutual fund with step by step action items.

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Here are several key factors to consider when choosing mutual funds:

1. Investment style: Mutual funds follow different investment styles, such as growth, value, or blend. Growth funds typically invest in companies that are expected to grow at a faster rate than the market average, while value funds typically invest in undervalued companies that are expected to increase in value over time. Blend funds invest in a mix of growth and value stocks.
2. Diversification: Diversification is an important aspect of risk management. Consider investing in mutual funds that invest in many different industries than a fund which focuses on a particular sector like technology, reality etc to spread risk.
3. Expense ratio: The expense ratio is a measure of the annual operating expenses of a mutual fund, expressed as a percentage of the fund’s assets. Since the different types of funds have different expense ratio, it is a good idea to check the expense ratio of different funds in the same field.
4. Performance: While past performance is not necessarily indicative of future results, it can be useful to consider a fund’s historical performance when making an investment decision. Even better idea would be to compare returns across different funds in the same category.
5. Fund size: Larger the fund size, it is assumed the fund is safer and gives better returns, Hence more traction. While it’s partially true for the first part, as the fund size keeps growing, investing huge amounts of money from investors in small cap companies might increase the stake size in small cap company making the fund more volatile. Hence the fund manager moves most of his stakes to large cap stocks to stabilize thereby lowering risk and as well as returns.
6. Investment horizon: Consider your investment horizon, or the length of time you plan to hold the mutual fund. A longer investment horizon may allow for a higher risk tolerance, while a shorter horizon may require a more conservative approach.
7. Risk tolerance: Mutual funds have different levels of risk, which can be influenced by factors such as the asset class they invest in, their investment style, and the specific securities they hold. Consider your own risk tolerance and choose a fund that aligns with your comfort level.
8. Fund plan: There are two types of mutual fund plans: direct and regular. In a direct plan, investors can directly buy units from the fund house without the involvement of a broker. In a regular plan, units must be purchased through a broker, which incurs commission expenses. Direct plans offer slightly higher returns because they do not incur commission expenses, which can be as high as 1–1.25%. Regular plans may offer lower returns because the asset management company pays a commission to the broker, which reduces the principal amount of investment. Direct plans may be a good choice for investors who are comfortable making investment decisions on their own and do not need the guidance of a broker.
9. Fund family: Mutual funds are often part of a larger fund family, which is a group of mutual funds managed by the same company. Consider the reputation and track record of the fund family when evaluating mutual funds. I am fond of Mirae Asset and Axis fund houses. You pick your facourite based on your research.
10. Returns against benchmark: While studying the historical returns of a mutual fund might give you insights about past performance of the fund, comparing the returns against other funds in the field and against the index returns, so you have a benchmark to compare against and pick a fund which beats the benchmark return.

Now that we know the terminologies, let’s look at a simple 5 step approach to analyze and pick a mutual fund based on the above discussed parameters.

Step 1 — Select the fund plan:

As we discussed above, regular funds cost 1% higher than direct funds. Hence it is always better to choose direct funds as we now know how to pick the best fund ourselves.

step 2 — Pick the fund capitalization type based on your time horizon

3–5 years : large cap and mid cap

5–7 years : mid cap and small cap

7+ years : small cap

If your investment horizon is less than 3 years, it’s better to stick with debt funds.

Though it seems that the smallcap is too risky, since we have the backup of diversification and experienced fund managers and long time horizons, the chances of risk are much lower. In fact, since the market inception, on any 7 year timeframe small cap funds have given average returns of 15% and go as high as 20% which is higher than the 12–13% standard returns. Hence, I would say it’s worth the risk.

Step 3 — Pick the fund based on investment strategy

Index funds invest in the index itself, for example nifty and sensex. Sectoral funds invest in particular sector like technology, infrastructure etc. Focus. Contra funds invest in underperforming stocks hoping they would recover later. So pick one which suits you. For a beginner I would advise not to venture into sectoral or contra funds and stick to index funds or diversified funds.

Step 4 — Pick the fund based on tax implications

If you are considering mutual funds investment as your tax saving investment, you should pick ELSS (Equity Linked Savings Scheme) funds as they provide tax exemptions under section 80C as well as market returns.

Step 5 — Compare expense ratio of the funds and pick the best one

To see how different funds compare in terms of cost, try comparing the expense ratios of similar types of funds. For example, you could compare the expense ratio of one large cap fund with another large cap fund, or compare the expense ratio of one index fund with another index fund. Its important that we don’t select the fund based only on expense ratio, but the other factors as well.

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Now that we have narrowed down our list based on categories, we can now further analyze the fund based on a few important ratios. Here is a website that I use to study a fund.

https://groww.in/mutual-funds

You can find all the ratios and metrics we discuss on the page. You don’t need any login credentials to use this.

Returns: Compare the annual returns of the fund with others in the same category and pick the fund which gives more returns than the category average.

Holdings: Analyze the holdings of the fund and see whether the investment’s holdings are not biased and invested across different industries.

Beta: Beta is a statistical measure that reflects the volatility or risk of a mutual fund’s returns. A higher Beta indicates a higher level of volatility, which means the fund’s returns may fluctuate more significantly over time. If one has a conservative approach, they should pick a fund with low beta. Beta of 1 indicates if the market moves 1% higher or lower, the fund replicates the same.

Alpha: Alpha is a measure of a mutual fund’s performance relative to a benchmark index, such as the Nifty 50. A positive alpha indicates that the fund has outperformed the benchmark, while a negative alpha indicates underperformance. Alpha can be a useful measure of a fund’s relative return.

With all the above metrics applied, we can pick the best mutual funds that align with your goals and criteria. Finally, “Remember that mutual funds are subject to market risk, so it is important to carefully review the terms and conditions before making an investment decision.”

Pro tip:

If you are considering investing in a large cap fund, you can invest in an index fund instead. The reason being, index funds usually invest in top 50 companies instead of a random list of companies and the expense ratio is much lower.