Nowadays we have many zero-brokerage investment platforms at our disposal like Groww, Paytm Money, Zerodha Coin, Kuvera, EtMoney and the list goes on. These platforms claim to give you a commission-free place to invest where you can go away from the brokerage charges. Also, these platforms try enough to make you aware of how you choose a mutual fund, to be honest, you are on your own to choose a mutual fund in those cases.
Let me share you my strategy to choose a mutual fund which in turn has turned out great for me in the long run and trust me, this strategy is completely based on research and logic. Solely it's my opinion and what I am going to talk about, is at the reader's discretion. Let's go step by step on choosing or analyzing a good mutual fund.
Duration
First and foremost factor, For how long do you want to stay invested? Depending on your answers, there are various categories of funds at your exposure.
1) Very Short Duration: If you are just willing to park your money for a goal which is just 3-6 months away. No arguments here, Liquid funds are a clear winner.
Fund type: Debt
Risk Profile: Low almost guaranteed positive returns (as per my analysis and observation for my own funds, at least 0.01% return per day)
Returns: 1.8% - 3.5% for 6 months, 7-8% in a year
Liquidity(ease of withdrawal): High, no fees charged.
Lockin period: 7 days, will charge fees if the withdrawal day is less than 7 days.
Why not savings account or FD? Let's take an example of the lumpsum investment of ₹1 lakh in all three instruments.
Savings Account Interest: ₹1726 for 3.5% for 180 days (Unless you have an account in IDFC First Bank)
FD interest: ₹1724 for 3.5% for 180 days
Liquid funds: ₹1800 to ₹3500 for 180 days
Why not other Debt funds or Equity Funds? Equity involves a lot of volatility for such short duration and other debt funds may have low liquidity and less ease of withdrawal.
2) Short Duration: If you are investing for a goal of the duration of fewer than 3 years, Debt funds should be your choice. To choose a Debt fund which invests in money market instruments, government and corporate bonds, four factors come into the picture -
Maturity Period: These funds have a maturity period after which it can be withdrawn without any fee. Just like liquid funds have a maturity period of 91 days. Higher the maturity rate, higher is the volatility and higher the risk and returns.
Interest Rate Risk: Interest rate risk is the risk involved with the interest rates on bonds. With interest rates going higher, the bonds you hold have lesser value and you lose money. With interest rates going down, your bonds with higher interest rate coupon become valuable and you earn money as it is desired by many. To give a simple relation, when the economy goes down, interest rates on bonds fall and when the economy goes up, interest rates go high too!
Credit Risk: Every corporate bond is given a credit rating by CRISIL or other bodies. Higher the rating, lower the risk and higher the chances of payback. However, a relationship can be established when the economy goes down, the business goes down and credit risk increases and when the economy is doing well, the credit risk is very low. Fund houses regulate the ratings of the bonds in their funds from time to time.
Liquidity: How easy the investment/bond can be liquidated in the market. Easier the liquidity, lower the risk.
So how maturity duration affects your choice? With increasing maturity duration, the volatility of the market goes up and chances of the interest rate change increases and debts to companies go default. On the contrary, these risk and duration bring in higher returns too. Liquidity for lower maturity period funds attract no or fewer charges and are easy to liquidate. So we classify the debt funds based on their maturity periods.
6-9 months: Ultra Short Duration Funds
9 months - 1 year: Low Duration Funds
1-3 years: Short term/Midterm Duration Funds
> 3 years: Gilt Funds
Why not Equity Funds? The uncertainty in risk and returns involved in short durations is very high for equity funds.
3) Long Duration: Since we are talking about staying invested for long, here you can invest in either Debt funds, Equity funds or Hybrid Funds.
Risk And Return
The second factor for choosing a mutual fund depends on your risk profile. Irrespective of what is popular in the market, I believe there are just three categories of investors:
Low-Risk/No Risk: Investors who have a low-risk profile, usually are afraid of negative returns. Such investors should stick to Debt funds especially that involve very low risk, usually of low maturity funds. If planning to stay invested for long should choose GILT funds over Equity funds.
Moderate Risk: Investors in this profile are willing to take some risk of negative returns in their journey of investment. These investors do understand in the long run, it doesn't matter and they don't get panic on seeing the negative returns. These investors should have a mixed portfolio of debt and equity funds, where debt funds hold a higher percentage/concentration.
High Risk: These investors are willing to risk for great returns. They understand that some things are to kept at stake to make some good money from your money. These are the long term players and understand the magic of compounding and market fluctuations.
Let's talk about returns, It's clear by now that debt funds are safer than equity funds as later invests in equity and market securities. When you play based on the market, the volatility is very high and create chances to go either way(up or down). So higher the concentration of equity funds in your portfolio, higher the risk, higher the returns in long run. Easy right?
Choosing Equity Fund
If you have already figured out that you want to invest in debt funds, you can skip this part. In this one, we will talk about some variety of equity funds at your disposal from the Indian mutual fund market.
Tax-saver funds: These funds are also called Equity Linked Savings Scheme(ELSS). These are open-ended mutual funds (unlimited shares in simple terms). They invest in the stock market but has a lock-in period of 3 years. You can not withdraw money before 3 years from investment. The invested amount can be claimed for tax exemption under section 80C.
Index Funds: These funds are directly linked to stock indexes and their values mirror the behaviour of indexes. These are not strictly equity but mostly include equity indexes. AMC charges less for these funds as they require less research and management.
Dividend Yield Funds: These funds include the stocks of the companies that pay out dividends or in other terms share of the profit to its investors. Not necessarily dividend will be paid out for all, it's just a strategy for investment in these funds. These funds cover companies with profit-making track records or the ones which have the potential to make great profits. The investments are not just based on higher dividends but also steady dividend payouts. If a stock pays good dividends but its market price is very high, then the dividend yield is low and the fund might not invest in it. Greater dividend yields ensure you get more profit at a lower cost of the stock.
Dividend Yield= Annual Dividend / Share Price x 100
Sectoral Funds: These are the mutual funds that invest in a particular sector of business. For example, during the corona crisis, IT funds(IT sector) and Pharma Funds(Medicine and equipment) did great.
Capital Based Funds: These funds invest in the equities depending upon the capital size of the companies -
Large Cap Funds: Top 100 companies in terms of market capitalization.
Mid Cap Funds: 101st- 250th companies in term of market capitalization
Small-Cap Funds: 251st company onwards in terms of market capitalization
Larger the capital of the companies in the fund, stable are the returns, lower the risk and lower the returns. Small-cap take a huge hit as compared to Large-cap funds but also the small-cap funds can grow more than a matured large-cap businesses. You can also opt for Multi-cap funds, just look for capital concentration in these funds as per your risk profile. After the recent amendment, Multi-cap will have at least 25% in each capital sector, i.e., will invest 25% of its funds in each(Large-cap, Midcap and small-cap stocks).
Shortlist one inside a category chosen
Once, you are sorted with the category of fund you want to invest, look for all the fund offerings on your favourite platform and shortlist them based on the following factors:
Past Performance: Look for returns from the fund for 1 month, 6 months, 1 year, 3 years and 5 years of past performance based on your goal's duration. Compare them based on their returns. This should not be the deciding factor, but one of the factors! We never know how will it perform in the next few months or years.
Fund Age and Size: Look for the funds which have been running for long and have huge capital investment in the fund. It ensures the trust of the masses and its past performance.
Exit load and Expense Ratio: Exit load of the mutual funds are basically AMC charges for the redemption of your fund. This varies from 0.1% to 1.5%. Choose the least that would charge you less on exiting the fund. Same goes for Expense ratio which is cost % of maintenance of your fund by AMC.
Lock-in Period: Depending on your goals, look for the lock-in period and also redemption charges before the lock-in period. This is one of the deciding factors.
Tax implications: Usually the tax implications on capital gains are same for most of the funds like 10% on LTCG and 15% on STCG, or based on your tax slab.
Underlying Holdings: Even after the above factors you are unable to decide among the funds to shortlist, look for underlying instruments of these funds. It's a great fund if Blue chip companies(Reputed Companies) hold greater allocation as an asset. This should be the last deciding factor.
Conclusion
The information above is enough for anyone to get started and invest in great funds, depending upon their risk appetite. Choose wisely and don't invest in too many funds. Many invest in the same stocks or bonds that may be holding already. In coming articles, we will discuss on diversifying our portfolio depending on one's risk appetite and discuss greater on debt and equity mutual funds. Any doubts, please leave a comment or reach me on any social platform. Till then, Happy Investing! Ciao!
Good work Kundu!