How To Pick The Best Mutual Fund for Maximum Returns?
Since I started creating content about Mutual Funds, there is one question that I get asked the most: 'Which is the best mutual fund to buy? And my answer is always the same. There isn't a "best" mutual fund. The goal shouldn't be to find the top performer and invest all our money in that. Instead, the key is to find a fund that aligns with our financial goals.
Trust me, there’s a mutual fund out there for our every financial need, but with over 1,000 schemes available, making that choice isn’t easy as said. So, In this blog, I’ll guide you on how to select a mutual fund based on your time frame, goals, and risk tolerance. So let's get started.
If you are searching for any specific fund recommendations here, you are in the wrong place. My goal isn’t to hand you a list of top-performing funds or ask you to blindly copy my investments. I want to share how we can use all the factors that we learned in the previous blogs to pick the right fund for ourselves that aligns with our financial goals. This is the 4th blog in the mutual fund series and I highly recommend you watch the other blogs to educate yourself so that you can become better at managing your mutual fund investments
How to Pick a Mutual Fund Category?
Your Financial Goals/Time Frame
There is a simple straightforward formula to find the perfect mutual fund match: Goal equals Fund. You need a short-term fund for short-term goals, a medium-term fund for mid-range goals, and a long-term fund for long-term goals. So before selecting a fund, we must first define our financial objectives. For example, if we plan to buy a house in the next 3-4 years, we should start investing in a fund category that aligns with that time frame. Every fund in our portfolio should serve a specific purpose.
So the first step is to make a list of our financial goals, and the next step is to classify them into three categories: Anything below 3 years is considered short-term, 3-7 years is medium-term, and anything above 7 years is long-term.
The short-term category includes things such as our emergency fund, and our next overseas vacation. These are financial needs usually served with savings accounts or fixed deposits, but they all come with limitations. Savings accounts typically offer lower interest rates and fixed deposits lock your money in for a specific period.
So mutual funds with their higher returns and better liquidity can be a better alternative for our short-term money needs. Within mutual funds, the asset class you should consider is debt funds, specifically liquid and money market funds. If you are not familiar with the different mutual fund categories, I recommend you watch the second video on my YouTube channel in this series.
To refresh, liquid funds are debt mutual funds with a maturity period of up to 91 days. They invest in highly liquid, high-quality, short-term debt instruments such as Certificates of Deposit (CDs), Commercial Papers (CPs), Treasury Bills, and others. While they are riskier than fixed deposits, they are less risky compared to other types of mutual funds. For money needs within the next three months, use the liquid fund category. And for everything above that and within a year, consider using money market funds.
Money market funds are similar to liquid funds, with an average maturity of one year or less, and offer better returns. For financial needs between one and three years, consider using a short-duration fund. Even though there are other categories in debt funds these three are all we need for our short-term financial goals.
Keep in mind that, with the short-term category, we are not aiming for huge returns. The idea of short-term funds is to make the money available when we need it with a moderate level of returns. However, once we go beyond the three-year mark, we can go for hybrid funds.
Hybrid schemes invest in a mix of equity and debt. And by bringing equity funds into our portfolio we can target better returns than what debt funds offer. We should invest in equity mutual funds for all our medium to long-term financial goals, such as house purchase, child’s education expenses, retirement, and others.
Within pure equity funds, there are three major categories based on market capitalization:
Large-cap funds invest in stocks of large-cap companies which are stable and less risky. Mid-cap funds target stocks of mid-cap companies, while small-cap funds focus on stocks of small-cap companies. They offer higher returns but come with higher risk as well. Additionally, there are Flexi-cap and Multi-cap funds, which combine these categories in different proportions. If you are not familiar with the classification based on market capitalization, do watch the second video in the mutual fund series.
For investment goals ranging from 3-5 years, like car purchases, I suggest maintaining a mix of short-duration debt funds and large-cap funds in your portfolio. Between 5 and 7 years, I recommend increasing the proportion of large-cap funds and also bringing in some multi-cap funds. For goals extending beyond 7 years like your child's education, or retirement, consider also Flexi-cap funds that invest a major share in Mid and Small Cap funds. Now how to divide our investments between these categories. The answer is in our risk profile.
Risk Profile
Warren Buffett famously said, “Risk comes from not knowing what you are doing.” The most important thing when it comes to mutual funds or any other investment is to understand that high returns typically come with higher risks. Investing is about efficiently managing such risks and not avoiding them entirely. So understanding our risk profile is key in investment planning.
Our risk profile is simply the sum of our risk appetite and risk tolerance. Both are different and I'll explain.
Risk Appetite
This reflects our financial ability to take risks. There are many factors that influence this, such as our age, our income, dependents, and others. Generally, a person with a stable, high income and fewer dependents can afford to take greater risks. And understanding our risk appetite is particularly important when we invest in risky assets such as equity funds. A common guideline is to subtract our age from 100 to decide the percentage of our investment that should be in equity funds. For example, a 30-year-old may invest 70% of their portfolio in equities, with the remaining 30% in debt funds.
Risk Tolerance
This is our psychological comfort with risk and does not depend on external factors like our age or income. It's about how much market volatility you can handle without feeling forced to make rash investment decisions. Because the market won't go always in a slow steady growth, there will be many ups and downs. If a 50% fall in your portfolio, gives you a heart attack then your risk tolerance is not that high.
So when choosing funds, make sure that the fund’s risk level matches our risk profile. For example, those with a high-risk profile can lean more towards Small and Mid-Cap or Sector funds for their long-term goals, because those funds are known for higher returns but with higher risk. And those with more conservative risk profiles might do better with Large-cap funds, which generally offer more stability. Always check the Risk-o-Meter for any fund you're considering and make sure that it aligns with your risk tolerance and investment goals.
How to Select a Fund?
Once we have identified the sector or category we want to invest in based on our investment time frame and risk, the next step is to select the best-performing fund within that category. But whatever you do, never buy MF based on casual tips given by neighboring uncles, or friends. Always do your own research and check for these 5 main factors.
Returns
This is the most important criterion for picking up a scheme. We should choose the scheme that has a very good long-term record both against their benchmark index and other funds in the same category. I know historical performance is in no way a guarantee that the fund will do well in the future, but it still gives a good pointer. It's better to go with funds that have consistently performed well over the last 3, 5, and 7 years. It would be a wise choice to avoid new funds if you are not very well familiar with their investment strategy.
Now how can we analyse the long-term performance of a fund?. Just look at its Compound Annual Growth Rate (CAGR) over different periods.
You can find this information on fund documents or financial websites. But don't look at the CAGR in isolation, always compare it with the benchmark index such as the S&P500, Nifty 50, etc, and also with other funds. It is also important to check the consistency of the returns by comparing the rolling returns over various periods. If you are not familiar with terms like CAGR and rolling returns, please watch the 3rd video in the series. Basically, our goal is to find a fund that regularly beats its benchmark and other funds in its category.
Because if a large-cap equity fund, for example, does not outperform its corresponding large-cap index, it might be more beneficial to invest directly in the index fund, which usually has a lower expense ratio.
Costs
Even if the fund we selected offers excellent returns, the cost of managing the fund can significantly eat away those returns. Therefore, it's important to always consider the expense ratio when selecting a fund. However, the lowest expense ratio shouldn't be your only criterion. A fund with slightly higher costs might still be a better choice if it delivers superior returns that more than compensate for the higher expenses. So use it as a secondary deciding factor, after comparing the returns.
Risk
We talked about different types of risks associated with mutual funds in the last video. Every investment carries a risk. So if two funds give the same return, we want to see which fund took the lesser risk to achieve it. We already talked about different parameters such as alpha, beta, standard deviation, etc to identify the risk associated with a mutual fund in the previous blogs. Ideally, we need a fund with:
Standard Deviation: low
Alpha: high
Beta: low
Sharpe Ratio: high
Sortino Ratio: high
If you want a simple solution to evaluate the risk associated with a mutual fund, you can also check the riskometer provided in the key information document and pick a fund that matches your risk profile.
Rating
Now if you think analyzing the returns, cost, and risk is too much of an effort, you can also compare mutual funds by their ratings. Each agency uses its own set of criteria to assess funds, focusing on factors such as risk-adjusted returns, liquidity, asset quality, and so on. For instance, CRISIL (Credit Rating Information Services of India) is a major rating agency that rates mutual funds in India. In such websites, you can find funds categorized into quartiles based on their performance:
Top-quartile: Represents the highest-performing 25% of funds.
Upper-quartile: The next best-performing 25%
Lower-quartile: The third group of 25%
Bottom quartile: The lowest-performing 25% of funds.
Fund rankings show a fund's performance in comparison to other funds in the same category. A fund consistently ranked in the first quartile in the past five to seven years could be considered reliable and high-performing. Whereas If the fund ranking slips below 50% or below the second quartile for four quarters, it’s better to stay away from that fund.
Even though I wouldn't suggest using the rating as the only parameter to pick a mutual fund, it's a good confidence booster if your final shortlisted funds based on other factors have good ratings.
Along with the ratings of the fund, also check the reputation of the fund house, when was it founded, the size of funds they manages, who is the fund manager and so on. The success or failure of a mutual fund largely depends on the fund manager and their research team. So do some research about the fund house and fund manager before you start investing. Now then where can we find all this information to do our research.
Where to Get the Information?
You can find all the details about the fund in its offer document. It contains all the necessary information about the fund’s objectives, strategies, and past performance. You can also find information about mutual funds from financial platforms such as Morningstar, and agencies such as CRISIL, SEBI, and others.
I understand that all this information can be overwhelming for a newbie investor. To make it easier for you, in the next blog, I'll share how I go on with the process of choosing funds for my short-term, medium-term, and long-term goals. This will help you see the process in action and make it easier to apply to your own investment decisions.
Disclaimer: The Content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice. It is important to do your own analysis before making any investment.