#riskprofiling

Mutual funds are certainly the best option for retail investors to grow their wealth. Unfortunately, when it comes to picking the best mutual funds to invest, investors are flooded with choices.

While mutual funds may be a good investment avenue, you would face the dilemma of which mutual funds to choose.

There are 36 different categories of mutual funds, across 40-odd fund houses. Many of the largest fund houses have a scheme for every category. Thus, as on date, there are as many as 857 open-ended mutual fund schemes across asset classes.

Most individual investors require just 10-12 mutual fund schemes in their portfolio. These would include schemes across equity mutual funds, debt mutual funds, hybrid mutual funds, and ELSS funds.

So yes, as an investor you face an uphill task to eliminate 98.8% of mutual funds in existence to arrive at the 1.17% schemes — the best mutual funds.

Don’t take shortcuts by investing in the top performing mutual funds of the past 3-year or 5-year periods. Doing so, you may end up short of achieving your financial goals.

An in-depth analysis is required to pick the top funds to include in your portfolio.

This 5-step guide will help you arrive at the top mutual funds for the long term.

Step 1: Set your financial goals

Before embarking on your investment journey through mutual funds, first set S.M.A.R.T. financial goals. This means that your investment goals should be Specific, Measurable, Adjustable, Realistic, and Time-bound. Investing in an ad-hoc manner without any focus will lead to the sub-optimal ndeavoron of your savings.

You may have long-term investment goals such as retirement, child’s education, child’s marriage etc. You need to make these goals more specific and adjustable. Thus, if you are preparing for retirement in 20-25 years, calculate the retirement corpus needed and how much you need to save to achieve this goal. Setting up financial goals will give your long-term investments in mutual funds a purpose.

Step 2: Understand your risk profile

Remember, your investments in mutual fund schemes should always be aligned with your risk profile and its suitability for your financial goal; because every mutual fund scheme carries some investment risk. It would be best to first consider your risk appetite and the suitability of the investment for your financial goal, and then decide whether to invest in a particular financial product or not.

Risk profiling determines your risk taking capacity and the willingness to take risk. It is measured based on various factors such as age, knowledge of financial products, investible surplus, time horizon, and investment objective. Don’t get carried away with the high returns of an investment product, it is vital to consider the risk involved in respective investments and weigh that against your risk appetite. It would be best to first consider your risk appetite and the suitability of the investment for your financial goal, and then decide whether to invest in a particular financial product or not.

Step 3: Suitably allocate your investments

It is pertinent to focus on optimal asset allocation as well. Asset allocation refers to distributing your investible surplus across asset classes such as equity, debt, gold, real estate, or even holding cash for that matter. Through proper allocation, you are essentially adopting an investment strategy that can balance your portfolio’s risk and rewards keeping in mind your risk profile, financial goals, and investment time horizon.

Along with the risk profile, your time horizon is also a key factor to decide the asset allocation, while you ndeavor to achieve your financial goals. Your time horizon will determine in which asset class you should invest a dominant portion of your investible surplus. Just remember, longer your time horizon of your financial goal, the more you can tilt your asset allocation towards equity and less towards debt.

Equities are considered very risky in the short term while less risky in the long term, as they will have more time to recoup from turbulent phase(s) of the equity markets. While debt is considered less risky, the returns clocked by the asset class are usually insufficient to beat inflation, thus mainly for this reason it doesn’t help you to achieve your long term financial goals.

This does not mean that if you have an investment horizon of over 20 years, you should only invest in equity. Proper asset allocation will help you to determine the correct mix of equity, debt, gold, real estate and even cash based on your time horizon to achieve your financial goals.

Do read: 5 reasons why asset allocation is important for your Financial Goals

Step 4: Pick the right fund category

As highlighted at the beginning of the article, there are 36 categories of mutual funds. There are 10 categories for equity-oriented schemes and 16 categories under debt-oriented schemes. The remaining 10 scheme categories cover hybrid and solution-oriented schemes.

However, for an investor nearly half the categories are redundant. For equity investments, you need to focus on all categories, except sectorial, thematic and index funds. Under debt funds too, there are as many as 16 categories. You need to decide the right funds based on your investment horizon and the current interest rate environment. It would be prudent to avoid debt funds with a very long-term maturity profile, as they can be quite risky.

All you need to know about the changes in mutual fund categorization here - Your Mutual Fund Scheme Renamed. All You Need To Know.

If you have age on your side, a steady source of income and financial goals that are five years or more away, you can invest in value funds, multi-cap funds, large-and mid-cap funds, and contra funds. These categories of funds will provide an adequate mix of stability and growth.

Value funds and large-and mid-cap funds invest in a mix of mid-cap and large-cap stocks, while multi-cap funds hold a mandate to invest across market capitalisation and sectors. Even though mid- and small-cap funds are suitable for your profile, with valuations stretched, these funds pose a high downside risk. You should be cautious of the higher risk in these funds.

If you have a moderate-to-high risk profile and an investment horizon of over five years, opt for large-cap funds or aggressive hybrid funds (earlier known as balanced funds). In times of high market volatility and chances of a market correction, large-cap funds and aggressive hybrid funds are better equipped to withstand a selloff.

If you have a low risk appetite and an investment horizon of less than five years, avoid equity-oriented funds altogether. But even if you have a long term investment horizon of above five years, then do consider a marginal exposure to large-cap or balanced funds, as such funds will help boost returns over the long term.

Step 5: Select the top funds

Once you have arrived at the right category of funds that are in line with your financial goals, it’s time to select the right funds under each category.

There are various aspects within a mutual fund scheme vital for investors to analyse before investing. These are:

Performance: The past performance of a fund is important. But, remember that past performance is not everything. It may or may not be sustainable and should not be used as a basis for comparison with other investments.

Comparison: A fund's performance in isolation does not indicate anything. Hence, it becomes crucial to compare the fund with its benchmark index and its peers, so as to deduce a meaningful inference.  

Time period: It is important to evaluate the long-term performance of funds across multiple periods, preferably in the form of rolling returns. However, this does not imply that the short-term performance should be ignored. Besides, it is equally important to evaluate how a fund has performed over different market cycles.  

Risk:  In non-financial terms, risk is referred to as the loss of life or property. In finance, though risk has a more complex definition, it can be easily termed as the loss of capital. But, that is the ultimate financial risk. Risk is normally measured by Standard Deviation (SD) and signifies the volatility the fund has exposed its investors to.

Risk-adjusted return: As a practice, most analysts use the Sharpe Ratio to measure risk-adjusted returns. It signifies how much return a fund has delivered vis-à-vis the risk taken. Higher the Sharpe Ratio, better is the fund's performance.

Portfolio Concentration: Funds that have a high concentration in particular stocks or sectors tend to be very risky and volatile. Hence, investors should invest in these funds only if they have a high-risk appetite. Ideally, a well-diversified fund should hold no more than 50% of its assets in its top-10 stock holdings.

Portfolio Turnover: The portfolio turnover rate refers to the frequency with which stocks are bought and sold in a fund's portfolio. Higher the turnover rate, higher the volatility. This indicates that compensation to the investors could be inadequate for the level of risk taken.

Fund Management: The performance of a mutual fund scheme is largely linked to the fund manager and his team. Hence, it's important that the team managing the fund should have considerable experience in dealing with market ups and downs.

Costs: If two funds are similar in most contexts, it might not be worth buying mutual fund schemes that have high costs associated with it. Simply put, there is no reason for an AMC to incur higher costs, other than its desire to have higher margins. Annual expenses involved in running the mutual fund include administrative costs, management salary, overheads, etc. The Expense Ratio is the percentage of assets that go towards these expenses. Direct Plans exclude distribution costs, hence, a cheaper alternative to Regular Plans.  

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Editor’s note:

If you’re unsure where to invest fresh investible surplus currently, to strike the correct risk-return trade-off we recommend adopt a ‘core and satellite approach’ to investing. Here are 6 benefits of ‘core and satellite approach’:

Facilitates optimal diversification;

Reduces the risk to your portfolio;

Enables you to benefit from a variety of investment strategies;

Aims to create wealth cushioning the downside;

Offers the potential to outperform the market; and

Reduces the need for constant churning of your entire portfolio

‘Core and satellite’ investing is a time-tested strategic way to structure and/or restructure your investment portfolio. Your ‘core portfolio’ should consist of large-cap, multi-cap, and value style funds, while the ‘satellite portfolio’ should include funds from the mid-and-small cap category and opportunities style funds.

But what matters the most is the art of astutely structuring the portfolio by assigning weightages to each category of mutual funds and the schemes you select for the portfolio.

Moreover, with change in market outlook the allocation/weightage to each of the schemes, especially in the satellite portfolio, need to change.

Keep in mind: Constructing a portfolio with a stable core of long-term investments and a periphery of more specialist or shorter-term holdings can help to deliver the benefits of asset allocation and offer the potential to outperform the market. The satellite portfolio provides the opportunity to support the core by taking active calls determined by extensive research.

So, PersonalFN offers you a great opportunity, if you’re looking for “high investment gains at relatively moderate risk”. Based on the ‘core and satellite’ approach to investing, here’sPersonalFN’s latest exclusive report: The Strategic Funds Portfolio For 2025 (2018 Edition).

In this report, PersonalFN will provide you with a readymade portfolio of its top equity mutual funds schemes for 2025 that have the ability to generate lucrative returns in the long run. PersonalFN’s “The Strategic Funds Portfolio for 2025” is geared to potentially multiply your wealth in the years to come. Subscribe now!

Author: Jason Monteiro