So finally you have decided that you want to invest in Mutual Funds in India. You go to internet to try and find the best mutual funds that you should invest in. To your surprise you discover hundreds of fund houses and tons of funds from these fund houses making the process to chose the funds even more complex. The blog discusses the various aspects that you should think of while choosing the Mutual Funds best suited to your investment style and risk profile.
Understanding your Investment goals
First question to ask is what do you want out of this investment, do you want long term capital appreciation, do you want quick liquidity , what is your time horizon, do you want regular income or you are more interested in growth of your capital, Broadly Investment goals can be understood with the below simple framework ( you either want regular income or you want capital appreciation)
Towards the end of the post, i will summarize how your investment goals translate into mutual fund selection, so keep reading on.
Assess your risk profile
Before choosing a mutual fund and for that matter any investment , understand the risk return equation, In general higher returns come with higher risk ( in next section i will explain how to measure risk in mutual funds), but before doing , this you should try to gauge what is your risk appetite, very simple risk assessment tools can help you understand your risk profile
Right Asset Allocation
Based on your investment goals and risk profile, you need to arrive at the right asset allocation, In general bodhik recommends following thumb rule for asset allocation
Know the key Ratios
In any investment you make you want some degree of consistency of returns, no one likes an investment which gives very high return in one year and very low returns next year, in general volatility is bad for Mutual funds, Good Mutual funds outperform markets both in good and bad times over 3-5 years and hence have lesser volatility.
Key Indicators that can be used for understanding the performance of your mutual fund are summarized in the table below, you can also calculate Risk return score for every mutual fund.
|Key Metrics||What does it Measure and what to look for|
|Beta||Beta measures funds volatility in comparison to a benchmark index. Beta of 1 means fund will move as much ashe index, if beta is 2 means for X% movement on benchmark fund NAV will move by 2X
In general lower beta with higher returns is good
|Standard Deviation||Standard deviation measures changes ( deviation) in fund returns over a period of time, so it tells you how much Fund returns deviates from historical means, which is an indicator of volatility of funds , in simple terms if fund has 10 % average rate of return, and a 2% standard deviation, its returns will be in the range of 8-12%, lowerr standard deviation means greater predictability hence lower risk|
|Alpha||Alpha measures excess returns that fund provides in comparison to a benchmark index, lets say if you have a large cap mutual fund, alpha will measure the excess return over the benchmark i.e Large cap index|
|Sharpe Ratio||Sharpe ratio measures the performance of funds vis-a-vis the risk it has taken by it it so it is the ratio of excess return over the risk free rate and Standard deviation, higher the sharpe ratio better the performance of the fund|
Quality of Fund house and Fund Manager
While one can keep on looking at key ratios and how the mutual fund is performing, Quality of fund house can also impact the future performance of the fund, Good quality fund houses bring professional management, transparent processed and attract good quality fund managers, while SEBI regulations make it tough for fly by night operators, I would always suggest all things being equal go for high quality fund houses, with Fund Managers with proven track record of performance.
Expense ratio measures annual expenditures made by fund as a ratio of total assets under management. Expenses includes operational cost, salaries of Fund employees, marketing and distribution costs , In general lower the size of the fund higher the expense ratio, as the fun starts doing well, it attracts larger investments and hence its expense ratio should drop, good funds ( equity) should have expense ratio in the range of 1.9-2.0 %, lower the expense ratio higher are the funds available for investment, debt funds have much lower expense ratios.
Sample Fund discovery flow
Now that you have understand the framework,let me use a simple example and try to suggest Mutual funds for a sample user.
Sample user: I am 35 years old and I want to chose a mutual fund which can provide capital appreciation over a period of 5-7 years, I have reasonable cash flows, so I will not be worried if my portfolio goes down is short term , I am looking to build long term value.
As per bodhik framework, your clear goal is capital appreciation and you are ready to take moderate levels of risks to achieve the same in 5-7 years, so i would suggest an equity heavy portfolio for you , here is suggested portfolio.
- 10 % Debt funds
- 45 % percent large cap funds
- 45 % balanced equity funds
Large Cap funds: Franklin India Bluechip fund (G) & ICICI pro-focussed bluechip fund
Balanced equity funds: HDFC balanced fund (G) & ICICI pru long term equity fund.