How to choose the right mutual funds?
Monday, Jun 3, 2024
Invest in a mutual fund, and you’ll be set! Or you’ll retire early, make money now for the future are some common reasons that you hear from people telling you to invest in mutual funds. But will any and every mutual fund help you make returns? You need not rush immediately for an investment without finding out!
You might want to see your mutual fund doing well, in turn giving you expected or more than expected returns, don’t you? Of course, isn’t a good return one of the motives for your bigger goal? Then how can it miss the careful investment move from your end to make an exceptional return?
This isn’t just about listening to people tell you to invest but also knowing how to invest!
How have people been investing?
It’s good to invest in mutual funds but not if you haven’t been doing it correctly. Let’s see what others have been doing since they invested.
ME, MEH MEH - Following the herd!
When you hire a new member of your team, will you hire them just because they were recommended by a referral or will you assess the candidate yourself? The perspective here is “How will you benefit from a hire?” It works the same way with your investments, too! It’s becoming increasingly necessary to understand where you are investing, how your investments are performing, and whether those investments are indeed worthy of your money.
Now, you can’t really base this crucial decision only on what your friend had to say, could you? They might have had an entirely different appetite for risk compared to yours. Do you think yours might be the same? If yes, think again! He might have a short-term goal, is yours the same? The odds are that they aren’t the same. It’s not just that; there are many other factors as well! So, now, really put some mind into it and think—will yours and his portfolio be the same?
Not really! So stop saying Mehhh! You need to do research and, if not, rely on expertly curated portfolios rather than those who might have less knowledge, to begin with, to even make suggestions in the first place.
In search of returns, you forget the fee.
Returns are always something investors are allured by, but what about the fees involved? Are you willing to pay such a fee? Mutual funds come with fees and are not free - the charges will involve fund manager fees, one-time costs on buy and sell, broker charges, service fees, and redemption fees. So isn’t the expense involved here huge? It may not look like it for now but you’ll realize it when you accumulate them over time.
It should matter to you when you invest, as it can drastically reduce the returns. If you are thinking I made 30% returns from my mutual fund, then don’t forget to deduct the fees from this, it’ll look pretty thereafter.
HOT is only until sometime, it’s bound to be COOL
Running behind the best return-giving scheme might turn your table around. Why is that the case? Everything that looks fresh doesn’t mean they are alive, it can just be surfacing. In mutual funds, a one-year record is not enough to make the big call on an investment. Look back, you’ll find the answers, whether they are short-lived or long-lived and consistent.
It’s these long-lived investments which will go a long way toward making your portfolio stay consistent, not the spiky ones which were momentary. Hot sales don’t always work, the fundamentals behind its performance matter when making that one bold investment.
Returns aren’t always constant if you think Guaranteed is the term
The returns in the market are based on the volatility of the asset, which may vary depending on various factors. Especially when there are many investments in a portfolio, the fluctuation is dependent on individual assets. So, how is this a guaranteed return, rather fluctuating, isn’t it?
If you get 15% returns this year, don’t expect it to be 15% next year. This will vary, it can be either 20% or even 5% depending on the market conditions and the type of assets and stocks picked in the portfolio.
You’ve got to correct your comparison metrics right
When you normally compare, say suppose the percentage a software engineer grad scores to that of a mechanical engineer, aren’t there many parameters to consider as to why they vary? Firstly, they aren’t the same branch and secondly, the kind of subject they study, the difficulty level, the study hours of an individual and many others will depend here to even conclude that both the toppers have a different score for obvious differences.
Then how doesn’t the same logic apply in regard to the mutual fund? Can a large cap return be compared with the mid-cap? Or can the EV sector be compared with the chemical sector? The basis of comparison is wrong that every mutual fund behaves similarly; it doesn’t! If your peer got a return in a mid-cap portfolio, that doesn’t mean you’ll get the same return in your large-cap portfolio.
Market gets noisy, and you’re the most panicked
The noises are too loud in the equity markets, but aren’t you often the one stuck in that fear of thought that all others tend to do? The exit?! How patient have you been in the market? Not most of the time, definitely!
But if you had held it, it might have actually helped you out. If the investment is for the long term, why should the short-term fluctuations matter? It definitely doesn’t make sense to exit. Stock investments work differently than mutual fund investments. You should understand the workings of each investment before making such an exit.
Mutual funds are goal-based; if you are not, then this is not for you
Most people just invest, thinking of the returns but do not really have a goal in mind to make an entry or an exit. Anyhow, even if you make an entry, when will you take it out? For say you have a retirement plan, then at least for about 30 years you have this dedication to keep doing your SIPs, but if you don’t have such a goal, where will you invest and when will you take it out is the question.
If you mistakenly think this is just like any other investment, then you are actually wrong. This is for those who are goal-oriented and want to go systematic with it!
That’s a lot of assumptions and misunderstandings people are making with their mutual fund investments. It needs to be rectified, though!
Investment style-based mutual funds exist!
The style gives them names:
Value Mutual Fund
The worth of a stock is more than what it seems but the value fund picks those stocks whose value is undervalued compared to their intrinsic value. Intrinsically, the value of that stock is higher and can grow. This is calculated based on the management team, financials, competitive position, business model, and much more.
The concept is to invest in a stock that has value and the market value will grow over time. In a value fund, you’ll have a portfolio of equity picked in such a format. The logic is to have a diversified set of undervalued stocks from various industries and sectors held over a long time until the market realizes their true value.
When you invest in fundamentally strong undervalued stocks they are highly stable and less volatile compared to the high growing stocks and hence the portfolio is less susceptible to volatility. Therefore, the risk-adjusted returns in such stocks are such that you get higher returns compared to the risk you take!
You can create a portfolio of such stocks by analysing valuation metrics, financial strength, and growth potential. Before investing in that, remember to not time the market; this portfolio must be diversified with fundamentally strong undervalued stocks and must be patient in holding for the long term.
Growth Mutual Fund
This style targets the stocks of those companies, which can skyrocket in the near future, bringing growth. It focuses more on capital appreciation than dividends, so you can’t expect dividends from such stocks.
What do the companies in such a stock selection look like? They are in an expansion stage where they are heavily reinvesting their profits in R&D, and all other initiatives that will elevate them to make greater revenue than normal.
This comes with a risk that is generally above average and is further capitalized into small, mid and large-cap funds. If you are looking to hold it for a span of 5 to 10 years with a high tolerance for risk over this time span.
In the market share aspect, the large-cap holds a huge part, and then the mid-cap follows. How would you go about investing in growth funds? Know what the goal of the investment, is and your risk appetite for a long horizon, if it’s not for long, then this isn’t for you. Find out which type of growth fund suits your personal goal. Relative to the historic performance, benchmark, and peer assessment, assess the one you want to pick.
You don’t want to be spending more than you make, so find out which funds allow you to lower the expense ratio and ensure to diversify it with other such stocks in your portfolio.
Contra Mutual Fund
This, as the name suggests, goes against the trend of the market, where you are buying when most others are selling and subsequently the exact opposite. The sentiment of the market doesn’t really impact making a stock selection but rather the value of stocks that are currently underperforming or have overperformed and these are those that are not mostly favored by others in the market as they have booked their positions.
Basically, purchasing the distressed stock for being too oversold and selling the distressed stock for being too overpriced means taking advantage of the herd’s fear and greed to wait until it regains its value. To invest in this fund, you need patience for it to actually work against the herds. So it's definitely a long-term strategy that requires you to research picking the undervalued and overvalued stocks correctly. When investing, one needs to be averse to any sort of fluctuation in the short term.
It also seeks frequent checking of the portfolio, adjustments, and rebalancing to reach a goal. While they can protect you from market bubbles, and make above-average returns, they involve risks with short-term fluctuations and mistiming. Handling this portfolio requires a bit of careful assessment and handling from the experts and an understanding of people’s psychology.
Choose the mutual funds the right way!
Here’s what they should have done instead; in fact, you should too when you are choosing the mutual fund to invest in.
1. Check the underlying quality of assets, not quantity
You have a portfolio with stocks, but it often raises the question of whether the portfolio should have many stocks or quality stocks. The number is less imperative than the stocks that are fewer but fundamentally strong. The question shouldn’t be about how many are there but rather whether they are quality ones.
2. Don’t be smitten by past performance
Investors are sometimes so crazy that they only get allured by funds that reaped great returns in the present year, this must have been the only reason to subscribe. But is that enough? There are also a few who look for past performance to make an investment without thinking enough. Is that enough too?
Not really! Current and past performance are not the only reason why you should subscribe to it, as that alone can’t help you predict the stock’s future. Rather, look at these:
The expenses of your funds matter to knowing how much greater your returns will be. Greater the expense, sometimes lesser can be your returns against lesser the expense and greater is your return.
It’s not the performance alone to assess in the past, it’s the performance over the years to find out how it sustained the ups and downs.
Is it ridden by higher volatility? If so, you know about the dips that you can expect. With that, you can’t achieve a short term goal.
See the steadiness of the fund over small bursts. You need something consistent, not the other way around.
How much is the risk that your fund is taking? Is it too exposed to the risk? For instance, the mix of both corporate and government bonds in a fund doesn’t mean there aren't any interest rate changes.
You are excited to invest because of the returns but what if the fund manager changed? What if your fund is merged with another? Think about whether it will perform the same and should you opt for it.
3. Learn the fundamental modes of evaluation
You have to be the one evaluating the fundamentals to pick the right mutual fund. Whether it is to look at the profit - earnings ratio, sharpe ratio, treynor ratio, r-squared, fund management turnover to understand the fund well,. Based on your assessment, you need to pick the one that suits your goal.
4. Assess the fund manager’s track record and investment style
As mentioned, there are various investment styles, and you need to find out what your fund manager follows and whether it matches your goals, risks, and investments. Get to know the fund manager’s performance a bit in the past to know how consistent he has been in handling your portfolio. With these two assessments, you’ll know if the fund manager is right for your investment or if you should look for someone else.
5. Look at the fund’s turnover rate to understand trading frequency
The fund’s turnover ratio is nothing but the times when the mutual fund holding has changed in the year. If it’s greater, you are prone to paying higher trading charges and taxes, such as capital gain, for the transactions. Suppose if the turnover ratio is lower, the style incorporated can be a buy and hold strategy. Higher prices can only mean they are trying to time the market. You can use this ratio to compare it with others who have the same investment approach. Suppose the mutual fund A turnover ratio is 25% and the mutual fund B turnover ratio is 50%. That doesn’t necessarily mean there might be something wrong but rather the investor can go deeper to understand the performance of the fund. If it was 50%, was there a change in strategy, in the fund manager, or in the objective? If it is 25%, why hasn't the fund manager taken any action? These are a few questions you get to think about with the turnover ratio.
6. Diversify across different sectors and asset classes
Although a mutual fund is a basket of assets, if it is concentrated on high risk assets, making a return is a bit risky. It must be diversified with different assets, such as cash equivalents, and bonds, as they work differently irrespective of the equity. When we talk about sectors, you know each sector's performance varies and is not always the same. Hence, when one is performing and the other isn’t, you are still in a good place as the other investment balances your portfolio from a dip. So look out primarily for diversification.
7. Research the fund’s benchmark and compare its performance
While you get excited to go ahead and invest, when you are looking at the past performance and other factors carefully that were mentioned earlier, keep the benchmark also in mind. Your mutual fund must at least meet the benchmark of the index. If it doesn't, then it only means that your mutual fund is performing worse than expected. Suppose you consider the benchmark index as nifty 50. Your mutual fund should at least be equal to or greater than the benchmark index annual return. If it’s consistently lower than you know, you might have to switch to a better one to achieve your goal.
8. Review the fund’s holdings for consistency with its stated strategy
Regardless of the strategy applied, the fund must be consistent in making returns from its holdings. This shouldn’t be about taking the shortest spike for the time being but rather being able to do well in the long run as long as you are invested in the mutual fund. Certain mutual fund performance over the years might either be performing well in the first half or underperforming in the second half compared to other mutual funds that give the same return as the former, but are consistently growing year on year. Which do you think you must invest in? It's, of course, the latter one, which is consistent, which can also signify that it will continue to perform similarly despite what.
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