How To Start Investing in Mutual Funds Part 2

In the previous chapter, you started learning about investing in mutual funds, and you have looked at the aspects of selecting a good platform to invest in, the KYC process, and got a headstart to start investing in mutual funds. In this chapter, you will learn about selecting a mutual fund for your portfolio and look at the parameters that can help you choose such a mutual fund. So, let’s begin. 

Mutual fund investment is a convenient and efficient method of increasing your money over time. As of 2022, the mutual fund folios in India went over 128 million, which suggests that these instruments are gaining popularity. However, the question the vast majority of investors have to cope with is choosing the appropriate mutual fund scheme that will coincide with their financial objectives and risk tolerance level.

Selecting appropriate mutual funds for your portfolio requires the analysis of some essential characteristics that include historical returns, risks, cost, tax efficiency, liquidity, and qualitative aspects. The selected mutual fund investments should primarily reflect your personal objectives and preferences. This extensive guide provides different tips and approaches to choosing, assessing and investing in mutual funds for the most profitable results.

Choosing The Right Fund

While past performance does not guarantee future returns, understanding a mutual fund’s historical track record provides insights into its investing style and market behaviour. As a starting point, analyse the fund’s performance over the past 8-10 years to determine:

• Returns across different market cycles: Study how the fund performed during bull and bear phases. Did it protect capital better during market downturns? Or did it capture the upside well during rallies? This showcases the fund’s resilience.
• Consistency in returns: While high returns are desirable, steady returns year after year indicate lower volatility. 
• Changes in fund management: Long-serving fund managers bring stability. Frequent changes may reflect inconsistent fund strategies.
• Investment style and strategy: Whether the fund takes an aggressive or balanced approach. Index hugging or active stock selection. Higher or lower portfolio turnover.

Essentially, look for steady outperformance across good and bad times. This promises a better scope for long-term compounding.

Investing For Long Term  

Mutual funds are meant for long-term wealth creation. However, studying monthly returns offers insights into a fund’s consistency. Analyse if the fund outperformed or underperformed its benchmark more often every month. 

Say Fund A generated higher returns than its benchmark in 8 out of 12 months. At the same time, Fund B outperformed only in 4 months. In this case, Fund A demonstrates more consistent monthly performance. Such an assessment reveals funds that perform well more regularly than just relying on annual returns.

Significance of Expense Ratios

The expense ratio refers to the annual fees charged by the fund house towards managing the portfolio. This directly impacts investor returns. Typically, equity funds have expense ratios between 1.5-2.5%, while debt funds range from 0.5% to 1.5%.  

Compare the expenses of the shortlisted fund with its category average and benchmarks. Index funds and ETFs have the lowest expense ratios. Opt for funds with lower costs that provide commensurate returns. As this directly boosts long-term gains in your hands.

Analysing Risk-Adjusted Returns

An investing truism states, “higher returns come with higher risks.” But how do you analyse if the risks taken are adequately compensated? This is where risk-adjusted return ratios come in handy. These calculated returns are generated per unit of risk taken by the fund.

Popular risk-adjusted ratios are:

• Sharpe Ratio: Indicates returns earned per unit of volatility. Higher Sharpe ratios portray superior risk-adjusted returns.
• Information Ratio: Measures returns generated vis-à-vis the chosen benchmark per unit of tracking error. 

Let’s understand this via an example. 

Fund A and Fund B belong to the same category. Over three years:

• Fund A delivered 18% returns with a standard deviation (volatility) of 12% 
• Fund B returned 15% with a standard deviation of 10%

On the surface, Fund A gave higher gross returns. However, its Sharpe ratio is lower at 0.5 versus 0.6 for Fund B. This shows Fund B provided better risk-adjusted returns. Thus, blindly chasing top-line returns without accounting for risks may prove detrimental.

Other Vital Aspects for Mutual Fund Selection 

Besides the quantitative parameters discussed above, qualitative factors impact a mutual fund’s suitability for your portfolio.

• Alignment with Investment Goals

Every mutual fund has a mandate ranging from income generation to capital appreciation to balancing stability and growth. Review if the chosen fund’s objectives match your goals before investing in them. 

Say your goal is a steady income. Then, debt funds are picked and focused on income payouts rather than capital gains. Growth-oriented equity funds would prove more appropriate if wealth creation is the priority.

• Fund Management Expertise  

The fund manager spearheads all investment decisions for the scheme. Their experience, past track record and capability directly influence portfolio performance. 

Give preference to funds where the fund management team has adequately long tenure managing a singular mandate. For instance, a fund manager with over ten years of experience solely managing mid-cap portfolios demonstrates domain specialisation.

• Reasonable Costs

Apart from expense ratios, check out:

• Exit loads levied when redeeming before the specified duration
• Switching charges for moving between plans  
• Advisory and distribution fees are paid in regular plans

Compare similar funds on overall costs. New fund offerings may have lower charges to attract investors. Due to passive management, index funds and ETFs tend to have the lowest costs.

• Tax Impact

Equity funds over 12 months attract 10% LTCG tax on gains above ₹1 lakh. For shorter durations, 15% STCG applies. Debt funds held up to 3 years have STCG taxed at slab rates.

While returns are essential, your post-tax returns matter more. After factoring in capital gain taxes, compare net proceeds across debt, equity, and hybrid schemes before investing. Also, check if the fund provides indexation benefits.

• Macro-Economic Environment 

Every mutual fund scheme has a predefined investment mandate catering to specific market segments. When you invest also influences eventual portfolio returns.

For instance, investing in mid-cap equity funds early in an economic recovery cycle captures superior upside as the economy rebounds. Similarly, active duration management benefits dynamic bond funds during declining interest rates. 

Time your entry into funds based on the prevailing macroeconomic cycle and segment attractiveness. Review if fund managers have the flexibility to contain downside risks during downturns. This further optimises the overall investor experience.

In summary, a combination of quantitative metrics and qualitative aspects determines a mutual fund’s ability to meet its investment objectives. An appropriate due diligence process evaluates all these facets before building your mutual fund portfolio.

Role of SIP, STP, SWP 

Systematic investment plan (SIP), systematic transfer plan (STP) and systematic withdrawal plan (SWP) are different ways of systematic investing and withdrawal, each serving a different purpose for the investor.

Systematic Investment Plan (SIP)

A SIP allows you to invest small amounts of money over time to build a corpus. By spreading out investments over a while, they help investors average their purchase cost. This prevents you from committing all your money at a market peak and maximises returns. SIPs also bring discipline to investing and make investing a habit.

The frequency of SIPs can vary, but you can do a monthly, weekly, or daily SIP. Also, there are various types of SIPs. For instance, a value SIP changes your SIP amount based on the expense of the market. Though having this option sounds good, tinkering with the basic idea of a SIP only makes it unnecessarily complex. You are better off sticking to an ordinary SIP, preferably every month.

Systematic Transfer Plan (STP)

Generally, one opts for an STP when investing a lump sum. Like an SIP, an STP helps spread out investments over time to average the purchase cost and rule out the risk of getting into the market at its peak. However, with an STP, you invest a lump sum in one scheme (mostly a debt scheme) and transfer a fixed amount from this scheme regularly to another scheme (mostly an equity scheme).

The basic idea behind an STP is to earn a little extra on the lump sum while it is being deployed in equity since debt funds provide better returns than a normal savings bank account.

Depending on the lump-sum amount, the investor can decide the period over which he wants to deploy the money in the market. Typically, the larger the amount, the longer the time period.An STP can also be done from an equity fund to a debt fund. If you are saving for an important goal like your child's education, buying a home or retirement and you are nearing your goal, don't wait till the target date. Begin moving your money from equity to debt well before the time when you will need the money.

Systematic Withdrawal Plan (SWP)

An SWP allows you to withdraw a specific amount of money from a fund regularly. Such a system is particularly suited to retirees, who are typically looking for a fixed flow of income. SWPs provide investors with a certain level of protection from market instability and help avoid timing the market.

How to Read Mutual Fund Fact Sheet

Mutual fund fact sheets offer a wealth of information about schemes in a transparent and easy-to-understand format. They enable factual comparison across funds to make prudent investment decisions. Typically updated monthly, these fact sheets disclose details regarding:

• Fund House: Offers background of the asset management company handling the scheme.
• Fund Manager: Highlights the experience and track record of the decision-maker managing the investment portfolio. 
• Investment Strategy: Indicates the broad investment style, philosophy, and market segments targeted.
• Portfolio Composition: This breaks down how the corpus is invested across assets. Equity funds showcase sector allocation, market cap focus, etc. On the other hand, debt funds list exposures to instruments, credit ratings, etc.
• Performance and Risk Metrics: Captures historical returns over various periods along with risk-adjusted return ratios. Enables comparison with category averages and benchmarks. 
• Fees/Expenses: Discloses all costs charged to investors, including expense ratios, exit loads, etc. Impacts investor returns.

Now, let us explore the vital parameters provided in mutual fund fact sheets to determine a scheme’s suitability.

Analysing Historical Returns

Fact sheets highlight year-wise returns over one year, three years, five years and ten years or since inception. The absolute returns showcase the fund’s track record in generating compounded annualised returns.

Compare fund returns to its assigned category benchmark and leading industry benchmarks. For instance, large-cap equity funds would be compared to the Nifty 50 index. Take note if the fund consistently outperforms benchmarks across more extended time frames of 3 years and above.

The upside capture ratio indicates returns captured by the fund when the benchmark delivered positive returns. The downside capture ratio reflects the extent of capital loss compared to the benchmark during corrections. Lower downside ratios portray capital preservation ability.

Evaluating Portfolio Characteristics

Equity funds showcase how the corpus is allocated across:

• Market capitalisation: Exposure to large, mid or small-cap stocks
• Sectors: Weightage to sectors. Diversified or concentrated bets
• Top 10 holdings: Returns concentration or diversification across top picks

Debt funds showcase distribution across: 

• Ratings: Exposure to AAA/AA bonds or higher credit risk
• Maturity Profile: Spread across short, medium and long-maturity bonds
• Instruments: Extent of investment in G-Sec, corporate bonds, money market options

This clarifies the underlying portfolio structure, diversification, concentration risks and potential volatility.

Understanding Risk Metrics

Volatility metrics like Standard Deviation and Beta reveal a fund’s price sensitivity to market movements. It indicates if the fund will rise more or fall less than the bull and bear markets benchmark, respectively.

A higher beta indicates a stronger correlation to the assigned benchmark.

The Sharpe and Sortino ratios analyse if the returns generated justify the volatility or downside risks undertaken. Funds with higher ratios deliver better risk-adjusted returns.

R-squared suggests how much the fund’s performance is linked to benchmark returns. Values over 0.6 reflect a strong correlation.

Analyse risk ratios with returns data to check if adequate returns are generated for risks taken.

Assessing Fees and Expenses

Fact sheets disclose key fee/expense parameters transparently:

• Expense Ratio: Ongoing annual fees covering fund administration, management fees, etc. One of the biggest expense heads.

• Exit Load: A penalty is charged when redeeming units before the specified duration.  Varies from 0-2%.
• Other Loads: Switching, subscription or redemption fees
• Total Expense Ratio: Overall costs charged to investors

Compare the expenses of the chosen fund with its peers, category average, and index benchmarks like the Nifty 500 index. Opt for reasonably priced funds that provide commensurate returns.

In summary, mutual fund fact sheets offer a data goldmine for understanding funds in depth before investing in them. Evaluate the above parameters in terms of historical returns consistency, portfolio characteristics, risk metrics, and costs. This helps construct a resilient mutual fund portfolio aligned with an investor’s return objectives and risk appetite. Track fact sheets regularly to monitor fund performance.

Why Does Long-term Investing Make Sense?

Long-term investing leverages the power of compounding and lets your money grow exponentially over extended timeframes. Consider this illustrative example:

Ram invested ₹1 lakh in an equity fund that delivers 15% annual returns on average. In 7 years, the investment grows to ₹3 lakhs at 15% CAGR. But after 15 years, the corpus ballooned to ₹13 lakhs due to compounding. This highlights why long investing horizons augment wealth creation potential. 

Challenges with Long-term Investments

However, a few key challenges crop up while planning long-term investments:

• Identifying products that reliably generate inflation-beating returns over 10-30 years.
• Committing to regular investments over decades.
• Withstanding volatility and staying invested during market swings.
• Rebalancing asset allocation aligned to evolving risk appetite.

So, how do you go about creating a compelling long-term investment portfolio? Here’s a step-by-step process.

Step 1: Define Your Investment Horizons

Every financial goal has a different milestone depending on individual needs and priorities. For instance:

• Retirement planning: 25-30 year horizon
• Children’s education: 10-15 years
• House purchase: 5-7 years
• Vacation corpus: 2-3 years

Accordingly, define your long-term, medium-term and short-term horizons upfront. This enables matching investments to relevant goals.

Step 2: Risk Profiling

Ascertain risk tolerance levels across various horizons via a systematic risk profiling process. This accounts for:

• Income stability
• Investment knowledge
• Loss bearing ability
• Return expectations

Your willingness and ability to stomach market volatility determine suitable asset classes for different tenures. For instance, equity exposure reduces as the duration shortens.

Step 3: Identifying the Right Investment Mix

Create customised portfolios addressing objectives for each timeline, factoring in your risk appetite. 

Given the high inflation-beating return potential, equities prove most apt for retirement planning over 20-30 years. Steadily include fixed income, debt and alternative assets while moving closer to the goal of capital preservation. 

Alternatively, for short-term dreams, liquid funds, arbitrage funds and short-term bonds better address stability needs.

Step 4: Monitor and Rebalance

Review portfolios periodically to check if asset allocation remains aligned to initial plans and risk profiling. Shift exposure from overweight to underweight assets via rebalancing to contain portfolio volatility.

Additionally, risk parameters should be reassessed as life stages evolve from growth to preservation needs. Adjust asset mix accordingly.

Avoid portfolio overlaps by analysing the correlation between funds.

Step 5: Avoid Pitfalls

To maximise portfolio returns, avoid common investing pitfalls like over-diversification, performance chasing, overtrading, lack of discipline, etc.

Staying invested over the long run lets compounding create prosperity. At the same time, frequent activity leads to transaction costs and taxes eroding corpus.

Earmarking goals, risk profiling, constructing appropriate portfolios and periodic reviews sets the foundation for a successful long-term investment strategy.

Building Wealth Through Consistent Investing

Mutual funds serve as apt vehicles to power various long-term financial goals. Their diversified structure, professional management and regulatory oversight make them reliable generators of inflation-adjusted returns. 

Let’s see how you can map different mutual funds across varied milestones:

Wealth Creation for Retirement

Retirement planning warrants pure equity exposure over 20-30-year horizons to generate inflation-beating growth. Some suitable options are:

• Equity index funds/ETFs: Deliver market returns mirroring benchmarks at minimal costs
• Multi-cap funds: Blend stability of large-caps with mid/small-cap growth potential
• Sector funds: Capture-focused sectoral plays in banking, IT, etc.  

Children’s Future Like Higher Studies

Balanced advantage funds benefit medium-range objectives, such as funding higher education due 15 years hence. These dynamically manage equity and debt allocation based on market conditions to balance growth and stability.

Alternatively, hybrid aggressive or conservative funds cater to different risk appetites here. 

House/Asset Purchases

For shorter 5-7-year targets of real estate buying or other asset acquisition, hybrid equity savings funds serve well. With ~70% equity exposure cushioned by debt and arbitrage, they deliver index-like returns with lower risk.

Short-Term Goals 

For shorter 2-3 year needs like vacations or buying an automobile, liquid/overnight/ultra-short funds provide stable returns akin to savings accounts. Being debt-oriented, they ensure capital preservation with added returns.

How To Invest in Mutual Funds on Angel One?

1. Open the Angel One app. On the Home page, go to ‘Mutual Funds’.

2. Choose the Mutual Fund that you want to invest in from the various lists provided on the Mutual Fund portal.

3. Choose whether you want to invest via lump sum or SIP mode.

4. Enter the amount that you want to invest.

5. Click on the payment button to complete the payment and start your investment.

Conclusion 

Thoughtfully planned long-term mutual fund portfolios pillared towards various milestones help to achieve evolving financial objectives smoothly. However, investing success depends more on temperament rather than intelligence alone. 

Cultivating prudence, patience, and discipline serves any investor better than blindly chasing past returns or ultra-aggressive investing. Gradually start early, avoid quick riches distractions, remain invested for long horizons, and let the world's eighth wonder compound your wealth to greater heights!

With this, you can build and manage your mutual fund portfolio. In the upcoming chapters, you will learn about some other nuances of mutual funds, such as investing in global markets, fund of funds, etc. So don’t think this is the last leg of investing; this is just the first step in your long-term investing journey!