After understanding the basics of investing in Mutual Funds, investors must answer the big question: “To invest or not to invest.”
Making that choice is fairly simple. If you want to create wealth and secure your financial future, Mutual Funds can be one of the easiest Investment avenues.
What matters most is how we choose from the various Mutual Funds options available. The choices we make while investing and how we build our investment portfolio could prove to be the difference between high returns and big losses.
Additional Reading: Which Mutual Fund To Choose
If you want to know how to choose good Mutual Funds to invest in, here’s a handy guide to help you on your way to financial success.
But first, we’ll give you an introduction to the different types of Mutual Funds.
If you’ve been exploring Mutual Funds, it is very likely that you may have come across some unfamiliar terms. Large-cap, mid-cap, and micro-cap funds? You’re probably wondering what these are.
Large-cap Mutual Funds
Large-cap Mutual Funds are those that invest primarily in companies which have a market capitalisation of over Rs. 20,000 crores. For these Mutual Funds, the fund managers handling them take the Sensex or BSE 100 Index of Nifty as a benchmark reference.
Mid-cap Mutual Fund
Mid-cap Mutual Funds are those Mutual Funds that invest in companies which have a market capitalisation value ranging from Rs. 5,000 crores to Rs. 20,000 crores. The benchmark reference index for these type of funds can be the BSE Midcap or the NSE Midcap Index.
Small-cap Mutual Funds
Small-cap or micro-cap Mutual Funds mainly invest in those companies that have a market capitalisation of less than Rs. 5,000 crores. The BSE Smallcap Index can be a suitable benchmark or reference for these funds.
Multi-cap Mutual Funds
Multi-cap Mutual Funds are diversified Mutual Funds. Multi-cap Mutual Funds invest in stocks across market categories. An investor’s assets can be invested across the shares of large, medium, or small-cap companies.
Additional Reading: Mutual Fund Terms You Should Know
How to check if your Mutual Fund scheme is large-cap or mid-cap
To find out about the type of Mutual Fund scheme you as an investor have invested in or plan to invest in, you must refer to the investment portfolio of that Mutual Fund and analyse the investment objective of the scheme.
Additional Reading: Rebalance Your Portfolio For Best Returns
How to decide which Mutual Fund suits you
This is always a rather difficult choice. But, here is some advice. In case you have an investment horizon of 5 years, you should think of making investments in large-cap or multi-cap Mutual Funds.
Why not small-cap or mid-cap funds, you wonder?
Well, small-cap or mid-cap Mutual Funds are rather volatile in comparison to large-cap Mutual Funds.
If you have an investment horizon of 7 years, mid-cap Mutual Funds can outperform large-cap Mutual Funds. Investing in small-cap, mid-cap, and multi-cap funds over a 7-year investment tenure will give you increased exposure to a wider range of stocks, which have better potential for long-term returns. Large-cap Mutual Funds will also provide your investment portfolio with a degree of stability.
Additional Reading: 5 Questions To Ask Before Choosing A Mutual Fund
We can tell you more about the types of Mutual Funds based on different parameters.
Classification of Mutual Funds based on fund structure
Mutual Funds are categorised on the basis of structure.
- Open-ended Mutual Funds
Open-ended Mutual Funds give investors a degree of investment flexibility. The entry and exit to investments in open-ended Mutual Funds are not restricted. Investors can transact these Mutual Funds on any business day at the prevailing fund price on that particular day.
- Close-ended Mutual Funds
The investment in close-ended Mutual Fund schemes is open only for a limited period of time, which is usually during the time of the scheme’s introduction. Further investments are not allowed once this new fund offer (NFO) closes.
Additional Reading: Types Of Mutual Funds
Classification of Mutual Funds based on asset allocation
Mutual Funds are also categorised based on the asset class they invest in.
Equity Funds
Equity Mutual Funds invest the investment corpus primarily in stocks of different companies. Equity Mutual Funds have an investment strategy of “high risk, high return”. They are further classified into various types on the basis of asset allocation. Some of them are:
- Diversified Equity Funds
These funds aim to diversify the risk of investment by investing in a wide range of equity shares. Equity Linked Savings Schemes (ELSS) are a popular variant that offers investors tax deductions up to Rs. 1,50,000 per year under Section 80C of the Income Tax Act with a lock-in period of 3 years.
- Sector Funds
Sector Funds have the highest level of risk because of their style of investing in shares of certain sectors such as banking, pharmaceuticals, and information technology, among others.
- Index Funds
Index Funds are designed with the strategy of creating diversification in an investor’s investment portfolio at a low expense ratio. This is because these funds mirror an index.
Additional Reading: Introduction To Equity Mutual Funds
Debt Mutual Funds
Debt Mutual Funds primarily invest in various debt instruments like corporate bonds, government securities, treasury bills, and other money market instruments with an objective to provide investors with a steady cash flow and rather stable returns. Debt Mutual Funds are further categorised on the basis of the different time horizons of investments.
- Money Market Funds
Money market funds come with the objective of easy liquidity because they invest in money market instruments. Money market funds are a safe option in which investors can invest their surplus money for a very short period of time.
- Income Funds
The portfolio of Income Funds consists of government securities, corporate bonds, and other money market instruments. The investment strategy behind Income Funds is to generate regular cash flows on a monthly or quarterly frequency for investors who are willing to remain invested for a longer tenure.
- Fixed Maturity Plan
Fixed Maturity Plans are close-ended Mutual Fund schemes which have a fixed investment tenure. Fixed Maturity Plans are invested in such a way that investments are not impacted by interest rate risk until maturity.
Additional Reading: Debt Mutual Funds Help Maximize Gains
Balanced Mutual Funds
Balanced Mutual Funds are those funds that generally invest in a combination of equity and debt with a typical 60:40 split ratio. The investment objective behind Balanced Mutual Funds is to achieve capital appreciation and offer investors a steady source of income.
Additional Reading: An Introduction To Balanced Funds
Now that we have given you an introduction to the main types of Mutual Fund categories, let us tell you how to choose good funds and make successful investments.
Choose to invest in no-load Mutual Funds
A few Mutual Funds charge investors a fee (called a sales load) to invest in the fund. The sales load is generally 5% of the value of the assets, which is paid to a wealth manager or the person who sells the fund units to the investor.
BB Tip: When creating an investment portfolio, the investor must consider buying no-load Mutual Funds to get the most value from his investments. Why? We’ll tell you.
Let us say you come into an inheritance of Rs. 10 lakhs at the age of 25 years. If you invest this lump sum amount in a no-load Mutual Fund, every paise of the Rs. 10 lakh amount will be invested in the fund and will start earning returns for you.
However, if you buy a Mutual Fund that has a sales load of 5%, then your investment will begin at 5% less of your total lump sum. You stand to lose capital on the sales load of the fund.
What should you do? Invest in a no-load Mutual Fund and save more.
Additional Reading: How To Meet Your Goals With Mutual Funds
Consider Expense Ratio
Mutual Fund houses make their money through portfolio management services and other advisory services. These costs are covered by a percentage of the investor’s money that is termed as the Expense Ratio. Simply put, this is the cost of owning the Mutual Fund.
Investors must, in order to get maximum returns from their Mutual Fund investments, always choose to invest in funds that have the lowest Expense Ratio.
It may seem like a rather minor percentage, but over time you will notice what a big difference the 0.5-1.5% Expense Ratio can make to your investment corpus.
Additional Reading: Term Of The Week: What’s An Expense Ratio?
Stay away from Mutual Funds with high turnover ratios
Always remember the primary objective of investing in Mutual Funds is to achieve wealth creation and grow your money.
Consider this. You have two investment options. Invest in a fund that offers 12% growth, with no turnover or invest in a Mutual Fund which gives you 17% growth and more than 100% turnover. Which fund will you invest in?
Are you leaning towards the fund that offers 17% growth? Stop right there. You should ideally choose to invest in the fund that offers 12% growth and no turnover. Why? It is important to consider the turnover ratio of a Mutual Fund. What’s that, you wonder? The turnover ratio is the percentage of the fund’s portfolio that is bought and sold every year.
You should be cautious about investing in Mutual Funds that consistently turnover 50% or more of their portfolio.
Additional Reading: Understanding The Importance Of Turnover Ratio
The portfolio manager matters
The investment manager you choose to handle your investments could have either a positive or a negative impact on your wealth creation objectives. You need to be very careful when selecting your investment manager and circle of advisors.
Stay away from Mutual Fund managers who have a sketchy track record or a history of sizable losses when the markets, in general, have performed well.
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Pick Mutual Funds to match your investment objectives
Investing in Mutual Funds is first and foremost about gaining value from your investments. Are you a value investor? Do you believe that all assets have a value equal to all the cash it will generate for the investor?
Or are you primarily a growth investor looking to invest in only the best and most rapidly growing companies? Do you bank mostly on blue chip companies that provide healthy dividends?
While investing in Mutual Funds, your focus must be to find those funds that cater to your individual investment goals and objectives.
Additional Reading: Set Your Goals Before Investing In Mutual Funds
Portfolio diversification is important
The advice going around from investing wizard Warren Buffet is that new investors should choose extreme diversification when creating their investment portfolio. You must attempt to spread your asset allocation among various investment sectors, companies and industries.
Portfolio diversification is important to minimise the effect of market volatility on your investments. Go beyond investing in stocks. Look at investing in real estate funds, arbitrage funds and fixed income funds. There are so many options out there.
It is also a good idea to invest a major portion of your investment portfolio in domestic equities for the long-term.
Additional Reading: How Important Is A Well-Diversified Portfolio
Think of investing in Index Funds
For the average investor with an investment tenure of 10 or more years looking to benefit from the effect of compounding, making investments in Index Funds can be a good idea.
Index Funds have low turnover rates and very affordable expense ratios. Index Funds also offer good scope for portfolio diversification.
Additional Reading: Index Funds – Are They Right For You?
Investing in international markets
If you are considering making investments in the international equity markets, you should ideally invest in established markets like Great Britain, Brazil, Germany, or Japan among others. However, investing in emerging markets will entail a high level of political and economic risks.
Additional Reading: Investing In Foreign Markets Through Mutual Funds
Benefits of Rupee Cost Averaging
Rupee Cost Averaging is the one best methods to minimise your risk exposure over the long-term. Mutual Fund investments can be successful if investors are disciplined in making the right investments and are not affected by short-term market volatility.
With investments in Mutual Funds, an investor’s focus should be on creating long-term wealth, which is why it is important to remain invested for a long tenure.
Additional Reading: Investment Options For Everyone
With this guide, you now know exactly what you should be looking for when choosing Mutual Funds.