Article

How to Invest in Mutual Funds in Indian Markets?

10 Jul 2019

When you get down to investing in mutual funds, there is a problem of plenty. With more than 40 AMCs, over 2000 schemes and with each scheme having a growth or dividend option along with a Regular Plan and a Direct Plan, you can imagine how complex it gets. Your screeners on the website can help you up to a point but you still need to narrow down to the scheme that best suits your needs. That is where this process will come in handy. Before you make your choice of fund, go through the following process.

Narrow down to funds based on AUM

A small fund with a corpus of Rs.100 crore may be the best performer but the fund business may be hard to sustain for them. Such funds are best avoided if you have a long term perspective. You must ideally stick to larger funds that have been around for over 15-20 years in the business. Such funds and fund managers have gone through cycles in business. Also, a higher AUM reduces your expense ratio as it gets spread over a large corpus.

In equity funds, prefer diversified funds over thematic funds

The whole idea of investing in mutual funds is to get the benefit of diversification. Don’t let go of this benefit by selecting thematic funds. The last thing you want is the fund manager to introduce concentration risk into your portfolio. This rule applies to equity funds and to debt funds also. While equity funds must diversify across sectors, business models and quality; debt funds must diversify across quality, tenor, duration etc.

Select funds that are consistent as they are more predictable

Two funds may have given the same CAGR returns over 5 years but you must look at the consistency. A fund that has given annual returns around the CAGR is better than the fund that has given super returns in 2 years and negative returns in 2 years. When you buy an inconsistent fund, timing becomes too critical. If you get in one of their super years, you may be disappointed at the end of 5 years. That is why consistent funds are a lot more predictable and reliable.

Is it the fund manager skill that is rewarding you?

An equity fund manager has to be better than an index fund manager. At the same time you cannot have a fund manager with the risk appetite of a seafarer. But how do you verifiably measure this? A simple method is the out performance of the fund returns over benchmark index. But that tells you only one side of the story. If the fund manager has outperformed by taking on too much risk then the fund manager is not working hard enough. Sharpe ratio and Treynor ratio can calculate risk-adjusted returns. You can also use the Fama coefficient to measure whether the fund manager is generating returns out of his stock selection skill or through pure luck.

Cost efficiency is the next thing to look at

Expense ratios on equity funds range from 2.50% to 2.75%. If you can save on these costs it can make a substantial difference to your returns in the long run. When you calculate the cost of the fund, include all relevant costs and that includes the TER as well as the exit load. Some funds may charge a lower TER but have a higher exit load. Such funds can become very expensive when you exit before the 1 year period.

Mutual fund must fit into your financial plan

In fact, your activity must begin with a financial plan and these mutual fund investments must fit into the plan. The question you need to ask yourself is, “Is this fund good enough for me”? Look at every fund from the perspective of your own goals; your return requirements, your risk capacity, tax status and liquidity needs. It is only when you apply this litmus test that the effort of navigating through a plethora of mutual funds actually becomes meaningful for you.

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Beginner's Corner

How to Invest in Mutual Funds in Indian Markets?

10 Jul 2019

When you get down to investing in mutual funds, there is a problem of plenty. With more than 40 AMCs, over 2000 schemes and with each scheme having a growth or dividend option along with a Regular Plan and a Direct Plan, you can imagine how complex it gets. Your screeners on the website can help you up to a point but you still need to narrow down to the scheme that best suits your needs. That is where this process will come in handy. Before you make your choice of fund, go through the following process.

Narrow down to funds based on AUM

A small fund with a corpus of Rs.100 crore may be the best performer but the fund business may be hard to sustain for them. Such funds are best avoided if you have a long term perspective. You must ideally stick to larger funds that have been around for over 15-20 years in the business. Such funds and fund managers have gone through cycles in business. Also, a higher AUM reduces your expense ratio as it gets spread over a large corpus.

In equity funds, prefer diversified funds over thematic funds

The whole idea of investing in mutual funds is to get the benefit of diversification. Don’t let go of this benefit by selecting thematic funds. The last thing you want is the fund manager to introduce concentration risk into your portfolio. This rule applies to equity funds and to debt funds also. While equity funds must diversify across sectors, business models and quality; debt funds must diversify across quality, tenor, duration etc.

Select funds that are consistent as they are more predictable

Two funds may have given the same CAGR returns over 5 years but you must look at the consistency. A fund that has given annual returns around the CAGR is better than the fund that has given super returns in 2 years and negative returns in 2 years. When you buy an inconsistent fund, timing becomes too critical. If you get in one of their super years, you may be disappointed at the end of 5 years. That is why consistent funds are a lot more predictable and reliable.

Is it the fund manager skill that is rewarding you?

An equity fund manager has to be better than an index fund manager. At the same time you cannot have a fund manager with the risk appetite of a seafarer. But how do you verifiably measure this? A simple method is the out performance of the fund returns over benchmark index. But that tells you only one side of the story. If the fund manager has outperformed by taking on too much risk then the fund manager is not working hard enough. Sharpe ratio and Treynor ratio can calculate risk-adjusted returns. You can also use the Fama coefficient to measure whether the fund manager is generating returns out of his stock selection skill or through pure luck.

Cost efficiency is the next thing to look at

Expense ratios on equity funds range from 2.50% to 2.75%. If you can save on these costs it can make a substantial difference to your returns in the long run. When you calculate the cost of the fund, include all relevant costs and that includes the TER as well as the exit load. Some funds may charge a lower TER but have a higher exit load. Such funds can become very expensive when you exit before the 1 year period.

Mutual fund must fit into your financial plan

In fact, your activity must begin with a financial plan and these mutual fund investments must fit into the plan. The question you need to ask yourself is, “Is this fund good enough for me”? Look at every fund from the perspective of your own goals; your return requirements, your risk capacity, tax status and liquidity needs. It is only when you apply this litmus test that the effort of navigating through a plethora of mutual funds actually becomes meaningful for you.