Step into any discussion regarding finance in India today, and mutual funds will be mentioned within the first five minutes, with phrases like “SIP kar raha hoon” being the catchphrases. However, as a newbie, this variety might overwhelm you, with thousands of schemes and numerous categories, and every other person claiming to know the best scheme.
The reality is, there is no such thing as the best mutual fund to invest in for everybody. The mutual fund scheme that is best for you is determined by a variety of factors such as goals and risks. What this guide will do is teach you the steps to take and the criteria used in choosing the best mutual fund investment schemes, without giving you a list of funds that might not even be the right fit for you.
What Is a Mutual Fund, Really?
A mutual fund, in its most basic definition, is defined as a pool of investors’ money that is professionally managed by a person called a fund manager, who invests this money in stocks, bonds, etc., on behalf of the investors. For example, if you invest your ₹5,000 in a mutual fund, your money becomes a part of a larger mutual fund pool, and you are allocated a certain number of units of the fund based on your investment amount.
As for your investment value, it goes up or down according to the NAV (Net Asset Value) of the fund, which is basically the price per unit of the fund calculated at the end of every trading day based on the value of the portfolio of the fund.
The benefit is simple: investors have access to professional management, diversification of their investments, and the possibility to start with a small sum of money, without having to own a stock portfolio.
Why Mutual Fund Investment Makes Sense for Most People
Before exploring the different categories, it is important to know the reasons behind the growing popularity of mutual funds among novice investors.
Diversification without complexity – To illustrate, a single equity mutual fund may hold up to 40-60 securities. Building such a versatile portfolio by yourself usually requires a lot of time spent researching and quite a bit of money that most new investors do not possess.
Professional management – There are teams of professionals working in the mutual fund field who do all kinds of research whenever needed. Investing in a mutual fund means that you get to benefit from their skills at a very low cost.
Accessibility – One can start their Systematic Investment Plan where the minimum investment can be as low as ₹500 in some funds. Thus, mutual fund investment is available to all investors regardless of their economic status.
Liquidity – Unless in some special cases (like ELSS mutual funds), one can redeem the mutual funds he or she invested in within a couple of days.
Regulation – In India, mutual funds are regulated by SEBI, which takes care of the enforcement of the system of disclosures, regulation, and protection of investors.
The Main Categories of Mutual Funds
Since “best” only makes sense inside a category and in relation to your objectives, you must first understand the categories in order to identify the top mutual funds for your needs.
1. Equity Mutual Funds
They mainly focus on equities and are designed for creating wealth over a period of five years or more. The various sub-categories in equity mutual funds include:
- Large cap funds – These are funds that invest in large and stable companies in India. They have low growth rates.
- Mid cap funds – Mid-cap funds invest in medium-sized companies which have high growth rates.
- Small cap funds – Small cap funds invest in small companies with high growth rates and high risks.
- Flexi cap/multi cap funds – This allows the fund manager to select stocks from large cap, mid cap, and small cap funds depending on the market condition.
- Sectoral/ thematic funds – Funds that invest in particular sectors like banking, IT and pharmaceuticals and hence, carry high risks due to limited diversification in sectors.
- ELSS (Equity Linked Savings Scheme) Funds – These are special funds with tax-saving features under Section 80C.
2. Debt Mutual Funds
These are investments in fixed income securities such as government bonds, corporate bonds, and money market instruments. They tend to be less volatile compared to equity mutual funds and are ideal for investors with a shorter investment period or low-risk profile. Some types of debt funds include liquid funds, short-duration funds, corporate bond funds, and gilt funds.
3. Hybrid Mutual Funds
These combine equity and debt in different ratios with the objective of balancing growth and stability. These include balanced advantage funds, aggressive hybrid funds, and conservative hybrid funds, which only differ in the amount of equity component present.
4. Index Funds and ETFs
Such funds do not invest in the market; instead, they replicate a particular market index, such as the Nifty 50 or Sensex, and as such, do not require a fund manager to make any calls. Since these funds have lower expense ratios, they have become popular among investors looking for investment options that do not require them to depend on a specific fund manager.
How to Actually Choose the Right Fund for You
This is where many beginners make a mistake – they want to know “what fund produced the highest returns last year?” and not “which fund fulfils my needs best?”. So, how do you go about this?
Start with your goal and time frame: The fund to save for the down payment of a house in 2 years is completely different from the one to save for retirement in 25 years. Usually, funds with shorter time frames are oriented towards bonds and hybrid funds, while longer terms can afford more equity investments.
Evaluate your risk tolerance accurately: It is very easy to say you are okay with experiencing the ups and downs of the market while it is on the rise. The true test occurs when the market tumbles by 20%. If such a thought makes you feel anxious, it would be better to stick to either a hybrid fund or a bond fund.
Don’t focus on past profits: First-time investors usually become obsessed with finding the most rewarding fund; however, it should be understood that last year’s leader may lose its attractiveness.
Look into the expense ratio of the fund: The expense ratio is the annual charge made by the fund to manage the investor’s portfolio as a percentage of the total investment made by the individual. A variance of 0.5%-1% in the expense ratio over a period of time can have a noticeable impact on the ultimate returns because of compounding.
Get familiar with the fund manager’s credentials and his approach towards stock selection, risk management and diversification strategy of the fund. The performance of the fund depends greatly on its fund manager’s skills and knowledge. Constant churn in fund managers may indicate that the fund lacks stability.
Do not confuse diversification with the number of funds in your portfolio. It is often observed that a novice investor starts off by putting money in eight or ten equity funds, assuming that he/she is diversifying his/her portfolio when in fact these funds share similar stock holdings.
SIP is the best option for novices in the stock market. Systematic Investment Plan enables an individual to make regular investments and thus takes away the problem of timing the market.
Common Mistakes Beginners Should Avoid
- Pursuing the past year’s top performer. The financial markets are characterized by a cyclical nature, which makes it unlikely that a present-day success will continue to dominate the future.
- Overestimating the influence of the exit load and lock-in period. This is particularly vital when it comes to ELSS investments with their three-year lock-in.
- Liquidating investments in a state of panic during market declines. This is true because the volatility of stock market returns has to be accepted for the sake of future profits; however, emotional decision-making often leads to realizing losses that would have been just a temporary condition.
- Not having a fund in line with your investment objectives. In other words, liquidating a savings deposit just in order to invest in a small-cap equity fund for two years is definitely a wrong choice.
- Disregarding taxation. It is important to remember different taxation regimes for long-term and short-term capital gains.
Final Thoughts
Finding a definitive response to the inquiry, ‘what is the most appropriate mutual fund option?’ is impossible since what qualifies as the best mutual fund will depend upon the individual financial ambitions, investment timeframe, and risk tolerance. What is more important than identifying one ideal mutual fund is getting into the habit of regular investment, selecting the appropriate category, and monitoring the portfolio from time to time, rather than obsessively.
Before proceeding with mutual fund investment, it would make sense to read the statement of the scheme, to analyze the category of fund and its risk-o-meter rating, and in the case of complex situations, consult with a SEBI-registered investment adviser who will be able to exploit the whole financial picture.
Frequently Asked Questions (FAQs)
Which type of mutual fund is best for beginners?
For the majority of novices, a combination of a short-duration debt fund (for immediate requirements) and a large-cap or flexi-cap equity fund (for long-term objectives) provides a balanced beginning point without undue risk.
How much money do I need to start investing in mutual funds?
Many mutual funds allow you to establish a SIP for as little as ₹500 a month, so even people who are just starting out in investing can participate.
Are mutual funds safe for long-term investment?
The funds come with market risks; they are not “safe” as a fixed deposit is; however, there has been evidence of equity mutual funds performing better than the rate of inflation over time periods of 7-10 years or more.
What is the difference between SIP and lump sum investment?
The SIP strategy requires you to invest a certain fixed amount in set periods, thereby averaging out your cost of purchase, whereas the lump sum strategy requires you to invest all the money at one time.
How do I know if a mutual fund is performing well?
Examine its performance over several time periods (1, 3, and 5 years), not just the most recent year, in relation to its benchmark index and category peers, as well as consistency and expense ratio.