How to select a Mutual Fund Scheme - (Part 1)

Selecting a mutual fund Scheme – (Part 1)

 

Arnav, an investor, calls me on the phone and speaks,

Can you recommend a good mutual fund scheme?

"What do you mean by a good scheme?" I ask him.

"I do not know exactly. But I guess it should be a top performer with the highest returns," Arnav replies.

"Yes, surely, I can suggest. However, selecting a scheme based only on returns is not in your interest." I try to warn Arnav.

"Then what more is needed? I want to get maximum returns." He pressed.

"Hold on and let us meet so I can explain it. Choosing a some from the list of top performers popping up on the internet is not correct method. You must follow a process to select a scheme." Arnav agreed to meet the following week.

Arnav is among the many investors who believe they should invest only in the top-performing mutual fund schemes. Sadly, this is a common misconception, as the recent track record is not the only parameter for selection. They are unaware that good or bad performance is often due to a specific situation, and no scheme remains on top for long.

When Arnav came for the discussion, I began,

"Many investors like you choose schemes with a five-star ranking without understanding their rating methodology. You may get it right for a short time, but soon you will realize that the scheme you chose does not stay at the top. Keep in mind that this is not a way to build your portfolio. You need a deeper thought process to arrive at a proper selection of the schemes."

Arnav was a professional auto consultant with a thorough knowledge of the automobile industry.

Before discussing selecting a mutual fund scheme, can you suggest a good car for me?"

"To answer your question, you will have to answer my questions. Selecting the right car involves evaluating several factors to ensure it meets your needs. After I know your response to these questions, I can suggest a suitable model." Arnav gave me a list of attributes with the options.

1. Primary purpose for using a car - Daily commute to workplace/long distance drive/family/casual travel

2. Your budget - Below 10lac/11 to 15 lac/ above 15 lac

3. Transmission - Manual/ Automatic

4. Type of car - Hatchback/Sedan/luxury car/SUV/MUV

5. Choice of fuel - Petrol, Diesel, EV, or CNG.

In addition to these questions, you should also tell me about your preferences for brand, new or used car, fuel efficiency, parking facility, safety features, availability of service set up and expectations about resale value."

"Arnav, you have asked me many questions I have never thought about. "

"Yes. However, you must consider all these factors before you decide which car to buy. Unless you give me your requirements, I cannot suggest a model. Opting for a top-selling model will not be the right choice."

"I agree, Arnav. I should buy a car that meets my requirements after a careful thought process. Similarly, when selecting a scheme, you must follow a process linking your needs to the scheme's specifications."

"Do you have a list of parameters as well?" Arnav asked.

"Yes, by addressing these questions, you can make an informed decision that aligns with your creative goals and practical requirements. Arnav, please remember that scheme selection is the last step in your investment process. The mutual fund universe is vast, with three asset classes, thirty-nine categories (as per SEBI circular), more than forty-five mutual fund companies, and more than 1,500 schemes. Before I suggest a scheme to you, here's my list of questions." I provided my list.

1. Have you done your financial planning, including your family members?
2. What are your financial goals? Have you classified them into short-term, medium-term, and long-term goals?
3. What is your risk profile? What type of investor are you? Aggressive, moderate, or conservative?
4. What is your asset allocation to reach your goals? What percentage of equity, fixed income, debt, and gold/silver do you want in your portfolio?
5. Are you aware of the categories of mutual fund schemes?

"Honestly, as you have not thought about cars, I know little about these financial matters. They seem to be more complex than deciding on a car." Arnav confessed.

"Not really. Being conversant with the basics is your advantage. It will be easier if you do your homework and think about what you want from investments. Please start with financial planning and decide on your financial goals. The next step will be doing your asset allocation. Only after this can you properly select a mutual fund scheme."

"I believe financial planning is only for rich people. I do not have time for all these things." Arnav commented.

"Don't worry. Financial planning is not difficult or time-consuming. It means knowing financial needs and aspirations. Your financial plan and asset allocation will be a guide for your life. Mutual fund scheme selection follows your asset allocation, which means allocating your money across multiple asset classes, such as equity, fixed income, debt, cash, etc. After considering your financial goals, return expectations, and risk profile, you can decide where to put how much money. Your asset allocation is the most crucial factor in determining your investment's return and risk. You cannot jump over scheme selection without asset allocation."

"Yes, I got it. I can follow these steps."

"Arnav, one more concept you should understand is correlation. More schemes or securities of the same asset class do not mean diversification. Including diverse asset classes with low correlation of returns and risk is the ideal way of investing. For example, returns on gold, debt, and equity tend to move differently. The mix of asset classes helps to get an optimum return performance. So, a well-thought-out combination of investments is desirable. Of course, this is not easy, but it should be attempted."

"It's like having a balanced meal with sweet, sour, and spicy elements," Arnav remarked.

Yes, something similar. As market volatility affects returns, having a cushion of low-volatility investments is crucial to reduce risk. Including multiple asset classes improves the chances of earning better returns.

"I got it. I should identify asset types where I should put  money to reach my goals. We will meet again after my financial plan is ready,’ Arnav promised.

“Great, Arnav. Today’s discussion was the first part of the selection process. After you do asset allocation, we will identify the category of mutual fund schemes. E.g. Large cap equity scheme. After this  further analysis is necessary to select suitable scheme from the available schemes in the category. So, let us meet next week with your financial plan.  Meanwhile, have a look at this chart to help you understand the investment process."

(This article is for general information only and not be treated as financial advice. Readers are advised to consult their advisers before taking any decision.)