As we have discussed in our earlier articles, mutual funds are pooled investment vehicles, and they invest in different asset classes. But as per the value research framework (that we use), there are 40 categories of mutual funds. Each category has its advantages and disadvantages. So the real question is “How to select mutual funds for our investment portfolio?”. We will try to answer this question using different use cases and try to develop a framework that can work as a stepping stone in your mutual fund investment journey.
Just a quick reminder, if you are looking for mutual funds names, then this article is not for you. Instead, in this 2 article series, we will create a process that will help you select funds per your financial objective. So, let’s dive in.
Finding the Right Category for Your Investment Goals
There are multiple categories of mutual funds like equity, debt, hybrid, etc. All these categories have different subcategories. You can find the list of all the different categories here. We can divide those categories by the risk associated with the category and the ideal time horizon for that category. Then we can align them with your risk appetite and investment horizon. So let’s understand these two variables in more detail.
- Risk: When you invest in any asset, there is a chance of losing money on that investment. At the same time, we should understand that risks and returns will go hand in hand. Higher risks should ideally generate higher returns. During a market downturn, assets might go down significantly from their peak. On top of that, some assets will have high volatility in their prices. We can quantify these risks using parameters like Maximum Drawdown and Standard Deviation.
- Investment Horizon: In investing, the longer the horizon, the better the chances of generating higher returns. But not all of us can invest for a very long period of time. Investors will have different time horizons based on their financial goals. We feel that investors with up to 3 years horizon should avoid investing in pure equity mutual funds.
Based on these 2 parameters, we can divide mutual fund categories for effective category selection.
From the above table, we can see that debt funds are suitable for a shorter time horizon. As the horizon increases, our inclination toward equity investment also increases.
Let’s discuss some key points before moving forward:
- The above-mentioned table should not be used as a rule of thumb. The table gives us a general idea about the suitable fund categories for each investor profile. For example, some investors may prefer to invest in value-oriented equity funds with a 3-year horizon as well.
- For each risk level and investment horizon, we have multiple categories. For example, high-risk options for the long horizon include small-cap, multi-cap, flexi-cap, etc. You can select any one option or multiple options from the mentioned categories.
- Sectoral equity funds require a closer watch as the cycle can turn quickly for a particular sector. For example, due to the Russia-Ukraine war, European economies are under pressure and that is impacting our IT sector negatively.
- Both equity and debt funds have various options for different risk profiles. So based on your liquidity and return requirements, you can select different categories.
Do note that the table above just indicates which type of MF is suitable for different combinations of risk and horizon. In reality, investors should follow a portfolio approach and align their risk and investment horizon with proper asset allocation. Below is an indicative asset allocation that investors can use:
General Recommendations
- You should have a healthy mix of different categories of mutual funds in your portfolio. For example, investors with a high risk appetite with a long horizon should consider a mix of small-cap, flexi-cap, index funds, and long-term debt funds. We believe you should not have more than 25% allocation in any category of mutual funds.
- You should limit the exposure of risky funds in your portfolio. For example, small-cap funds are one of the riskiest funds. We believe that you should limit the exposure to a maximum of 15% in your portfolio.
- More than 80% of large-cap funds can’t beat the index in the 5-year time frame. So, we believe that index funds (or ETFs) can be a better option compared to large-cap funds.
- All multi-cap funds must invest 25% of funds in small, mid, and large-cap stocks. This can lead to underperformance in the long run. So, we believe flexi-cap funds are a better option when selecting a fund that invests across multiple market caps. Flexi-cap funds do not have any restrictions based on percentage allocation.
- We believe that to get the best out of equity mutual funds, you should stay invested for at least 4-5 years. For short-term investments, debt funds used to be a good choice compared to FDs of similar tenure because of the indexation benefits. But after the recent amendment by the government, that advantage is gone.
- Debt funds are good options for investors looking for a regular periodic income. They also have a lower risk compared to equity funds. This makes them suitable for post-retirement financial planning.
Conclusion
After reading this article, you clearly know about mutual fund categories and their selection based on risk level and investment horizon. You can find mutual fund categories suitable for you using the framework provided in this article. In the next article, we will define a process of finding out the best fund from our selected categories.
FAQs
Which mutual fund category is best for my portfolio?
We can not define a single best category for any portfolio. The best category depends on risk appetite, return requirements, investment horizon, etc.
Should I invest in Debt funds as they provide better returns than FDs of similar tenures?
Debt funds can be a good option for your low-risk investment. But still, they are riskier compared to FDs. So make sure that you have a decent understanding of the risks involved with different debt funds.
How much should I invest in gold mutual funds?
Gold is considered a hedge against inflation and volatility. This makes it a worthy candidate for some portion of your portfolio. Ideally, you can allocate 5-10% of your portfolio to gold based on your risk appetite.
Disclaimer:
The article contains the personal views and opinions of the authors. The information contained in this article is for general, educational, and awareness purposes only and is not a complete disclosure of every material fact. Any investment advice should not be construed as such.
