A Beginner's Guide to Mutual Fund Investments

Legendary investor Warren Buffett's famous quote, “Be fearful when others are greedy and be greedy when others are fearful,” often resonates in investing. This philosophy highlights the importance of investing wisely, especially when others are uncertain or scared. The Indian mutual fund market has seen an impressive surge in retail investments, with a net inflow of ₹41,877 crores in October alone (up 22% month-on-month), despite the stock market witnessing a significant drop of over 6%. This spike in mutual fund investments shows growing confidence among Indian retail investors, who are taking advantage of market volatility.

In this article, we will explore mutual funds, the different types of mutual funds, and key metrics you should consider before investing in them. By the end of this guide, you will have a better understanding of how to approach mutual fund investments and make informed decisions.

What are Mutual Funds?

A mutual fund is a pool of money collected from various investors to invest in a diversified portfolio of securities like stocks, bonds, and other financial instruments. Instead of investing directly in individual stocks, investors contribute money to a mutual fund, which is then managed by professionals. The aim is to generate returns for the investors, who receive profits based on the performance of the fund. In India, mutual funds are run by reputed financial players like SBI, HDFC, UTI AMC, etc.

The Securities and Exchange Board of India (SEBI) tightly regulates mutual funds to protect investors, making them a trustworthy option despite inherent market risks.

Understanding Mutual Fund Categories

1. Equity Mutual Funds:

These funds invest primarily in stocks/equities (like Reliance, HDFC Bank, etc). This category is popular among retail investors who seek higher returns over the long term. The returns can be substantial when the market performs well. However, they come with higher risk, as the stock market can be volatile.

2. Debt or Liquid Mutual Funds:

These funds invest in fixed-income securities such as corporate bonds, government bonds, and money market instruments. Debt mutual funds are typically safer than equity funds and are a popular choice among investors who want to park their surplus cash. These funds generally provide stable but lower returns compared to equity funds, making them suitable for conservative investors.

3. Balanced or Hybrid Funds:

Balanced funds invest in a combination of equities, bonds, and sometimes commodities like gold. These funds aim to provide the best of both worlds: growth potential from equities and stability from debt instruments.

While balanced funds can be a good option for beginners, investors looking for higher returns may prefer to focus more on equity funds once they understand the basics of investing.

How to Invest in Different Mutual Funds?

• Long-term goals (e.g., buying a house): High equity allocation for better returns over decades.
• Short-term goals (e.g., a foreign trip): Focus on debt funds for stability.
• Balanced Funds: For beginners with no specific goals, offering simplicity and diversity.

Thumb Rule:

• Long-term = higher equity allocation.
• Short-term/emergency = higher debt allocation.

Active vs Passive Mutual Funds

Mutual funds can be broadly categorized into two types based on their investment approach: active mutual funds and passive mutual funds. Here's a breakdown:

1. Active Mutual Funds

Active mutual funds are managed by professional fund managers who actively make decisions about which stocks or securities to buy, hold, or sell. Their goal is to outperform a specific benchmark or index by leveraging market insights, research, and expertise.

Example: A large-cap equity fund aiming to outperform the Nifty50 Index.

2. Passive Mutual Funds

Passive mutual funds, often called index funds or exchange-traded funds (ETFs), aim to replicate the performance of a specific market index rather than beat it. They invest in the same securities in the same proportions as the underlying index.

Example: An index fund that tracks the Nifty50 or Sensex.

How to Choose an Active Mutual Fund?

When investing in mutual funds, it’s crucial to assess key factors that determine the fund's performance. Here are five key ratios and metrics that will help you choose the best mutual fund:

1. Rolling Returns: This metric measures the fund’s performance over different periods, helping you understand its consistency. Look for funds with strong rolling returns over 3 years, ideally 30% or more.

2. Alpha: Alpha represents the percentage by which the fund outperforms its benchmark index. A positive alpha indicates that the fund manager is adding value by selecting the right stocks. Look for funds with an alpha of at least 2%, meaning the fund is outperforming its benchmark by this margin.

3. Sharpe Ratio: This ratio measures the risk-adjusted returns of a fund. It compares the return of the fund with the risk-free return (such as government bonds). A Sharpe ratio of more than 1 is considered good because it means the fund is delivering decent returns for the level of risk taken.

4. Assets Under Management (AUM): AUM refers to the total market value of the assets managed by the fund. A higher AUM can indicate a stable, trusted fund with significant investor interest. However, a very high AUM may affect the fund’s ability to generate returns, especially in smaller-cap stocks.

5. Percentage Away from All-Time High: This metric indicates how much the fund has fallen from its peak. While investing in a fund that has recently dipped might seem like a good deal, it’s essential to evaluate the reasons behind the drop. Look for funds that have a reasonable distance from their all-time high and aren’t in a downtrend due to poor management or strategy.

Practical Application: Using Screening Tools

To simplify the process of selecting mutual funds, investors can use online tools like TickerTape. TickerTape allows you to filter mutual funds based on the above metrics, helping you narrow down your choices. You can analyze funds in different categories (like small-cap, mid-cap, or large-cap) and make informed decisions based on their performance metrics.

For example, if you're looking for a small-cap mutual fund, you can apply the following filters:

• Rolling returns of at least 30% over 3 years
• Alpha greater than 2%
• Sharpe ratio of more than 1
• AUM above 5,000 crores

By using these parameters, you can shortlist funds that meet your investment objectives and risk profile.

Check out the filtered Google Sheet of mutual funds derived from the formula given above: https://marketfeed.me/mutualfundlist

Conclusion

Mutual fund investing can be a smart way to build wealth over time, especially for those who are new to the stock market. By understanding the different types of mutual funds and applying key metrics like rolling returns, alpha, and Sharpe ratio, you can make informed decisions and build a diversified portfolio. Remember to tailor your investments to your financial goals—whether it's a long-term objective like retirement or a short-term goal like funding a vacation.

The Indian mutual fund market is growing rapidly, and by making the right choices, you can benefit from the wealth of opportunities available. Always do thorough research and, if necessary, consult a financial advisor to ensure your investments align with your goals and risk tolerance.

Disclaimer: Mutual fund investments are subject to market risks. Please do your own research or talk to a registered investment advisor/profession before investing in mutual funds.