How to Choose an Equity Mutual Fund Scheme?

After you decide your amount of money to be invested in equities, how do you decide which specific scheme is right for you?

Which type of equity scheme is right for you?
All equity schemes can be divided into 2 categories – based on number of industries they invest money across.

A) Diversified schemes (invest in stocks of many sectors) and
B) Single sector or theme based schemes (invest in stocks of only one sector)

A) Diversified schemes: Invest money across all industries like banking, IT, engineering, pharma sectors, etc. The proportion of investment in each sector can vary based on outlook for each sector. By investing in many sectors, the schemes reduce the risk of one industry/sector not doing well and hence these are evergreen funds and should form a CORE part of an investor’s portfolio.

Nearly 90% of an average investor’s portfolio should be in diversified schemes.

B) Single sector or theme based schemes – eg. only infrastructure sector, only banking sector, only pharma sector, only technology sector, etc.

These schemes invest money in single sectors like banking sector, pharma sector, infrastructure Sector, etc. Hence, their performance will completely dependent on that specific sector doing well. There can be 3-5 year phases when these schemes do poorly, which is a high level of risk for any equity investor to live with. If you don’t have that appetite – ignore this category.

These are specialised schemes which an investor with higher risk appetite can use them as a topping in your core portfolio of schemes.

Eg. – Normally not more than 10% of the money invested in equity schemes should be invested in these categories.

We will primarily focus here on diversified schemes as these should account for more than 90% of any investor’s money and hence need more attention.

How to go about distributing your investments across these categories?
The first and primary investment of any investor in an equity scheme should necessarily be in a diversified equity fund, which offers lower risk vs. directly buying specific shares in the market. The diversification across industries also takes care of regular business cycles; downturn in one sector is balanced by growth in the other. Eg. if infra sector is not doing well, consumer sector might be doing well, etc.

The diversified schemes can be classified on the basis of the size of companies they invest in

1. Large size or large cap companies – schemes which invest in large established companies which have good track record over many years. Eg. Infosys, Tata Consultancy, Reliance Industries, Coal India, ONGC, State Bank, etc.
2. Mid-size or mid cap companies – the companies are mid-sized in established industries or emerging industries. The success rate of companies in this category for creating shareholders’ returns is considered lower than the large cap category. Many companies in this category can even fail to grow big.
3. Combination of both – schemes which consist of both large cap and mid cap companies in proportion. These are also call multi-cap/flexi-cap funds.

First time to equities or are you a professional investor?
For a first time investor into equities, who will prefer lower risk needs to follow this simple step – invest in large-cap or multi-cap schemes.

For an investor who can take some risk and is investing for a minimum 3-5 year period can put 20% of the money on mid-cap schemes. Once the investor has invested into the above category, he can add some mid-cap funds to his basket of schemes to allow him to participate in high growth – but high risk companies. The exposure to this segment of funds should be limited (eg. Less than 20% of money invested in equity schemes) as these are very volatile and carry high risk as the companies invested in might not be able to scale up into big companies and hence fail to give good returns.

Index funds (passive funds) – These are low cost schemes which invest in specific indices – for Eg. Nifty Index Fund (large cap index), Sensex Index Fund (large cap index), S&P Nifty Junior Index (mid cap index), etc.

They invest your money in same stocks which are in the index which they track; for eg. a sensex fund will invest in the same 30 companies of the sensex and also in the same ratio as in the sensex. In this case, the portfolio is not created by a fund manager, but just replicates the market index (of the stock exchanges). The advantage here is the fees can be lower and disadvantage is that it will not benefit/lose by the fund managers intervention in the portfolio.

So an investor can also buy for large cap exposure – S&P Nifty Index funds, and for mid-cap requirement invest in S&P Junior Nifty Index funds, introduced by fund houses.

In simple words – Index funds are low cost mutual funds, which invest in a fixed list of stocks in fixed proportion as in the underlying index.

The difference in investing in an Active fund (fund manager managed fund) or a Passive fund (index fund) will be overtime reflected in the fund managers’ ability to beat the index and give higher returns over periods of time of say 3 years or 5 years.

Simple questions to answer in choosing an equity mutual fund scheme – a Checklist

a) Is it a diversified or single sector based scheme? FOCUS ON DIVERSIFED SCHEMES FIRST; THEY SHOULD HAVE 90% OF YOUR MONEY.
b) Is it large-cap or multi-cap or mid-cap fund? DEFINE THE CATEGORY YOU WANT TO BE IN. 80% of your money should be in Large Cap and Multicap, if you are an early level investor for equities.
c) Does the fund house have strong capabilities and scale? If it is among the Top 5 fund houses, it is better equipped to meet the needs of the operating environment. BUY FROM A STABLE/LARGE FUND HOUSE.
d) Does the scheme have at least a 5 year track record of doing well/beating its index benchmark in at least 3 out of 5 years? BUY A SCHEME WITH A TRACK RECORD.
e) Has the fund manager of the scheme changed? If so, please look at his past track record and give at least 1 year before deciding to invest? KNOW YOUR FUND MANAGER.
f) In how many schemes should an investor diversify? A diversified fund is already diversified, so the risk left to be diversified is only the fund manager style risk (his style may not work every single year). In this case taking 2/3 superior funds in the specific category is enough. So having more than 2 or 3 funds in any category (large cap, mid cap, or multi-cap) is not helpful and can actually dilute your return. So DONT OVER DIVERSIFY, 2 or 3 SCHEMES ENOUGH PER CATEGORY.
g) Review your mutual fund portfolio, with a focus on long term track record. Short term track records can be just luck of the fund manager or market behaviour, LONG TERM TRACK RECORD REFLECTS ABILTY and REPEATABILITY.

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