Scheme Selection based on Investor needs, preferences and risk-profile :
- Scheme Selection is based on the investor’s needs, preferences, and risk profile, such as the need for growth, income, or liquidity.
- Setting clear financial goals and assessing risk appetite are the first essential steps in mutual fund selection.
- Risk profile depends on the need, ability, and willingness to take risks, which guides asset allocation decisions.
- Asset allocation considers investment need, risk-taking ability, and time horizon, as equity suits long-term growth, while debt suits income and lower risk.
- Investor’s age alone isn’t a reliable factor for risk profiling; financial goals and situations vary widely within age groups.
- Investment time horizon is crucial — longer horizons allow for higher risk, while shorter-term goals call for safer options.
- Core and Satellite portfolio strategy is recommended, where core investments align with long-term goals, and satellite investments capitalize on short-term opportunities.
- Tactical investments (satellite portfolio) include sector funds, gold funds, or gilt funds, based on market conditions and risk appetite.
- Conservative investors prefer a minimal tactical portfolio, while aggressive investors allocate more to it.
- Final scheme selection involves analyzing risk-return levels, fund performance, portfolio composition, fund age, size, turnover, and expenses.
Risk levels in mutual fund schemes :
- Risk-Return Hierarchy: Mutual fund schemes exhibit increasing risk and return potential as one moves from liquid to debt to hybrid to equity funds.
- Debt Funds: Their risk is divided into credit risk and interest rate risk. Returns and interest rate risk both increase from overnight to long-duration funds, assuming constant credit risk.
- Credit Risk in Debt Funds: Credit risk increases from gilt funds to credit risk funds, assuming similar interest rate risk across categories.
- Equity Funds: Risk increases as one moves from large-cap to small-cap funds; smaller companies are inherently riskier.
- Concentration Risk: Diversified equity funds are less risky compared to focused, thematic, and sector-specific funds due to broader exposure.
- Hybrid Funds: SEBI defines various hybrid fund categories with ascending risk—from arbitrage to aggressive hybrid funds.
- SEBI Product Labelling (2013): Introduced colour-coded labels (blue, yellow, brown) to indicate scheme risk and help investors choose appropriate products.
- Riskometer (2015 Update): SEBI replaced colour codes with a 5-level pictorial ‘Riskometer’—ranging from Low to High—offering a more nuanced risk classification.
Scheme Selection based on investment strategy of mutual funds :
- Scheme Selection Basis: Mutual fund scheme selection depends on investment objective, strategy, and portfolio. Strategies may differ even for the same objective, so investors must evaluate all components.
- Active vs Passive Funds:
- Passive Funds (e.g., index funds, ETFs) mimic benchmarks, have lower costs, and no fund manager risk.
- Active Funds aim to outperform benchmarks with higher risk and cost; success depends on fund manager skill.
- Open-ended vs Close-ended Funds:
- Open-ended Funds offer liquidity and redemption at NAV but may dilute returns due to maintaining liquidity.
- Close-ended Funds allow long-term investments without redemption pressure but have limited exit options and may trade at a discount to NAV.
- Diversified vs Sector vs Thematic Funds:
- Diversified Funds reduce risk via multi-sector exposure.
- Sector Funds focus on one sector, are riskier, and require timing.
- Thematic Funds invest across sectors within a theme (e.g., infrastructure), combining focused and diversified strategies.
- Market Cap-based Funds:
- Large-cap Funds invest in stable, mature companies.
- Mid/Small-cap Funds have higher growth potential but also higher risk.
- Multi-cap/Flexi-cap Funds offer broad exposure; suitable for varying risk profiles.
- Growth vs Value Funds:
- Growth Funds invest in high-growth companies, perform well in bull markets, riskier in downturns.
- Value Funds seek undervalued stocks, perform better in bearish markets, suitable for long-term holding.
- International Equity Funds: Offer exposure to global markets and currency movement. Suitable for diversification and satellite portfolio exposure.
- Fixed Maturity Plans (FMPs) vs Target Maturity Funds (TMFs):
- FMPs are close-ended, suitable for predictable returns with low liquidity.
- TMFs are more flexible, invest in top-rated securities, and offer better liquidity.
- Debt Fund Types:
- Short Duration, Liquid, Ultra-Short, Floater Funds offer varying liquidity and risk levels.
- Strategy and interest rate outlook define fund suitability.
- Hybrid Funds: Combine equity and debt; suitable for investors wanting equity upside with lower risk. Equity and debt components must be evaluated individually.
- Gold Funds:
- Gold ETFs track gold prices directly and offer efficient exposure.
- Gold Sector Funds invest in gold-related companies; influenced by both gold prices and company-specific factors.
Selection of Mutual Fund scheme offered by different AMCs or within the
scheme category :
- AMC Reputation & Style: Investors should choose Asset Management Companies (AMCs) whose values, styles, and business approaches align with their comfort and goals.
- Portfolio-Objective Alignment: The scheme’s portfolio must reflect its stated investment objective and strategy; mismatches (e.g., riskier instruments in low-risk funds) indicate deviation.
- Fund Manager’s Role: A skilled fund manager is crucial for identifying market trends and enhancing performance consistency.
- Performance Evaluation: Analyze historical performance versus benchmarks and peers across various timeframes and market cycles, especially using rolling returns.
- Portfolio Assessment: Evaluate diversification, credit quality, maturity profile, and strategy to assess risks and returns, especially in equity and debt funds.
- Fund Age & Track Record: Older funds offer a proven track record. New funds need to be evaluated carefully, particularly in diverse categories like multi-cap funds.
- Fund Size Considerations: Fund size should suit its investment universe. Large sizes aid diversification in large-cap funds but may constrain mid/small-cap or sectoral funds.
- Portfolio Turnover: High turnover may indicate tactical trading and increased costs. Suitability depends on the fund’s investment style.
- Expense Ratios: High costs erode returns, especially in debt and index funds where lower costs are expected.
- Ratings & Rankings: Ratings reflect past performance, not future. Consistent top-tier performers (not quarterly leaders) are better long-term picks; avoid frequent fund-switching.
Selecting options in mutual fund schemes :
- Mutual fund schemes offer three options: Dividend Payout, Dividend Reinvestment, and Growth.
- Dividend Payout provides regular income; Growth allows tax-deferred compounding.
- Repurchasing units may result in capital gains/losses, which can be used for tax set-off.
- Dividend Payout is not guaranteed even in monthly options—dependent on distributable surplus.
- Systematic Withdrawal Plans (SWP) are more reliable for regular income needs, though subject to tax.
- Dividends are taxed as per investor’s tax slab, reducing net returns.
- Dividend option is less favorable for taxable investors; SWP is a better alternative.
- Taxation and liquidity needs should guide option selection, requiring proper assessment by distributors.
Do’s and Don’ts while selecting mutual fund schemes :
- Ensure Suitability: Choose schemes aligned with the investor’s financial situation and needs, as required by SEBI regulations.
- Follow Asset Allocation: Stick to the investor’s predetermined asset allocation while selecting schemes.
- Avoid Chasing Past Performance: Don’t rely solely on historical returns; past performance doesn’t guarantee future results.
- Understand Scheme Strategy: Assess the scheme’s investment objective and strategy to know what to expect.
- Consider Taxes and Loads: Evaluate the impact of capital gains tax, exit loads, and differences between dividend and growth options.
- Use a Consistent Selection Method: Follow and document a uniform scheme selection approach to maintain consistency.