How to select an equity mutual fund -preamble

Published: June 2, 2015 at 10:46 am

Last Updated on

Over the next few days, I would like to do a series on “How to select an equity mutual fund”. This is the long overdue update to the step by step guide to mutual fund selection.

I write this primarily because my understanding about  mutual funds has grown significantly since I wrote the pdf guide. I have already shared this with you in the form of analysis and calculators. Would like to consolidate it in terms of specific steps.

In this post, I would like to start with a preamble which will define the objectives and the framework of what will follow.

The central objective is quite simple: To enable anyone to select a mutual fund in about 20-30 minutes. This time will reduce significantly once the investor gets a better grip on the method.

There are however a few necessary prerequisites to make the selection process easier.

The following and ensuing posts are valid only for long-term goals that is 10 years or more away.

1) A financial goal is mandatory. Questions like, “why am I investing?” and “when do I need the money?” should be answered.

2) What is the proposed asset allocation? For a given goal and duration, how much will the exposure in the equity fund that you would like to select be? This is crucial because many people make the mistake of investing in 100% equity for long-term goals. The equity:debt (fixed income) allocation is mandatory.

3) What is the expected return from the equity mutual fund for the investment duration? Personally I will use 10% for calculating the investment amount and expect about 12%. Do not expect more than 15%.

4) Expected return from total portfolio  = (expected return from equity) x (equity allocation) + (expected post-tax return from debt) x(debt allocation)

5) Use the expected portfolio return in a standard goal planner with about 10% inflation for all goals expected retirement. For retirement use a minimum of 8% inflation. With other inputs found in the goal planner, you should be able to determine the necessary monthly investment. Even if you are not able to invest as much, this step is necessary to understand the requirements of the financial objective.

6) Decide about the debt portfolio. For goals which are 15 financial years away, PPF is a good choice. EPF or mandatory NPS will do fine for retirement. For other goals, you can consider short-term debt mutual funds.

7) Decide about the equity portfolio. There are many ways to do this. I prefer minimalist portfolios

I prefer 60% in large cap and 40% in mid and small caps. So one large cap fund and one mid and small cap fund is all that you need. You can also opt for a single large and mid-cap fund.

A single equity-oriented balanced fund will also work fine. In which case you need to take care of overall equity:debt asset allocation.

Once you have decided how you are going to construct your portfolio and what mutual fund categories you are going to choose, you are all set to pick a fund to invest in.

Those who have already started investing but have not performed any of the above steps, can do so now. Better late than never.

There are many ways to select a mutual fund. I would like to present three ways to do it.  I do not qualitatively analyze a fund too much. If the fund is good, I believe it should show up in the NAV movement. So for the most part I treat a fund as a black box. However, I ensure  that is label on the box is the one I want.

Here are the methods to be discussed. Regular readers will understand where I am going with this.

Method 1:  This is identical to mutual fund guide published earlier. Short-list funds based on consistent performance and then consider risk-return metrics for last 3 years.

Method 2: Short-list funds based on consistent performance and then consider risk-return metrics for longer durations either based on investment duration or for each year.

Method 3: Short-list funds based on consistent performance and then consider downside protection and or consistent long-term rolling returns.

You can save this post as a pdf document with the button below.

Part 2: How to select an equity mutual fund – Creating a shortlist


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