How to select mutual funds after the SEBI categorization rules

With most AMCs complying with SEBIs mutual fund categorization rules, the implications are slowly sinking in. Since most mutual funds have changed in nature, their past history is now useless. Star ratings are useless. My monthly mutual fund screeners are useless. The selection methods I have discussed earlier are useless. SEBI has hit the reset button and we must quickly learn to adapt. In this post, I discuss how investors can now select mutual funds.

What follows should be familiar to many experienced investors and regular readers, but I have received a few requests in this regard and hence this post. First of all, this post is about selecting new mutual funds. DO NOT confuse it with reviewing existing holdings. You don’t need to know how to select mutual funds, you can simply use Inky Pinky Ponky for selecting Mutual Funds! Why? Because Selecting the right equity mutual fund scheme is not possible! Run away from anyone who says otherwise. So why this post then? Because (1) most people would not dare to do choose randomly and (2) some context to the selection process will not hurt.

Second of all, choosing a mutual fund is not the same as choosing a restaurant! You need a clear goal, decide on the asset allocation for it with a reasonable return expectation from each asset class. Then you need to select mutual fund categories suitable for your financial goals (not funds). After doing all this, you are ready to choose products.

In this post, I will focus on the construction of a diversified equity mutual fund portfolio. The debt fund selections have not changed much and the following can be easily extended with one thumb rule – stick to liquid or ultra short-term funds if you do not know what to do.

SEBI has made the construction of a diversified equity folio easy now:

Option 1:  One large-cap + one mid-cap fund should be more than enough. The large cap will have 80% of stocks with top 100 market cap. The midcap will have 65% of stocks within the top 101-250th market cap.

Option 2: One equity-oriented balanced fund or what is now known as an aggressive hybrid fund. Market cap is unknown but you can expect a reasonable spread.

Option 3:  Single multi-cap fund but cap allocation is again unknown.

Option 4:  Single large and mid-cap fund with min 35% large cap and 35% mid-cap and rest up to the fund manager.

That is all that you will ever need.

How to choose?

If you are a new investor with no knowledge ( = bias) about mutual funds, then here are your options:

Option A: If you take me seriously, these are my Handpicked Mutual Funds May 2018 (PlumbLine): Revised and Updated

Option B: Just pick ANY large-cap mutual fund and ANY mid-cap fund if you do not want to dig deep. Trust me, even if you analyze a lot, finally the choice will be a gamble. After you start investing, learn how to review a mutual fund portfolio. That is all that matters. If you are scared, pick only the large-cap fund.

Option C: If you are young, want to invest for the long-term, don’t care about risk, then use ICICI Nifty Next 50 Direct Plan Growth Option (part of my list)

Option D: Don’t want to pick randomly, want to dig a bit deeper, then see below.

If you are not a new investor, meaning you know a few fund names, then this is what I would suggest:

Have the guts to choose funds randomly or stick to well-known funds that have not changed category. Then you can look at their past history and choose a fund that has consistently beaten its benchmark in terms of risk and downside protection.

If you are a new investor and want to choose funds with good track record, then you can follow the steps outlined in my mutual fund screener guide: How to select an equity mutual fund in 30 minutes! Make a short-list in each category and find out from the respective AMCs if those funds have changed nature. If they have not (i.e. not too much), then you can pick one of them.

My take: Use this opportunity to overcome the need to pick “best” funds based on past returns. Choose the correct mutual fund category and within that category, you can choose pretty much any fund as long as it is not a dud (lagging behind benchmark for 3+ years or bottom 25%). OR use this opportunity to become an index investor if you can quickly learn How to reduce risk in an investment portfolio. This way, you can eliminate the need to compare with peers

Let me know your thoughts about this and any questions you may have.