Mutual funds: How and why to invest in them

Aggressive hybrid schemes are the best investment vehicle for very conservative equity investors looking to create long-term wealth without much volatility. Some equity investors want to play safe even while investing in stocks. Large cap schemes are meant for such individuals. These schemes invest in top 100 stocks and they are relatively safer than other pure equity mutual fund schemes. They are also relatively less volatile than mid cap and small cap schemes. In short, you should invest in large cap schemes if you are looking for modest returns with relative stability

Mid cap schemes invest mostly in medium-sized companies and small cap funds invest in smaller companies in terms of market capitalisation. These schemes can be volatile, but they also have the potential to offer superior returns over a long period. You can invest in these mutual fund categories if you have a long-term investment horizon and an appetite for higher risk.

Multi cap funds are diversified equity funds that invest in stocks of all market capitalization (large cap, mid cap and small cap) across sectors. Fund managers are required to invest at least 25 per cent each in large-, mid and small-cap companies

Proper investment is a very important thing. As it's a start of financial year, we have decided to put out a list of different mutual fund categories and few good mutual fund schemes- Aggressive hybrid schemes (or erstwhile balanced schemes or equity-oriented hybrid schemes) are ideal for newcomers to equity mutual funds. These schemes invest in a mix of equity (65-80 per cent) and debt (20-35). Because of this hybrid portfolio they are considered relatively less volatile than pure equity schemes.

Aggressive hybrid schemes are the best investment vehicle for very conservative equity investors looking to create long-term wealth without much volatility.

Some equity investors want to play safe even while investing in stocks. Large cap schemes are meant for such individuals. These schemes invest in top 100 stocks and they are relatively safer than other pure equity mutual fund schemes. They are also relatively less volatile than mid cap and small cap schemes. In short, you should invest in large cap schemes if you are looking for modest returns with relative stability.

A regular equity investor (one with a moderate risk appetite) looking to invest in the stock market need not look beyond flexi cap mutual funds (or diversified equity schemes). These schemes invest across market capitalisations and sectors, based on the view of the fund manager. A regular investor can benefit from the uptrend in any of the sectors, categories of stocks by investing in these schemes.

Mid cap schemes invest mostly in medium-sized companies and small cap funds invest in smaller companies in terms of market capitalisation. These schemes can be volatile, but they also have the potential to offer superior returns over a long period. You can invest in these mutual fund categories if you have a long-term investment horizon and an appetite for higher risk.

Multi cap funds are diversified equity funds that invest in stocks of all market capitalization (large cap, mid cap and small cap) across sectors. Fund managers are required to invest at least 25 per cent each in large-, mid and small-cap companies

The flexi-cap funds invest a minimum of 65 per cent of its assets in equity and equity-related instruments across market capitalizations. The key difference between flexi-cap and multi-cap funds is that flexi-cap does not restrict investments in large, mid and small-cap companies to a minimum threshold and the exposure can be dynamically managed.

ELSS funds are equity-oriented funds that allow investors to invest in stocks and take advantage of tax deduction on the invested amount. The tax deduction falls under Section 80C of the Income Tax Act that allows investors to get tax exemption of up to Rs1.5 lakh applicable on yearly taxable income.

Value oriented funds invest in companies with a predefined investment strategy described in the scheme's investment objective. Focused funds invest in a maximum of 30 stocks in a limited number of sectors rather than investing in a diversified mix of stocks and sectors.

These schemes which we believe should be enough for regular mutual fund investors.

- UTI Flexi Cap Fund

- Axis Midcap Fund

- Kotak Emerging Equity Fund

- Axis Small Cap Fund

- SBI Small Cap Fund

- SBI Equity Hybrid Fund

How to choose an equity mutual fund?

To choose an equity mutual fund, investors need to bear in mind the cost that they are willing to pay to own a fund, its performance over a considerable period of time, its risk-adjusted returns and the volatility of the fund. When choosing an equity mutual fund, investors need to shortlist peers to compare the mutual fund performance on key metrics that need to be analysed before choosing a fund.

Expense ratio

This is the annual fee paid to cover the operating expense of a mutual fund or an exchange-traded fund (ETF). This expense included the management cost, administrative cost as well as marketing and advertising cost borne by the asset management company to maintain the mutual fund.

When choosing a mutual fund scheme, you must select mutual funds that charge a reasonable expense ratio to ensure the majority of your investment is used to generate returns. When you buy a mutual fund, you don't pay an expense ratio over and above your investment as the expense ratio is directly deducted from your returns.

What is a benchmark index?

A benchmark index is used to evaluate the performance of an investment in the stock market. A benchmark index covers different market capitalizations, sectors and themes. When making an investment, a portfolio manager evaluates the returns of an investment based on the performance of a set or a group of securities called the benchmark index.

When choosing a mutual fund, investors need to evaluate how the fund has performed in comparison to its benchmark index to evaluate if investing in the fund will garner returns. A mutual fund that has outperformed the benchmark index is preferred over a fund that has underperformed the benchmark index.

What is Alpha?

The alpha is the excess returns over the benchmark index that a fund generates. Alpha is generated by portfolio managers by diversifying their investments and can be positive or negative. An alpha at zero indicates the fund manager has not generated more or less returns compared to the broad markets and the fund's performance is in line with that of the benchmark index.

When choosing a mutual fund, you must consider the alpha of the fund compared to its peers. This alpha must be higher than that of other mutual funds as well as higher than the expense ratio of the fund. Higher the alpha, higher is the excess returns the fund has generated.

What is beta?

The beta is a measure of the volatility of the mutual fund when compared to the broader market. Beta indicates the risk that a stock or a portfolio carries and it changes as the market swings.

When choosing a mutual fund, beta of less than one is considered less volatile when compared with funds that have beta higher than one. When a mutual fund's beta is compared with its peers, it is important to evaluate other factors as well before deciding if the fund will increase or decrease the risk associated with the fund.

What is standard deviation?

The standard deviation is a measure that indicates the volatility of a fund; the higher the standard deviation, the higher is the volatility of the fund and vice versa.

When choosing a mutual fund, lower standard deviation of the fund compared to peers' implies lower risk. It is, however, not necessary for a fund to have lower standard deviation for it to generate higher returns.

What is Sharpe ratio?

The Sharpe ratio indicates the return of an investment when compared to its risk. It shows the extra returns you make for the additional risk that you have taken. When choosing a mutual fund, a high Sharpe ratio is preferred when compared with peers' performance and implies better risk-adjusted returns of the fund.