(types of mutual funds, number of mutual funds, rebalancing of mutual funds)

Introduction

There are more than 2500 mutual fund schemes in India. Choosing suitable schemes remains a big challenge for investors. Investors get confused when they try to look for good schemes to invest in. They also don’t know whether they should invest in one scheme or multiple schemes. 

In this article we are going to solve the following problems faced by many investors:

1. How to choose the best mutual funds and make a winning portfolio?
2. Should you select one or multiple mutual fund schemes for your portfolio?

Types of mutual funds

First, let’s understand about the various type of mutual funds. Mutual funds can be primarily be categorised into below categories:

Equity mutual funds

Equity funds make investments in stocks and the performance of the stock market affects how much money they make. These investments are regarded as risky but they might generate high profits. They can be divided into additional categories based on their characteristics, such as ELSS, Focused Funds, Large-Cap Funds, Mid-Cap Funds, and Small-Cap Funds, among others. If you have a long time horizon and a high-risk tolerance, invest in equity mutual funds.

Debt mutual funds

A debt fund is a type of mutual fund that invests in fixed income securities that have the potential for capital growth, such as corporate and government bonds, corporate debt securities, and money market instruments. 

Debt funds have a low cost structure, somewhat constant returns, strong liquidity, and good safety, to name a few benefits.

Hybrid mutual funds

Hybrid mutual funds are like combo meals in a restaurant. They invest in two asset classes such as equity and debt, debt and gold or equity and gold to get the advantages of both asset classes. Earlier these mutual funds were known as balanced mutual funds.  The ratio of investment can be fixed or varied, depending on the fund house. The broad types of hybrid funds are balanced or aggressive funds.

Hybrid funds can be of the types:

• Conservative hybrid funds
• Balanced hybrid funds
• Aggressive hybrid funds

Category	Equity Funds	Debt Funds	Hybrid Funds
Investment Objective	To invest in equity shares of companies with potential for high growth	To invest in fixed-income securities with a stable return and low risk	To invest in a mix of equity and debt instruments to balance risk and return
Risk Profile	High Risk	Low to Moderate Risk	Moderate Risk
Returns	Potential for high returns in the long-term	Stable but lower returns than equity funds	Moderate returns with a balanced risk-return profile
Ideal Investment Horizon	Long-term (5 years or more)	Short to medium-term (1 to 3 years)	Medium-term (3 to 5 years)
Investment Strategy	Active Management, Stock Picking, and Sector Rotation	Passive Management, Credit Rating-based selection, and Portfolio Diversification	Active and Passive Management, Asset Allocation, and Risk Management
Investor Profile	Investors with high risk tolerance and a long-term investment horizon	Investors with low to moderate risk tolerance and a short to medium-term investment horizon	Investors seeking a balance between risk and return with a medium-term investment horizon
Examples	SBI Equity Fund, HDFC Top 100 Fund, ICICI Prudential Bluechip Fund	HDFC Short Term Debt Fund, Kotak Dynamic Bond Fund, Aditya Birla Sun Life Corporate Bond Fund	HDFC Hybrid Equity Fund, ICICI Prudential Balanced Advantage Fund, Kotak Balanced Advantage Fund

How to choose a mutual fund

Choosing a mutual fund that will suit you perfectly depends on three factors:

1. Your financial goals
2. Your time horizon for investment
3. Your risk taking ability

Before making any kind of investment you should clearly define these factors. 

Suppose ‘Raj’, who is 30 years old, has 3 investment goals:

1. Buy a car in the next 5 years
2. Save for study expenses for his child in the next 15 years
3. Create an adequate retirement fund in the next 30 years

No Raj has to calculate the amount that he will need for fulfillment of each goal. He must ensure that his goals are aligned with his risk-taking capacity. 

Now Raj knows how much amount he needs for each goal and how much time he has to reach that goal.

How to choose the right category

The first goal of Raj is a short term goal, the second is medium term and the third is a long term goal. 

For his first goal which is a short term goal, he should focus on debt mutual funds because they are less volatile and give somewhat constant returns. For a short duration, he can choose from short duration bond funds or liquid funds. 

For his second goal which is a medium term goal, he should focus on hybrid mutual funds because they are better returns than debt funds and are less volatile as compared to equity funds. Depending on his risk appetite choose from conservative, balanced or aggressive funds. Conservative funds have a higher allocation to debt instruments and aggressive hybrid funds have a higher allocation to equity. Balanced hybrid funds have an almost equal allocation to debt and equity. 

Since Raj is young and can withstand a moderate amount of risk and volatility in his investments he should allocate a larger portion of his portfolio to equity mutual funds for his long term goal planning. For his long term goal, he can explore large cap and mid cap equity funds. If he wants better returns and can withstand more volatility and risk then he can also explore small cap funds. 

How many mutual funds should you have

Since mutual funds are already diversified, It is not advised to have more than one fund in one category otherwise chance of overlap between the funds will increase. The increased overlap will only decrease your returns. 

Sometimes investors keep on buying mutual funds which are advertised as top-performing funds for the last year and by repeating this buying action several times they end up with a lot of funds in their portfolio. You should never buy a fund just because it was the best-performing fund in the last year. If it is a thematic fund then you should clearly stay away from it. 

Let’s understand this by an example. Suppose there are two cricket teams, Team A and Team B. 

Team A has the best batsman of last year, best bowler of last year and best folder of last year. Batsmen, bowlers and fielders of team B may or may not have topped the chart of their respective category but they have been consistently in the top 20% of their category for the last 10 years. 

When these two teams compete for a series who do you think will win the series?

The probability of winning is extremely high for team B. That’s why your methodology for constructing the mutual fund portfolio should be like team B. 

Just because a fund has performed best in the last year is no assurance that it will repeat this performance in future also. As long as your chosen fund performs in the top quartile of the fund’s category, your portfolio is going to do fine. There is no need to chase every hot fund you come across. This mistake has caused most investors very dearly.

Periodic review of the portfolio

Your job is not done after buying the mutual funds. It is absolutely vital to keep on reviewing the portfolio periodically. If your portfolio is deviating from your goals then you have to rebalance your portfolio so that it is aligned with your goals. 

Conclusion

Before investing in mutual funds you should be very clear about three things:

1. Your goals
2. Time duration for your goals
3. Your risk taking ability

After this, you should choose the mutual fund or combination of funds best suited for those goals. Remember time in the market is more important than timing the market. You should not buy every top performing fund. Curate your portfolio wisely and stick with this for a sufficient time. As long as your funds perform in the top quartile of their respective categories you are well on track to achieve your goals. You should keep reviewing your portfolio periodically so as to ensure that the funds’ performance is aligned with your goals. If funds are deviating from their performance then you should consider rebalancing your portfolio. 

Thank you for taking the time to read this blog post. I hope you found it informative and enjoyable. I would love to hear your thoughts on the topic and any suggestions you may have for future posts. Please feel free to leave a comment below.
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Also read:

1. The basics of index fund investing: What you need to know
2. Understanding Mutual Fund Portfolio Overlap and Strategies to Minimize It
3. Unveiling the Millionaire-Making Secret: See How Investing in Mutual Funds Can Make You a Fortune!