How to Invest in the Best Equity Mutual Funds for the Long Term

Investing in equity mutual funds provides you with a potential to earn good risk adjusted returns through a professionally managed portfolio of equities.

The most important question investors often face is how to select the best mutual funds to invest in for the long term?

As you may know, there are around a dozen sub-categories of equity mutual funds, which can make it challenging to select the most suitable one. Therefore, finding the most suitable equity mutual fund type is the first step in investing. This can be achieved by clearly defining your investment objective, risk appetite, and the time horizon to the goal.

The next crucial step is to shortlist and choose the best equity mutual fund scheme within the selected sub-category. With a plethora of mutual fund schemes on offer within each sub-category of equity mutual fund, analysing and comparing them to select one is truly worthy.

Often investors opt for schemes that have performed well in the recent past. However, such an approach may not yield the best results in the long run.

To create a truly winning portfolio of equity mutual funds, analyse the schemes on both quantitative and qualitative parameters.

Here are the parameters you should evaluate to select the best equity mutual fund schemes for your portfolio:

I. Quantitative Parameters

1) Past Performance

Equity mutual funds aim to outpace their respective indices over the long run. Therefore, it makes sense to analyse how well the fund has performed across various time frames in the past, such as 1-year, 3-year, 5-year, 7-year, since inception, etc. While past performance is not an indicator of future returns, analysing the track record of the scheme will provide meaningful insights on how consistently it has performed compared to its peers and the benchmark. You will be better off avoiding a scheme that does not have a long-term track record or has generated a one-off superior performance.

2) Performance Across Market Cycles

Most equity mutual funds tend to perform well during market uptrends. However, when the market momentum weakens, many funds fail to contain the downside risk. Therefore, it is vital to select schemes that perform consistently well across bear and bull market phases compared to their benchmark and the category peers.

3) Risk-adjusted Returns

Investment in equity mutual funds is susceptible to market volatility, which makes them a risky proposition. Thus, when you invest in equity mutual funds, it makes sense to consider the level of risk taken by a scheme to earn higher returns, i.e., risk-adjusted returns. The point is that the scheme must reward investors by undertaking a reasonable level of risk consistent with its investment style and strategy. Risk-adjusted returns can be determined using various ratios such as Sharpe Ratio, Sortino Ratio, Treynor Ratio, etc.

II. Qualitative Parameters

Qualitative parameters are as important as quantitative parameters. This involves determining the quality and efficiency of the fund house and the fund management team. Remember that only process-driven schemes can be expected to generate consistent returns for investors.

Here are the factors you should look into:

1) Portfolio Quality

Since the performance of a scheme depends extensively on the quality of its underlying portfolio, it is important to ensure that the scheme is well-diversified across stocks and sectors to avoid concentration risk. To assess this, analyse the scheme's top-10 holdings, the top-5 sector exposure, and the market capitalisation bias. Also, ensure that the scheme does not churn its portfolio too often as it may lead to higher volatility.

2) Efficiency of the mutual fund house

It is advisable to always give higher importance to mutual fund houses that follow sound risk management techniques and have robust investment systems and processes in place. Understand whether the scheme aims to create wealth for investors or are they in a race to garner more AUM by showcasing higher returns generated by chasing higher yields and taking higher risks.

3) Experience of the fund manager

The performance of an equity mutual fund is directly dependent on the ability of its fund manager timely identify various opportunities available in the market. The fund manager should be devoid of personal/emotional biases and should have a decent performance track record of schemes under his/her management. Moreover, the fund manager should not be over-burdened with the task of managing too many schemes as it can lead to inefficiency.

Whether to invest via SIP or lump sum route?

Once you have identified the best equity mutual fund to invest in using the abovementioned parameters, the next step is to figure out whether you should invest in a lump sum or through SIP. Investing in equity mutual funds via SIP is preferable when you are addressing long-term financial goals. It allows you to spread your investments over time at various market levels. By doing so, you benefit from the inherent rupee-cost averaging feature and power of compounding. Thus, SIP averages out the cost of investment, and you earn risk adjusted returns over the long run. But along with SIPs, whenever the equity markets have witnessed a remarkable correction, it also makes sense to deploy a portion of your investible surplus in lump sum.  

To conclude

The above mentioned factors will help you select the best mutual funds to invest in for the long term. Remember that the selection of schemes should be made as per your financial goals, risk appetite, and investment horizon, and not based on what your friend/colleague/relative is doing with his mutual fund investments. Avoid investing in very high-risk equity mutual fund categories if it does not align with your needs. You can also seek the assistance of a SEBI-registered financial advisor who can help you make informed financial decisions.

Happy Investing!

Above article is authored by Quantum.

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