Why You Should Avoid These 3 Types Of Mutual Funds? | The Mutual Fund Show

Summary

The Mutual Fund Show focuses on three types of mutual funds to avoid: sectoral/thematic funds, new fund offers (NFOs), and credit risk funds. The guest, Udan, explains that sectoral funds are risky due to concentrated exposure, while NFOs lack track records and often underperform. Credit risk funds carry high default risks, making them unsuitable for most investors. Udan also offers tips on how to choose better funds, emphasizing rolling returns and capture ratio analysis to minimize mistakes and maximize returns.

Takeaways

• 💡 Avoid Sectoral and Thematic Funds: These funds concentrate too much risk in one sector, making them risky investments in most cases.
• 📉 Be Wary of New Fund Offers (NFOs): Without a track record, most NFOs tend to underperform established mutual funds. Around 6 out of 10 NFOs underperform the benchmark.
• ⚠️ Avoid Credit Risk Funds: These funds invest in low-rated bonds, which carry higher risk and may not offer significant returns compared to safer options.
• 🔍 Carefully Evaluate NFOs: While most NFOs should be avoided, some (like HDFC's defense fund) may perform well. Still, it's better to invest in funds with proven performance.
• 📊 Rolling Returns Matter: Instead of relying on one-year returns, consider rolling returns, which analyze the fund's performance over multiple time periods for a more comprehensive view.
• 📉 Capture Ratio: A key metric to evaluate funds is the capture ratio, which measures how well a fund performs when the market goes up or down. A ratio over 1 is ideal.
• 💼 Diversification is Key: Avoid putting too much money into one sector or thematic fund. Diversify across different funds to reduce risk.
• ⏳ Rebalance Periodically: Rebalance your portfolio every 2-4 years to manage gains and reduce risks, but don't rush into it without considering potential tax impacts.
• 📈 Focus on Long-Term Goals: Align your investments with your long-term financial goals and risk profile rather than chasing short-term gains.
• 🛑 Investing is a Loser's Game: The goal is to avoid mistakes rather than chasing big wins. Minimizing errors leads to successful long-term investing.

Q & A

What are the three types of mutual funds that should generally be avoided?

The three types of mutual funds to avoid are: 1) Sectoral or thematic funds, 2) New Fund Offers (NFOs), and 3) Credit risk funds.

Why should investors avoid sectoral or thematic funds?

Sectoral or thematic funds should be avoided because their risk is concentrated in specific sectors. If the sector performs poorly, investors may face significant losses. It is advised not to allocate more than 10-20% of the portfolio to sectoral funds.

What are the risks associated with New Fund Offers (NFOs)?

NFOs lack a track record, making it difficult to evaluate their future performance. Many NFOs underperform compared to established funds with proven records, making them riskier investments.

How can an investor filter which NFOs are worth considering?

Investors should avoid about 90-95% of NFOs, but they can filter good ones by checking if they are unique and fill a gap in the market or offer something that existing funds do not. However, in most cases, there are better established alternatives available.

Why should credit risk funds be avoided?

Credit risk funds invest in low-rated bonds with a higher chance of default. The risk is not worth the small potential gain of 1-2% over safer investments, especially considering the possibility of losing the principal investment.

How do rolling returns help in evaluating mutual funds?

Rolling returns show the performance of a mutual fund across different time periods, providing a more consistent and reliable picture of how a fund has performed in the past, rather than just focusing on a single period of performance.

What is a capture ratio, and why is it important in evaluating mutual funds?

The capture ratio measures how much of the market's upside or downside a fund captures. A good fund should capture most of the market's upside while limiting losses during downturns. A capture ratio above 1 is ideal for outperforming the market.

When should an investor consider rebalancing their portfolio?

Rebalancing should be considered every 2-4 years. Frequent rebalancing can result in unnecessary tax liabilities and reduce long-term gains. It is mainly done to adjust the risk exposure and maintain the desired asset allocation.

How should one approach investing in sectoral funds if they are still interested?

If an investor is interested in sectoral funds, they should limit their exposure to 10-20% of their portfolio and ensure that their other investments are diversified across different sectors to minimize the risk of being overly exposed to one sector.

What should be the primary factors to consider when picking a mutual fund?

The primary factors include the fund’s rolling returns, capture ratio, and its alignment with the investor’s goals and risk profile. Additionally, the overlap of holdings and consistency of the fund’s performance are also important considerations.