How To Choose the Best Mutual Funds Based on Risk Profile?

When it comes to building wealth through the financial markets, mutual funds have become a popular choice for many investors. They are investment vehicles that pool money from various investors and allocate it across different securities based on the fund’s objectives.

However, with thousands of schemes available, knowing how to select the best mutual fund to align your financial goals and risk tolerance becomes crucial. Keep reading to learn more.

Factors To Consider Before Selecting Mutual Funds

When determining how to choose the best mutual funds for your portfolio, consider these essential factors:

Fund Performance Analysis

While past performance doesn’t guarantee future results, examining how a mutual fund scheme has performed across different market cycles provides valuable insights. 

• Compare returns over three, five, and 10-year periods rather than focusing on short-term results.
• Assess performance against appropriate benchmarks instead of viewing returns in isolation.
• Examine behaviour during market downturns to understand how well the fund preserves capital.
• Look for consistency in returns rather than occasional spectacular performance.

Fund Manager Expertise

Behind every mutual fund is a fund manager who makes critical investment decisions. Their experience and strategy determine how well your money grows.

• Research the fund manager’s experience, qualifications, and historical performance record.
• Check the manager’s tenure with the specific fund you’re considering.
• Evaluate how the manager has navigated through different market cycles.
• Understand the investment philosophy that guides their decision-making process.

Expense Ratio Examination

The expense ratio is the annual charges levied by the fund house for managing your money. Lower expense ratios allow more of your investment to work for you.

• Compare expense ratios with similar funds in the same category.
• Passive funds typically charge lower fees than actively managed options.
• Consider whether a higher expense ratio delivers proportionally better performance.
• Check for hidden costs beyond the published expense ratio.

Fund Size and Liquidity

A fund’s asset size affects its manoeuvrability and investment opportunities. The right size depends on investment strategy.

• Large funds may struggle with nimble positioning in smaller market segments.
• Very small funds might face higher expense ratios and operational challenges.
• Mid-sized funds often balance flexibility with operational efficiency.
• Check redemption policies to ensure you can access funds when needed.

For instance, liquid funds are designed to offer high liquidity while preserving capital, making them suitable for parking funds with very short to medium-term needs.

Essential Tips To Select Mutual Funds

Your risk profile should dictate the asset class distribution in your portfolio, with conservative investors leaning towards debt funds and aggressive investors favouring equity funds.

Here are some tips to help you understand how to pick the best mutual funds as per your risk profile:

For Conservative Investors

If capital preservation is your priority with modest return expectations:

• Liquid Funds: Put your money in short-term instruments with minimal interest rate risk.
• Banking and PSU Debt Funds: Focus on debt instruments from banks and public sector undertakings (PSU).
• Arbitrage Funds: Aim to generate returns with very low risk through price differences in different markets.

These options are particularly suitable for investors with short to medium-term investment horizons of six months to three years.

For Moderate Risk Investors

If you can accept moderate volatility for better growth potential:

• Balanced Advantage Funds: Dynamically manage equity and debt allocation based on market conditions.
• Conservative Hybrid Funds: Maintain 10-25% in equity with the rest in debt instruments.
• Corporate Bond Funds: Focus on corporate debt securities with moderate credit risk.

These funds often work well for investment horizons of three to five years, balancing growth needs with reasonable stability.

For Aggressive Investors

If significant market fluctuations don’t disturb your sleep:

• Equity Funds: Focus primarily on stocks across various market segments.
• Sector or Thematic Funds: Concentrate on specific sectors or investment themes.
• Small and Mid Cap Funds: Target smaller companies with higher growth potential and volatility.

These options are better suited for long-term goals of more than seven years, as they allow time to ride out market volatility.

Tax Considerations in Fund Selection

The taxation of mutual fund returns under the Income Tax Act varies depending on the fund type and holding period. 

• Long-term capital gains (holding period > 1 year) above ₹1.25 lakh are taxed at 12.5% without indexation. 

• Short-term capital gains (holding period ≤ 1 year) are taxed at 20%.

Practical Approaches to Mutual Fund Selection in 2025

Here is how to pick the best mutual funds in the current environment:

1. Start With Goal-Based Selection: Define what you are investing for and the time horizon before choosing funds.
2. Use the Core-Satellite Approach: Build the core portfolio with index funds for stability and add satellite funds for potential outperformance.
3. Consider Fund House Reputation: Established Asset Management Companies often have better risk management practices.
4. Review the Portfolio Composition: Understand what assets your funds invest in, rather than focusing solely on returns.
5. Check for Consistency: Identify funds that have consistently delivered strong performance across various market cycles.

With these parameters in mind, you can approach the mutual fund investment process more systematically.

Final Thoughts

The right approach to mutual fund selection isn’t about maximising returns at any cost, but about striking a suitable balance between risk and return that is in sync with your financial requirements and comfort level.

For comprehensive tools to help you analyse and select mutual funds, visit Torus Digital.