How Do Mutual Funds Actually Choose Stocks

When you invest ₹10,000 in a mutual fund SIP, do you know what happens next? Your money joins a pool of crores from thousands of investors.

A fund manager and a research team then decide which stocks deserve your money and which don't.

But how do they decide? Is it gut instinct, fancy algorithms, or something more structured?

At Belong, NRIs ask us this regularly in our WhatsApp community.

And the answer matters because understanding the process helps you pick better mutual funds for your own portfolio.

Here's a look behind the curtain at how your money actually gets invested.

Every Fund Has a Mandate: The Rules Come First

Before a fund manager picks a single stock, SEBI has already drawn the boundaries. Every mutual fund scheme has a mandate that the fund manager cannot violate.

A large-cap fund must invest at least 80% in the top 100 companies by market capitalisation.

A mid-cap fund must put at least 65% in companies ranked 101 to 250. A small-cap fund must hold at least 65% in companies ranked 251 and below.

SEBI's 2017 mutual fund categorisation rules created these guardrails. So when you buy a large-cap fund, the manager can't secretly load up on small-cap stocks chasing higher returns.

The mandate acts as a contract between the fund and you.

Flexi-cap funds are the exception. They give the manager freedom to invest across market caps without minimum allocation rules. This flexibility is exactly why some NRIs prefer them.

👉 Tip: Always read the Scheme Information Document (SID) before investing. It tells you exactly what the fund can and can't buy. You can find SIDs on any AMC's website or through Belong's mutual fund tools.

Top-Down vs Bottom-Up: Two Approaches to Stock Picking

Fund managers broadly follow one of two approaches. Most Indian fund houses use a combination.

Top-down approach: The manager starts with the big picture. How is the economy doing? Which sectors will benefit from current trends?

If GDP growth is strong and interest rates are falling, a manager might overweight banking and real estate. Once sectors are identified, specific stocks within them are selected.

Bottom-up approach: The manager ignores the macro picture and focuses entirely on individual companies.

Does this company have strong financials? Is management trustworthy? Is the stock undervalued?

The logic is simple: a great company will perform well regardless of broader economic conditions.

Franklin Templeton India, for example, has publicly described their approach as bottom-up, focusing on fundamentals with a medium to long-term perspective (Business Today).

Funds like UTI Opportunities have historically taken more concentrated sector bets using a top-down lens.

For NRIs, this distinction matters when you're choosing a mutual fund. A bottom-up fund tends to be less affected by macro shocks.

A top-down fund can outperform dramatically if the manager gets the sector call right, but it cuts both ways.

The Research Machine Behind Every Fund

Picking stocks isn't one person's job. Behind every fund manager sits a research team of 10 to 50 analysts at major AMCs. Here's what they actually do, day after day.

Quantitative screening comes first.

Analysts run stocks through filters: revenue growth, profit margins, return on equity (ROE), debt-to-equity ratio, cash flow patterns. Thousands of stocks get narrowed down to maybe 100 to 200 candidates.

Deep fundamental analysis follows.

For each shortlisted company, analysts dig into quarterly results, annual reports, competitive positioning, and management quality. They build financial models projecting revenues, profits, and cash flows for the next 3 to 5 years.

Company visits and management meetings are the next layer.

Analysts travel to factory floors, meet CFOs, attend annual general meetings. In India, SEBI requires AMCs to disclose their voting records at AGMs, adding transparency to this process.

Valuation assessment is the final filter.

A company may have excellent fundamentals but if the stock price already reflects all the good news, it's expensive.

Analysts estimate "intrinsic value" using metrics like price-to-earnings (P/E), price-to-book (P/B), and discounted cash flow (DCF). They buy when the stock trades below this estimated value.

👉 Tip: You can see exactly what stocks your fund holds by checking the monthly portfolio disclosure on AMFI's website. SEBI mandates this transparency.

Growth vs Value: What Style Is Your Fund Manager Playing?

Even within the same fund category, two managers can pick very different stocks based on their investment style.

Growth investing targets companies growing revenues and profits faster than the market average.

Think IT companies during the 2020-21 boom or defence stocks in recent years. Growth managers accept higher valuations because they expect earnings to justify the price.

Value investing hunts for stocks trading below their estimated worth. These are often out-of-favour companies or sectors.

PSU banks before their 2023-24 rally are a classic example. Value managers need patience because these stocks can stay cheap for a long time before the market recognises their worth.

Blend or GARP (Growth at Reasonable Price) combines both.

The manager looks for companies with solid growth but refuses to overpay. Many large Indian fund houses like HDFC AMC and ICICI Prudential follow this approach across their flagship funds.

For NRIs evaluating which funds to invest in, understanding your fund's style helps you set the right expectations. A value fund might underperform in a roaring bull market but protect you better in a crash.

How Fund Managers Decide How Much to Buy

Stock selection is only half the job. Position sizing, or how much of the fund goes into each stock, is equally important.

A typical diversified equity fund holds 40 to 70 stocks. The top 10 holdings usually account for 40% to 55% of the portfolio. The fund manager allocates more money to stocks with the highest conviction.

SEBI imposes limits here too. No single stock can exceed 10% of the fund's NAV. No single sector can exceed 25% for diversified funds. These rules protect investors from excessive concentration risk.

Fund managers also think about liquidity. A small-cap fund managing ₹20,000 crore can't load up on micro-cap stocks because there wouldn't be enough trading volume to buy or sell without moving the price. This is why large small-cap funds often end up buying mid-cap stocks too.

👉 Tip: Check your fund's "active share," which measures how different it is from the benchmark index. A fund with 80%+ active share is making genuine stock-picking bets. Below 60%, you're essentially paying active fund fees for index-like returns.

When Does a Fund Manager Sell?

Buying gets all the attention. Selling is where the real discipline shows up.

Fund managers typically sell for four reasons.

First, the stock hits its target price. The thesis played out, gains are booked.

Second, the fundamentals deteriorate. Maybe the company lost a major contract, took on bad debt, or management changed. Third, a better opportunity emerges.

The manager sells Stock A to buy Stock B, which offers a better risk-reward. Fourth, the fund needs cash to meet redemption requests.

SEBI tracks portfolio turnover ratios, which show how frequently a fund churns its holdings.

A high turnover ratio (above 100%) means the fund is trading aggressively. A ratio below 30% means the manager is patient and holds stocks for years.

For NRIs, lower turnover funds tend to be more tax-efficient. Every sale triggers capital gains. More turnover means more tax events embedded in the fund, which eventually affect your returns.

Active vs Passive: Does Stock Picking Even Work?

Here's the uncomfortable truth. Globally, most actively managed funds underperform their benchmark index over 10-year periods.

The S\&P SPIVA India scorecard shows that roughly 60% to 70% of Indian large-cap funds have underperformed the Nifty 50 over 5-year periods in recent years (SPIVA India).

But here's the nuance. In less efficient market segments like mid-caps and small-caps, active managers in India have historically added more value because there's less analyst coverage and more mispricing to exploit.

This is why many advisors, including our team at Belong, recommend a blended approach: index funds for large-cap allocation and actively managed funds for mid-cap and small-cap exposure. Compare the options using Belong's fund comparison tools.

What About Debt Funds? How Do They Choose Bonds?

Debt fund managers don't pick stocks. They pick bonds, government securities, and money market instruments.

But the process is equally rigorous.

Credit analysis replaces equity analysis. The team evaluates the issuer's ability to repay: credit rating (AAA, AA, BBB), debt-to-EBITDA ratio, interest coverage, and cash flow stability.

One default in a debt fund's portfolio can wipe out months of interest income, as investors in Franklin Templeton's shuttered debt funds discovered in 2020.

Duration management is the other lever. If the manager expects interest rates to fall, they buy longer-duration bonds to capture price appreciation.

If rates are expected to rise, they shorten duration to protect NAV.

For NRIs, debt fund taxation changed significantly in 2023. All gains are now taxed at slab rates with no indexation benefit.

This has made GIFT City alternatives more attractive since Section 10(4D) of the Income Tax Act provides tax exemptions on GIFT City fund returns.

👉 Tip: NRIs wanting fixed-income exposure with tax efficiency should compare regular debt funds against GIFT City FDs and GIFT City mutual funds. Track performance using GIFT Nifty.

What NRIs Should Look For When Evaluating Fund Managers

Understanding the stock-picking process helps you ask better questions when choosing funds.

Consistency over star returns. A fund that delivers 14% to 16% every year is better than one swinging between -5% and +35%. Check rolling returns, not point-to-point returns.

Manager tenure. If the fund manager who built the track record left last year, the past performance data is less relevant. Look for managers with 5+ years at the same fund.

Portfolio overlap. If you hold three large-cap funds and all three own the same top 15 stocks, you're not diversified. You're concentrated with extra fees.

Expense ratio.Lower costs directly translate to higher returns for you. Always choose direct plans over regular to save 0.5% to 1% annually.

Why This Matters for Your Money

Knowing how mutual funds pick stocks won't make you a fund manager. But it will make you a better investor.

You'll know what questions to ask, what red flags to watch for, and why past performance alone is a terrible way to pick a fund.

Many NRIs in our WhatsApp community started investing with more confidence once they understood the process behind the product.

If you want the same clarity, download the Belong app, explore our mutual fund and FD rate tools, and join thousands of NRIs making smarter financial decisions.

Disclaimer: Mutual fund investments are subject to market risks. Read all scheme-related documents carefully. Past performance is not indicative of future results. This article is for educational purposes only. Consult a qualified financial advisor before making investment decisions.