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How to choose a mutual fund?
Finance - Mutual Fund

When a mutual fund advertises high returns on a particular equity scheme, investors get lured. If the actual returns disappoint, they stay on, hoping for luck to turn, or move to another top-ranked (as they believe) scheme. The fundamental question is whether returns should be the sole or crucial differentiator to pick an MF scheme.

Returns are one of the most important aspects, but you shouldn't ignore other factors. Returns Demystified : First, let us understand the concept of "returns". Take the case of an equity growth scheme. For simplicity, assume the NAVs are as given below :

In this case, we have different absolute returns for different periods. The simple average annual return since inception is 16 per cent. The absolute return for the first six months is 20 per cent, whereas for the first year it is only 10 per cent. If you calculate the return from June 30, 2008, to June 30, 2009, it is zero. The above example makes it clear that a return by itself may not give a clear indication of the scheme's features. By using different time periods, a fund house may give you a misleading picture.

Opting for right performance evaluation period: Each type of scheme has a different investment objective and time horizon of investment for risk-adjusted return expectation. An equity fund should be evaluated over the medium to long term (i.e. two to three years).

The other factors to be considered are as below:

Investment objective:

Each fund scheme is based on an investment philosophy, predefined in the funds' objectives. An investor has to find the right scheme which matches his investment needs with the funds' objectives and invest accordingly. For instance, some funds invest in mid-caps to give better than index returns, some invest in companies in the infrastructure sector only, etc.

Portfolio:

You will get a clear picture of the investment style of a fund if you look at the portfolio of the scheme. For example, take diversified equity funds. Among the top performers, the portfolio would reveal that a particular scheme or schemes have only top quality stocks, whereas another has a large exposure to midcap companies. In a rising market, the scheme with large mid-caps may outperform the other, but when the market is in a bad shape, the mid-caps can also take asevere beating. So, ensure your objective matches with the fund's strategy.

The portfolio is constructed depending on the risk/return profile, as well as the liquidity needs of the with the scheme objective.

Corpus Size:

Certain schemes from fund houses like Sahara Mutual Fund, Taurus Mutual Fund, ING Mutual Fund, etc.

may be in the top five or 10 rankings on performance. However, their corpus size is very low (e.g. that of Sahara Power & Natural Resources Fund is just Rs 6 crore, of Taurus Infra Fund is Rs 28 crore, ING Contra Fund is Rs 16 crore, etc. Usually, schemes with low corpus have higher volatility and standard deviation. Investors should prefer a scheme with sizeable corpus.

Benchmark Performance:

It is important to compare the returns of funds vis-à-vis the respective benchmark across various time frames. The benchmark is usually the S&P CNX Nifty, BSE Sensex, BSE 100, BSE 500, etc. The trademark of a good fund is its ability to deliver superior performance year after year. The objective of any active investment strategy is to outperform the benchmark and this excess return is what is called the 'alpha'. An investor should also ensure consistency in returns over different periods of time before investing.

Business practices:

The most important aspect is how the fund houses conduct themselves. How much transparency is there in their operations? If the fund house doesn't have high ethical standards and good corporate governance, the best performance can turn into a nightmare in no time (e.g. Schemes of JM Mutual Fund such as Hi Fi Fund, Small and Midcap Fund, etc.). It is necessary that you don't overlook what yielded that performance. For example, a fund can take a huge risk and book exceptional profits. However, if the strategy boomerangs, there will be heavy losses. In case you knew you were taking a huge risk for high rewards, it is a different case. However, if you are caught unawares by a sudden change of tactics of the fund, then it hurts.

Expense Ratio:

Usually, schemes disclose their expense ratios. The expense ratios affect the fund's performance. Higher expenses charged to a scheme can alter its performance. The impact is more in case of debt funds, as the returns are lesser than that of equity funds.

Peer return comparison:

This information is usually available with investment advisory teams. It shows how a particular scheme has performed in comparison to schemes of other fund houses. Peer return comparison is a must to understand if the fund manager is able to outperform the other schemes.

Conclusion:

The mutual fund industry in India has prospered due to transparency and disclosures. Most fund houses come out with a fund fact sheet for each scheme every month. They provide information about the investment particulars of the corpus (company and sectorwise), credit ratings, market value of investments, NAVs, returns, repurchase and sale price of the schemes.

A fund house normally comes out with various publications which contain the scheme's objectives, fund manager's commentary on the portfolio, market outlook, etc. The aim is to help an investor take an informed decision to invest, stay invested or redeem out of the fund. It is upto the investor i.e. you, to make the best use of it.

An equity fund should be evaluated over the medium- to long-term, that is, two to three years

Each scheme is based on an investment philosophy, pre-defined in the funds objectives

Fund houses should conduct themselves in a transparent manner

Peer return comparison is a must to evaluate the fund manager's strategies

The aim of an active investment strategy is to outperform the benchmark

It is up to the investor to make the best use of information available

 
 

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