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MF Selection - The Right Approach

| 11/8/2011 5:44 PM Tuesday

Mutual funds are said to be the lay person’s route to the stock market. What makes them a mass market product is the fact that a professional level of fund management becomes available to any class of individuals for a price. The advent of mutual funds in India dates back to 1963, with the formation of the Unit Trust of India and the launch of its first scheme in 1964, called the Unit Scheme-1964, or US-64. Nonetheless, the real growth in the industry came in after March 1993, with the entry of private sector players in the industry. With this, the industry witnessed exponential growth not only in terms of size, as measured by the assets under management (AUM), but also in terms of the various products for investors to choose from. The total AUM have increased from Rs 1.2 lakh crore as of March 1993 to more than Rs 6 lakh crore now, and there are almost 900 type of schemes on offer.

However, such a spurt in the number of schemes has, at the same time, increased the dilemma in the minds of investors. They often get confused when it comes to selecting the right mutual fund scheme from the plethora of schemes available. Far worse, many investors think that any mutual fund with a good past performance can help them achieve their desired goals. This is despite the ubiquitous warning of “past performance is no guarantee of future results” found in mutual fund advertisements.

The theory that supports such an investment style is that there is a positive serial correlation of returns. What this means is that if the price of an asset is moving in a certain direction, there is a higher probability that it will continue to do so in the future too. However, the lay person investing in these schemes does not have a crystal ball to gauge when the trend will reverse, and according to the same logic of serial correlation, may continue to drift downwards and wipe out the entire gain, and in many cases, the capital too. This is more apt in volatile markets like the current one.

A befitting example of such a trend and its reversal can be found in various thematic funds, like infrastructure, that floated during the last bull run and are currently out of favour. Therefore, before investing in mutual funds, as in any other asset class, one needs to be cautious and consider the fact that past performance should be only one criterion, and not the sole one, before committing your funds.

So, how do you go about selecting a fund for investment? The first and foremost step before investing in any fund is that one has to be sure of one’s own investment objectives, time horizon and expected returns. Once this is determined, one needs to gauge one’s risk-taking appetite, since investments in stock markets, and therefore in equity funds, tend to be volatile in the short term. Even the debt market is currently volatile due to rising interest rates. Once you have determined your investment objectives, you can now go out looking out for those funds that suit you.

Like your own investment objective, every fund has its own investment mandate within which the fund manager creates a portfolio. One needs to ensure that these two – your objectives and the fund’s objectives – are aligned. For example, if an investor is risk averse and wants his/her capital to remain intact, he/she should ideally invest in those funds whose mandate is capital protection.

Once you have zeroed in on the type of fund that you will be investing in, you will find various funds that offer these types of schemes. Now, you need to consider the current portfolio, that is, the type of securities and shares such funds have invested in. This will give you an idea of how any possible downfall in the underlying shares and securities that the fund is invested in will impact the fund’s performance, and of the probabilities of such a downfall. You should also look at the concentration of the top 10 stock holdings in the fund. This should be preferably not be more than 40 per cent of the total assets. Therefore, an investor who does not want to take risks should abstain from investing in thematic or sector funds, or any funds that have major investments in a particular sector, or where more than 50 per cent of the fund’s assets are invested in the top 10 stocks.

As discussed, returns are regarded as the single-most important criterion for selecting a fund by most investors. There are two major issues that need to be addressed before judging a fund’s performance. First is selecting the appropriate benchmark for comparing the returns, and second is the level of risk taken by the fund manager to produce such returns. As risk and returns go hand-in-hand, risk-adjusted returns is the correct parameter to judge a fund’s performance. There are basically five ways to calculate risk: alpha, beta, r-squared, standard deviation and the Sharpe ratio.
(Detailed discussion on these is out of the scope of this article. Going forward, we would be analysing funds based on these and various other parameters).

Therefore, one should always judge the performance of the funds vis-a-vis the risks taken, and while comparing two or more potential investments, an investor should always compare the same risk measures to each investment in order to get a relative performance perspective. The most common form of risk-adjusted returns is given by the Sharpe Ratio. Nevertheless, in the case of new funds on offer, where there is no past performance to take into account, one should look at the performance of other funds managed by the same fund manager to get a sense of the performance. Even in case of an existing fund, it pays to follow this approach to avoid performance aberrations wherein only a single scheme is doing well in the recent past, thereby reducing the probability of consistent performance.

Once these major issues are taken care of, there are also some minor issues that are equally important, but are often ignored. One of such thing is the expense ratio. Everything else being equal, it makes sense to invest in those funds that have a lower expense ratio, as a fund with a higher expense ratio needs some extra earnings to break even. The expense ratio is the percentage of assets that go towards these expenses. If we look at the universe of equity diversified funds, we find that the median expense ratio is 2.25 per cent. Though it might not be significant in the short term, but in the long term, this may make a big difference to your earnings. Other than management and administrative fees, what it also includes is brokerage paid each time a fund manager churns the portfolio. This leads to higher expenses as well as riskiness of the assets. Therefore, it is also important to look at the portfolio turnover of the fund before investing in it.

With this, we kick off our series on fund analysis in all earnest, wherein all due care will be taken to ensure that a completely objective analysis of funds comes to the table of our readers. This endeavour is intended to put forward more investible ideas to our readers and add value to their investment.

In A Nutshell
When selecting a mutual fund for investment, find a fund that agrees with your own objectives.
Check the securities where the fund has invested.
Pay attention to the expense ratio.
Avoid mutual funds with high turnover ratios.
Look for an experienced and disciplined management team.
Compare returns with the appropriate benchmark for your mutual funds.

 

Find More Articles on: Personal Finance, Mutual Funds, DSIJ Magazine, Special Report

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