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How To Become
Your Own Financial Planner?

An exclusive Program To Develop The Skills To Manage Your Personal Finance

We believe by signing up for the initiative, you too endeavour to develop the skills needed to understand the nuances of personal finance and be money-wise.

Module IV: Prudent Ways To Plan Your Investments

Now that you've understood the financial mistakes to avoid and the importance of asset allocation, let us move on to the next important topic of this module...

Session 12: How To Select Winning Mutual Funds?

With a plethora of mutual fund schemes to select from, the task of picking the best mutual funds can be challenging.

While there's information galore that addresses this issue, 'information overload' may add to the confusion rather than simplify the task to select a winning mutual fund scheme!

Each mutual fund scheme could be unique, and it's important to recognise if it caters to your risk profile and investment objective.

Selecting best mutual funds is a rigorous process, where you need to pay heed to both quantitative and qualitative parameters. It is important to have consistently performing mutual fund schemes in your portfolio that can stand by you in good stead during sickness and health.

And going with a star-rated mutual fund is not enough, as usually many of these ratings take into account only quantitative parameters: risk-return trade-off, AUM, portfolio concentration, expense ratio, and so on.

The important qualitative factors that are critical to select consistent performers are often ignored, and hence, you find a 5-star rated fund today, becomes a 2-star rated fund a few months down the line.

Moreover, ratings subscribe to the "one size fits all" approach. But in reality you may need another fund to accomplish your financial goals. Remember investing and financial planning are personalised activities - you cannot generalise it. A mutual fund scheme could be right for one investor and (despite its sterling performance) be completely unsuitable for another.

Perhaps, as a starting point, you may look at ratings. But as a responsible investor, you need to evaluate mutual funds far more carefully before investing.

In this session we'll take you through a scientific approach on how to pick the best mutual fund scheme for your portfolio.

So, let's talk about...

8 Factors to select winning mutual fund schemes

  1. Performance:

    The past performance of a fund is important in analysing a mutual fund. But, remember that past performance is not everything; It is not THE ONLY factor as past performance may or may not be sustained in the future.

    For a prudent evaluation, you need to do...

    • Comparison analysis - A fund's performance in isolation does not indicate anything. Hence, it becomes crucial to compare the fund with its benchmark index and its peers, so as to deduce a meaningful inference. But when you compare be careful so as to not compare apples with oranges.

    • Time period - It's very important that investors have a long-term horizon (of at least 3-5 years) if they wish to invest in equity oriented funds. So, it becomes important for them to evaluate the long-term performance of the funds. However this does not imply that the short term performance should be ignored. Besides, it is equally important to evaluate how a fund has performed over different market cycles (especially during the downturn).

      During a rally, it is easy for a fund to deliver above-average returns; but the true measure of its performance is when it posts higher returns than its benchmark and peers during the downturn.

    • Returns - Although return is one of the most important, it is not the only parameter. Many investors simply invest in a fund because it has given higher returns. In our opinion, such an approach for making investments is incomplete. In addition to the returns, one also needs to look at the risk parameters, which explain how much risk the fund has undertaken to clock higher returns.

    • Risk - To put it simply, risk is a result or an outcome that is other than what is / was expected. The outcome, when different from the expected outcome is referred to as a deviation. Risk in case of mutual funds is measured by Standard Deviation (SD or STDEV) and signifies the degree of risk the fund has exposed its investors to.

      It is vital to check the risk a mutual fund scheme has exposes to check, in order to have funds which fit in line with your risk profile.

      If two funds have delivered similar returns, then as a prudent investor you should invest in a fund with less risk i.e. the fund that has a lower SD.

    • Risk-adjusted return - This is normally measured by Sharpe Ratio (SR). It signifies how many returns a fund has generated vis-a-vis the risk taken. Higher the Sharpe Ratio, better it's performance.

      This parameter helps you know if the fund justifies the risk taken. Besides, it depicts whether high returns of a fund are attributed to good investment decisions, or to higher risk.

  2. Portfolio Characteristics:

    Where you need to evaluate aspects such as...

    • Portfolio Concentration - This parameter reveals the over-exposure of a mutual fund to a particular company or a sector.

      Funds that have a high concentration in particular stocks or sectors tend to be very risky and volatile.

      Hence, invest in such funds only if you have a high risk appetite. Ideally, a well-diversified fund should hold no more than 50% of its assets in its top-10 stock holdings.

    • Liquidity of the portfolio - It is also vital to take note of how much liquidity a mutual fund scheme's portfolio has, by assessing the quality of equity instruments and debt papers the fund holds.

      Liquidity reveals the ease with which the portfolio - equity and debt - can be converted into cash. Hence, higher liquidity is always preferable.

    • Portfolio Turnover - The portfolio turnover rate refers to the frequency with which stocks are bought and sold in a fund's portfolio. It also depicts whether the fund manager of the respective fund holds his portfolio with conviction towards the long-term fundamental portrayed by the security, or does he indulge in mere momentum playing.

      Higher the turnover rate, higher the volatility. The fund might not be able to compensate the investors adequately for the higher risk taken.

      Remember: Invest in funds with a low turnover rate if you want lower volatility.

    • Average Maturity, Modified Duration, Yield To Maturity (YTM) - These parameters are important while evaluating debt mutual funds.

      The average maturity refers to weighted average time until all securities in a debt portfolio of a mutual fund mature. Lower the average maturity; the better it is in terms of the interest rate risk and lower volatility.

      Modified Duration (MD), reflects the responsiveness of the debt securities' price to the change in interest rate scenario. It is based on the inverse relationship between the price of the bond and interest rates. Taking this parameter into consideration reveals the volatility of the debt portfolio.

      YTM refers to the expected rate of return anticipated on a debt portfolio, if all instruments in the portfolio are held till maturity. It is also commonly referred to as the yield on the debt portfolio.

  3. Fund Management:

    The performance of a mutual fund scheme is largely linked to the fund manager and his team. Hence, it's important that the team managing the fund should have considerable experience in dealing with market ups and downs. As mentioned earlier, investors should avoid funds that owe their performance to a 'star' fund manager. Simply because if the fund manager is present today, he might quit tomorrow, and the fund will be unable to deliver its 'star' performance without its 'star' fund manager. Therefore, the focus should be on the fund houses that are strong in their systems and processes.

    Remember: Fund houses should be process-driven and not 'star' fund-manager driven.

    While you form a view on the fund management team, take a look at:

    The number of schemes the fund manager is managing (If he's managing too many schemes, the overburden would lower the efficiency. So ideally, a fund manager should not solely manage more than 4 to 5 schemes, as any number beyond this would reflect increasing pressure on the fund manager, which may result in reducing efficiency and replicating the portfolio, which consequently may defeat the unique mandate of each scheme he/she has managed.)

  4. Cost of investing:

    Here you need to evaluate the expense ratio and exit load...

    • Expense Ratio: There are annual expenses involved in running the mutual fund include administrative costs, management salary, overheads etc. Expense Ratio is the percentage of assets that go towards these expenses. Even though expense ratio is a fraction of the NAV, it eats into your investment value. So remember to invest in a fund having low expense ratio and stay invested in it for a longer duration.

      -Exit Load: An exit load is charged when you sell units of a mutual fund within a particular tenure; most funds charge if the units are sold within a year from date of purchase.

      Along with these factors, as an investor, you should also look into the fund house before investing in the Mutual Fund.

  5. Facets of a fund house

  6. Fund sponsor with integrity:

    Sponsors are individuals or entities who initiate the process of forming a mutual fund. While SEBI would grant permission to start a mutual fund only to a person of integrity, with significant experience in the financial sector and a certain minimum net worth; it is imperative for you to be satisfied (by your own judgement) on these aspects.

  7. Judge the credibility:

    In order to judge the credibility of a mutual fund house, you must read two things in the offer or information document...

    • Investor grievances - You see, every fund has to disclose the status of investor grievances in the statement of additional information/offer document/prospectus of the fund. The mutual fund house has to reveal the number of queries and complaints received towards a particular scheme and the complaints that have been addressed. This information shows you, how proactive and responsive a fund can be towards investor grievances.

    • Penalties & pending litigation - Every fund has to disclose the penalty imposed on the mutual fund house or the fund sponsor for any economic offence or violation of any securities' laws. Also they have to disclose any pending litigation or proceedings towards the mutual fund, fund house, trustees, associated companies, or the directors of the mutual fund house.

  8. Investment philosophy, processes and systems followed at the fund house:

    It is noteworthy that, processes and systems followed at respective fund houses have a major impact on individual mutual fund scheme's performance. Thus, it is important for you as an investor to delve a little deeper in understanding these aspects before entrusting your hard earned money to respective fund houses, in the mutual fund schemes they manage.

  9. Investment style - Generally, every mutual fund house has a forte in a particular fund management style i.e. value, growth, blend, opportunities; and even a market capitalisation bias: largecap, midcap, smallcap, micropcap, multicap, flexicap, etc. Thus it is vital to assess this, in order to see what suits your need.

Finally, here are some key takeaway points...

Points to Remember

  • Care should be taken while selecting mutual fund schemes so as to have the appropriate ones that can help you meet your financial goals. Remember each mutual fund scheme is unique and caters to a certain risk profile and investment objective. Therefore, hold mutual fund schemes from the respective categories that can help you meet your investment objectives.

  • Consider both -- quantitative and qualitative factors - to select best mutual funds for your portfolio.

  • Analyse performance holistically rather than looking only at past returns.

  • Evaluate mutual fund schemes over the bull and bear phases of the markets.

  • Gauge the risk (measured by the standard deviation) a fund is exposing you to.

  • Risk taken should commensurate with the returns generated by the mutual fund scheme; so...check the Sharpe Ratio.

  • Higher the Sharpe Ratio, better the fund's performance.

  • Compare mutual fund schemes prudently with their peers and benchmark because a fund's performance in isolation does not indicate anything. And judge over a longer time horizon of at least 3 to 5 years

  • Check the portfolio characteristics, wherein see: portfolio concentration, liquidity of the portfolio, portfolio turnover ratio, average maturity, modified duration and YTM.

  • Know the fund management team well.

  • Ascertain the cost of investing by checking the expense ratio and exit load levied by the mutual fund scheme.

  • Also, determine the taxation aspect of a mutual fund scheme before investing

  • Do not rely heavily on star ratings when choosing mutual fund schemes. Do your own homework and select those that fit your requirement. You see, most star ratings are on the principle of "one size fits all"; which is not the case in reality.

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