1. Select low-cost funds

Costs play a crucial role in shaping long-term return of any investment. Seriously, costs matter. As the dust settles and our funds travel through the cycles of the market, which they haven't yet, a low expense ratio will increasingly become the most important reason for a fund's success. So, carefully consider the role of the expense of a fund in shaping its returns. And regarding cost, soon little things will mean a lot. With the average fund portfolio turnover of 120 per cent per year for the top 10 equity funds, I wonder if it is long-term investing? These turnovers carry transaction costs that reduce returns by as much as 1/2 to 1.0 percentage points on top of the fund expenses. So its time to consider funds with low-turnover.

2. Consider carefully the added cost of participation

The sales load is supposed to be a cost for an investor who needs assistance in making an informed choice and guidance in allocating assets and selecting funds. Many investors need them. But given the structure of the fund distribution, does one really get that for the cost? And many of the fund investors today do not need it anyway - as mutual funds' appeal being its simplicity and the new generation fund investor being self-reliant, intelligent and informed who takes his decisions without an intermediary salesman. Assuming the funds are properly selected, a no-load fund is the least costly way to own mutual funds. A no-load fund will consume the lowest possible proportion of your future returns. Avoid fund with steep entry load, as it can be a drag on performance.

3. Do Not attach great importance to a fund's past performance

Past performance is an alluring lure to most investors - new and experienced. The fund's past "track record". The track record may be a helpful pointer in a horse race, but can be highly misleading in case of funds. There is simply no way to forecast a fund's future absolute returns based on its past record. And even if one can accurately forecast future market returns, there is no way that relative fund returns can be forecast.

The secret lies in over-coming the lure. Haven't you recently come across the two-month return of SBI Sector Funds, boldly announcing the fantastic return over the past 60 days. It is likely that top performing funds can lose their edge. Funds persist in promoting their most successful past performance for understandable reason as it brings in lot of new money and new fees to the AMC.

But this strategy defies investment rationale and leads investors in wrong direction. Ignore past performance numbers, and shut your eyes altogether to short-term performance.

4. Use past performance to gauge consistency and risk

Nonetheless, past performance does play an important role in your fund selection. While you should disregard a single aggregate number showing a fund's past long-term return, it can help learn a great deal about the nature of its past returns and the all important consistency of return.

Careful analysis of past performance can also reveal a lot about risk - the key element in investing. As relative fund returns can vary randomly from one period to the next, relative fund risks carry a reasonable degree of consistency. To guard your assets, don't ignore risk.

5. Beware of superstars

The emergence of private sector funds has lead to the emergence of superstar portfolio managers. And the fact is that there are a precious few. And even the temporary superstars we have, are more likely to have a limited longevity, as they haven't been through a full market cycle yet. It is not their mistake, as the first private fund was flagged just over five years ago. And the unknown old star managers of UTI and other bank-sponsored funds have not come up to stake a claim on the performance credit, for obvious reasons. And unfortunately, the star will never be knows before he becomes one. Look for good managers and rely on their professionalism, experience, and tenacity rather than stardom.

6. Beware of Huge Funds - Prefer an Index fund to a Goliath

Funds can get too big for their own peril. Hope you have not yet forgotten Mastergain and Morgan Stanley. Avoid large funds letting themselves grow to seemingly infinite size, beyond their power to differentiate their investment results from the herd and irrespective of their investment goals.

Something too big is also complex and you cannot relate to the fund's style, management philosophy and portfolio strategy. And going by the performance of the large equity funds of UTI, which have delivered returns identical to a broad based unmanaged Index, why not choose a relatively low cost index fund instead.

A broad-based market index fund should be able to grow without any size limits. A giant fund, say Rs 2000 crore Masterplus investing in large-cap stocks, with very little portfolio turnover, can be managed effectively, albeit not for truly exceptional returns. For a fund investing aggressively in infotech stocks, even Rs 300 crore might be too large. Kothari Pioneer Infotech, the block-buster started as a Rs 7 crore fund just an year ago. And on September 30, 1999, it has Rs 120 crore under management. I wonder it is as easy or difficult to manage the fund, given the breadth of Indian Infotech Industry. Besides this, many of our star fund managers can easily be termed as momentum riders. And growing size of a fund can be serious handicap in pursuing the momentum strategy. The present and potential size of a fund is important. Huge size can and very likely kill possibilities of investment excellence. For a vast majority of the stellar returns in recent years, the best years have been when they were small.Vigorous growth in terms of size for an equity fund should be a warning to an intelligent investor.

7. Avoid Over-diversification

To my understanding, a single balanced fund with 65 per cent equity allocation and 35 per cent debt allocation can meet the needs of many investors. And a pair of equity and debt funds with a custom-made balance can meet the needs of many more. I seriously wonder, what is the optimal number of funds for investors to own? To keep it simple, I think not more than three or four. Owning too many equity funds easily results in a dangerous combination of over-diversification and excessive cost. There is no rationale for owning as many as 20 diversified funds in a portfolio and thereby owning at excessive cost, perhaps 2,000 stocks. Perhaps a simple balanced portfolio with three equity funds and a debt fund would suit the needs of investors seeking active equity management and willing to accept marginally better or worse than the market returns.

8. Build, maintain and hold your portfolio

Once you decide on your long-term financial goals, define your risk-tolerance and carefully select funds that meet the above rules, then follow this. Hold tight. Stay the course. Sleep Tight. Complicating your investments will merely add to the clutter and you will also run the risk of diluting your plan with unnecessary irrational emotions.

You can tightly hold your investments only if you own the right ones. And the right fund is not the one you don't understand, or the best past performer, or the one I tell you, or is managed by a star manager. But surely a low cost fund with consistent performance is more likely to be a long-term Star Fund.

-- Value Research