Being one of the great instruments for wealth creation, mutual funds are highly popular with investors. However, there are different kinds of mutual fund schemes and choosing the right fund is essential for an investor for meeting his/her financial goals. Mutual fund investments are also subject to market risks and most funds have underlying assets that fluctuate in value.
Therefore, just investing in any fund is not enough. You also need to select your fund carefully as investing in mutual funds is still riddled with lots of perceptions, opinions and myths.
Here’re some parameters of selecting the right mutual fund schemes for you:
1. Right Match in Objective: The first most relevant component in knowing whether a mutual fund is right for you or not is to ascertain whether the funds’ investment objective and investment philosophy matches with yours (or not). You don’t go out and buy apples no matter how delicious or cheap they are when you really set out to buy was the floor cleaner.
Likewise, “an investor with a lump-sum money who would be in need for cash 6 months or one year hence, is advised to invest in an ultra-short term debt fund rather than an equity fund – regardless of the temptation of high returns. Similarly, there would be investors who would have a high-risk appetite and a long-time horizon for it, but would be invested in an equity savings fund in the mistaken belief that it is as good as diversified equity. I have seen such cases of mistaken assumptions. So, a right match of expectations and what the fund is likely to provide is very important,” says Lakshmi Iyer, CIO (Debt) & Head-Products, Kotak Mutual Fund.
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2. Low Cost: Mutual funds are limited by the maximum they can charge to the investor annually. It’s approximately 2.5% p.a. for equity funds and 2.25% p.a. for debt funds. But the competition for performance has seen the actual expense ratios going down voluntarily. An expense ratio differential can substantially impact the investment outcome over the long term due to the impact of compounding. Therefore, this fact must be kept in consideration while investing in a fund.
3. Tax Incidence: Tax liability on the investment choices can significantly impact the eventual realization. For that purpose an eye on this tax incidence before investing is a must. For instance, investment in equity funds is tax free provided the period of investment is more than 1 year. For investments redeemed within 1 year of investing, short-term capital gains tax becomes liable.
Likewise, “for the fixed income funds, the fund houses have to deduct dividend distribution tax. Capital gains realized within three year of investment invite short-term capital gains tax. Capital gains realized after three year of investment invite long-term capital gains tax incidence. So an investor has to factor in these things before deciding,” says Iyer.
4. Risk Metrics: This is another criterion on which the fund needs to be measured for suitability and position correction. Some funds within a similar asset category might be taking higher risks to generate better performance. So optically, the high performance number may lull the investors into believing that such a fund is a good investment idea. However, the comparison of the fund’s risk ratio vis-à-vis the peers provides a clearer picture. There are many statistical risk measures available online to give that input.
a. Standard deviation is one such measure, which shows the volatility in performance of a particular fund. A higher standard deviation implies higher volatility in return – and thus higher uncertainty of performance. For that reason equity funds usually have higher standard deviation while fixed income funds have low standard deviation.
b. “Other important risk measurement tools are beta and Sharpe ratio. Beta ratio measures the co-relation of the fund with the market benchmark. In simple terms, it tells the degree by which your portfolio is likely to move for per unit movement in the benchmark. Sharpe ratio measures risk adjusted return of your fund. Not getting into the details, the higher the Sharpe ratio, better is the fund usually,” informs Iyer.
5. Portfolio Quality: This is the qualitative aspect of the fund and as such is a difficult measure. Here the investor is advised to dissect the quality of the securities held by the fund, their growth prospects and the value inherent in it. Here the investor can also determine the outlook the fund manager has pertaining to the economy and whether that matches with views of the investor. An investor can take inputs regarding these issues from their respective financial advisors and formulate their own independent opinion.
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6. Portfolio Metrics: Measures such as portfolio turnover ratio, portfolio liquidity risk, and portfolio concentration risk help an investor in gauging the quality of the portfolio and the risk therein. This helps the investor get a perspective on how well the portfolio is structured for long-term growth and how well the portfolio is constructed to mitigate various market situations.
7. Fund Ranking/Rating: There are many independent research agencies of repute that do fund ranking and rating based on various criterions of performance, risk, portfolio quality etc. “An investor can cross check these ratings to corroborate his/her fund choice. However, there is a caveat here. These ratings/rankings do imply that the fund will have a good performance in the future. These ratings and rankings only measure the performance in the past,” observes Iyer.
8. Exit Load: Exit load of a mutual fund is paid by the investor when he redeems the investment before a certain period. Different types of funds have different exit loads, depending upon the nature of assets held by them. “Exit loads are imposed to discourage premature withdrawals. Fund managers who manage schemes meant for the long run would like their investors to stay invested for long tenures. It is, therefore, important to check exit load of the mutual fund scheme as you might need money before investment horizon. Try to invest in schemes with minimal exit load requirement,” says Saravana Kumar, CIO, LIC Mutual Fund.
9. Quartile Performance of the MF Scheme: Each mutual fund is assigned a rank based on trailing annualized returns. Mutual funds are categorized into four quartiles, namely Top Quartile, Upper Middle Quartile, Lower Middle Quartile and Bottom Quartile. Quartile rankings are a measure of how well a mutual fund has performed against all other funds in its category. “Many mutual fund research websites publish the quartile performance of mutual fund schemes. The rankings range from “Top Quartile” to “Bottom Quartile” for all time periods. While you may want your scheme to be in the top quartile, what is even more important is the consistency of quartile ranking across several quarters,” says Kumar.
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10. Fund House: The quality and reputation of the fund house has an important bearing on the fund selection. Well-managed fund houses are able to invest in their investment processes, knowledge management and investor servicing. They are also able to institute technology-enabled risk monitoring systems and performance attributing tools. These elements make such organizations more performance-centric and risk prudent.
These are some of the ways an investor can choose and churn his/her mutual funds’ portfolio. However, those who have limited time should find a good investment advisor, thrash out an investment plan with him/her, follow it, and then monitor it from time to time.