Mutual funds: How DIY investors should select funds

October 16, 2020 12:45 AM

Choose funds based on consistent performance across market cycles and not just a single period. Complement this with qualitative analysis which will give insights into how a scheme is likely to perform in the future

However, these could at best be starting points for the analysis of mutual funds.However, these could at best be starting points for the analysis of mutual funds.

By Ghazal Jain

Mutual funds are designed to make the investor’s life easier. Investors, who do not have the time, inclination or expertise to directly invest in stocks, choose mutual funds as a way to invest in equities. But with the vast number and variety of mutual fund schemes in the market these days, choosing a scheme itself has ironically become a complex task.

So what does a typical retail investor do when faced with this overload of options? He resorts to picking his schemes from the widely published top-ranked funds list of rating providers. These ratings are well-researched and reliable, based on quantitative metrics such as historical returns and risk performance of the fund, and how that stacks against the peer group.

Quantitative metrics
However, these could at best be starting points for the analysis of mutual funds. The top ranked funds keep changing and hence one should look for consistency and not necessarily the ones at the top. In addition, there are other quantitative metrics to look at like expense ratio, portfolio concentration levels, portfolio churn rate, etc., which may not form a part of the ratings analysis. Basing your investment decision entirely on backward looking performance data may not be a prudent thing. A high ranked fund may not be able to continue its outperformance in the future or a fund ranked low due to market conditions could be set for a turnaround. Even then a majority of investors do just that.

So what are investors missing? Well, there is an entire other side to fund analysis and selection—the qualitative criteria. After all, there are so many parameters that you can’t assess just by number crunching. The fund house’s investment systems and processes, consistency in characteristics of portfolio, whether the stock-picking style changes with fund manager, whether the fund has remained true to its mandate, whether the fund’s success is a result of well-researched decisions or not, and star fund manager risk are some of them.

Due diligence
These metrics require one to invest time, dig deeper and look beyond the surface. Many of these even require personal interactions with the fund managers. But the due diligence eventually pays off. You don’t get stuck with a fund that may not have followed processes and checks for risk mitigation, or one that is at risk if the star fund manager exits or one whose recent outperformance was driven solely by random chance or owning the flavour of the season. Thus, while quantitative metrics do give you a good understanding of the fund’s past performance, the qualitative aspects would help you recognize how a mutual fund scheme is likely to perform in the future, making it essential to consider both aspects in order to choose good mutual funds. The equity fund of funds category of mutual funds is one way for investors to do that.

The funds in this category invest in diversified equity schemes based on extensive qualitative and quantitative research. Not only are these schemes subjected to hard-core number crunching and detailed analysis, but they are chosen only after gaining valuable insights from one-on-one interactions with the fund managers themselves, something that retail investors don’t have easy access to.

For DIY (do it yourself) investors, it is important that they choose funds based on consistent performance across market cycles and not just a single period. And this exercise has to be complemented with qualitative analysis using available tools and resources. After all, good investment outcomes come from combining statistics with insights.

The writer is associate fund manager, Quantum Mutual Fund

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