How to select the best mutual fund
In my seminars and workshops, I am often asked this very innocuous question: “So, which is the best mutual fund to invest in? How to select the best mutual fund?” Well, the simple answer to that question is that there is no such thing as the best mutual fund. If such “best” mutual fund existed, then everybody in the world would have invested in it and in no other fund. This is similar to asking “Who is the best batsman in the world?” Even if you decide that a certain Mr. Tendulkar is the best batsman, would that necessarily mean that he would score a century in the next match being played? If Mr. Tendulkar had scored a zero in his previous innings, would you not include him in the team for the next match? Team selection is based on consistent, top class performance. Simple enough, selection of our Mutual fund investments is also based on consistent, top class performance.
However, even before we get into performance, there are other things that we need to understand. This article tries to break down the Best Mutual fund selection process into simple steps that can be followed by any investor. Even if you cannot follow all the steps, you should still be able to select a decent fund with the help of the steps that you could follow.
1.Understanding Asset Classes
Let us classify all Financial Assets into 4 asset classes, namely Equity, Debt, Cash and Gold. Equity is like investment in a partnership business. Your partner manages the business and you simply share the profits/ losses. The returns can be very high, but the risks are also higher. Debt is like loans given to acquaintances. You earn an agreed interest income and your money hopefully comes back.
However, there is a risk that the person who took the loan defaults and does not pay back your money. Cash is money that is freely available for you to do anything you like with it. You can either use it to order a pizza, buy the latest mobile phone or invest it in any other asset. Gold should be looked at as a store of value. It is a hedge against inflation. It also protects the portfolio when everything else seems to crash.
When we invest in a mutual fund, we are indirectly investing in a particular asset class
Thus, Equity funds invest in Equities, Debt funds invest in Government and Corporate debt, Cash or Liquid funds invest in Short-term debt instruments that can be easily and quickly converted into cash and Gold funds invest in Gold.
2. Understand associated Risks
Every asset class is exposed to certain risks. Most of us understand the risk in equity. We call this “market risk”. In simple terms, we know that prices of equity shares keep moving up and down. This can result in losses. For example, if we buy a share and its price falls thereafter, we suffer a (notional) loss. However, when you give loan to a person, he/she may not return the money. The risk of such loss is called Credit risk. Just like Equity, gold prices also fluctuate and are subject to market risk.
Keeping money in the form of cash may feel safe, but unless our money grows at-least at the rate of inflation, our money is losing value in real terms. Thus, all asset classes are exposed to some risks. There is no “risk free” investment. We should choose our investments based on our risk-taking capability. When it comes to mutual funds, we can evaluate mutual fund schemes on the basis of “risk adjusted returns”.
3. Determine Financial Goals (Investment Objective) and Time Horizon
Investments are a means to meet our financial goals. For example, we aspire to buy a car, go for a vacation, provide for our child’s education or for our own retirement. Some of these goals may be short term, while others could be long term. For example, a 25 year old person planning for retirement is a long term goal. A 45 year old person planning for post-graduation of his 18 year old daughter is planning for a short term goal. Understanding why we are investing and how much time does our investment have to help us meet our goal is very critical in the choice of appropriate mutual fund.
4. Asset Allocation
Just like a balanced diet is essential for our health, asset allocation is necessary for our financial health. Our financial goals will define our asset allocation. Long term goals will allow us to invest more in equity funds, whereas short term goals are best met through debt and liquid (or cash) funds. A sample, non-goal based asset allocation could be to have 40% of our money in equity, about 15% in Gold, 25% in Debt and the balance of 20% in Liquid funds. Asset allocation ensures that our portfolio is prepped up with equity, but the downside is protected with debt funds. Gold provides the perfect foil for a crisis in financial markets.
5. Understand Sub Asset Classes
After deciding the allocation across the 4 asset classes, we need to get deeper into each asset class. For example, Equity mutual funds could be further classified into Large Cap, Mid Cap and Small cap funds. Large Cap funds invest in large sized companies such as Tata Steel, L&T, TCS, etc. Mid Cap funds invest in relatively smaller companies that have the potential to become large companies in future. Small Cap funds invest in relatively small and unknown companies. The risks, as well as returns, are relatively lower in the case of Large caps. They progressively increase as we move to mid-caps and then to small caps. Similarly, all debt funds are not the same. There are Gilt funds, which invest only in Government Securities.
Bond funds invest largely in Corporate Bonds. Some funds make investments based on their prediction of interest rate movements and their impact on bonds (called Duration funds), while some focus on earning interest and minimizing the impact of fluctuation in interest rates (Accrual funds). Based on financial goals, our risk profile and time horizon, investment in each asset class has to be further sub-allocated into the sub-asset classes. For example, out of the money allocated to Equity, about 60% can be allocated to Large Cap funds and 40% to Mid and Small Cap funds. Similar allocations need to be made for Debt.
6. Fund House
Now that the categories in which we need to invest are decided, we have to start shortlisting the specific funds in each sub-asset class. One way to begin, particularly if you are new to investing, is to short-list a few fund houses. This is blatantly unfair to new asset management companies. It might also work to our disadvantage if a relatively new fund outperforms the market. However, mutual fund investments need trust and confidence, which cannot be earned in a short period of time. If a fund house has been existing for a long period of time, it would have seen the ups and downs of the market.
A new fund can also be considered, provided it has been launched by an entity which has strong credentials. Choice of a fund house with strong pedigree is some sort of insurance against risks such as fund manager not sticking to investment objectives, fund manager going overboard in his/her positions, etc. We can reasonably expect the fund to have processes and policies in place. It is just that you want to go with a “trusted and tested” partner. While you can have your own criteria for shortlisting the fund houses, one basis could be the number of years of operation. You can consider only those fund houses which have been in the business for more than 10 years.
7. Fund Size
We must remember that mutual funds charge us for their services. This is because they incur expenses such as rent, salaries, travel, etc like any other business. If the fund is managing a large amount, these expenses get spread over a larger corpus. Thus, as investors in a large fund, we get “economies of scale”. A large fund is a testimony to the fact that it is being trusted by a large number of people. We get the “comfort of numbers” although that should not be the reason for our choice. An equity fund managing at least Rs.2000 crores would be a good cut-off criterion.
8. Fund Performance
This is probably the most important criteria. The standard disclaimer made by any fund house, portfolio manager or advisor is that past performance may not be repeatable in future. However, past performance cannot be ignored. If we have shortlisted funds which have been in existence for more than 10 years, we get to see how these funds have performed over a long period of time. However, apart from looking at returns across different periods, we should look at Risk. If one wishes to just look at risk, standard deviation indicates the risk inherent in the portfolio. Higher the standard deviation, higher is the risk. Risk-adjusted returns tell us how much return the fund has earned for a given unit of risk taken. While this looks complicated, tools such as Sharpe Ratio and Treynor’s ratio are measures of risk-adjusted return.
9. Fund Manager
Often, the performance of the fund is the direct result of the calls taken by a smart and savvy fund manager. However, in such cases, the fund performance can dip when the fund manager quits. Hence, we need to know whether the fund is managed by only one person or by a team. We should look at total years of experience of each of the fund manager as well as their association with the fund currently being managed by them. One should also look at the performance of other funds that are being managed by the fund manager.
The association of the fund manager with the fund and its performance during the corresponding period can give us some insights into the quality of the best fund manager. If the fund manager has been managing the fund across the ups and downs of the market, it gives us greater comfort in his/ her ability to steer our money into the uncertain future.
10. Portfolio Diversification and Portfolio Churn
Do take some time to study the portfolio of the fund. Do all stocks look the same? For example, do the top picks consist of HDFC Bank, ICICI Bank and SBI? One of the reasons we choose a best mutual fund is to benefit from diversification. If the fund is having too much concentration in a few stocks or sectors, then the purpose is not served. Too many changes in the portfolio is not an encouraging sign.
11. Loads, Commissions, and Fees
This is probably the least emphasized aspect of best mutual fund selection. Mutual fund investments are subject to various expenses such as loads and commissions. Thankfully, entry loads are now restricted to Rs.100 and no longer percentage based. Exit loads discourage investors from redeeming their investments before a certain time and are a blessing in disguise. The big robbery is in terms of commissions. It is very easy to avoid these hidden charges. Having short-listed a fund, simply opt for the “Direct plan”. No broker or bank or online platform which does not charge you separate fees for their services will recommend direct plans for you. Online trading platforms like Jama, which charge you a nominal subscription or advisory fee, suggest ONLY Direct plans.
The differential when you buy a “Direct” vs “Regular” plan is significantly higher. However, you may not have the friendly broker helping you anymore. You will have to do it yourself, but as your experience with Jama proves, it is unbelievably simple. Suffice it to say that by subscribing to a Regular plan, you are allowing yourself to be robbed.
12. Feel good factor
Based on the above criteria, you would hopefully be able to shortlist a few funds under each category. You can choose any two out of your shortlist in each category. Which two of the short-listed funds should be chosen is best answered by your heart. You may prefer to choose one over the other for reasons that you might not be able to explain logically. That is perfectly fine. You will not be too much off target, if you have followed the earlier steps without much of a compromise. Ultimately, your choice of one best batsman between Dravid, Sachin, Laxman and Ganguly won’t land you in trouble, irrespective of the choice you made!
Based on the investment plan, the category of funds should be chosen from debt, equity or hybrid category. Within a category the right scheme can be selected based on criteria such as past performance of the scheme, comparison with peer set and benchmark, volatility measures and risk adjusted performance of the scheme, scheme size, expense ratio of the scheme.