How to select a Mutual Fund — Part II
In the previous post, we learnt about primary factors for selecting a Mutual Fund. After selecting the mutual fund category on the basis of investment objective, time horizon and risk tolerance, you can select a mutual fund scheme within the category on the basis of following parameters:
Investment Strategy
It is important as an investor that we understand the investment strategy of the fund that we would like to invest in. The investment strategy should align with our investment objective in order to achieve the desired returns. For example, if your objective is long term wealth creation with low risk, then a large cap fund should be your preferred choice and not a small cap fund where the risk involved is the highest with volatile returns.
Fund performance — Past & Future
The next thing to consider is the consistency in performance of the fund. It is sometimes seen that a fund achieves an average of 10%-11% over a period of 5 years, however, the underlying annual returns for each year can be -10%, 25%, 8%, -5% and 39%. One should look for a fund that is consistently delivering similar (and desired) returns year on year (YoY) which indicates a stable and dependable performance.
Another crucial thing to note is that past performance doesn’t ensure similar performance in the future. You should understand the investment philosophy of the scheme and analyse the holdings of the scheme to gauge its future performance. You should select a scheme where you believe the scheme holdings include stocks and other financial instruments that shall outperform in the subsequent period.
(Pro tip — invest a part of your corpus in schemes that are inclined towards stocks research & development or innovation, because financial markets handsomely reward innovation)
Fund performance — against Peers & the Benchmark
Evaluating the performance of the fund against its peers & benchmark can give useful insights. If a fund is delivering lower returns than its peers or the benchmark, then it indicates that the fund isn’t being optimally managed. Though it is difficult to achieve the best returns across category every year, constant underperformance is a sign to move on to other better performing schemes.
Fund manager
Behind every successful mutual fund there is a fund manager. Investors generally tend to overlook this critical aspect. It’s the ability and experience of the fund manager that drive a fund’s performance. Hence, investors should review the portfolios of the funds managed by the fund manager and the manager’s past track record, especially during the turbulent phases of the economy.
Check out the fund manager’s years of experience in managing the particular fund. Also, you need to ensure that the fund manager who was at the helm of the fund during its high performance is still there managing the fund. A successful fund with a new manager is as good as a new fund.
Assets under Management (AUM)
The AUM of a scheme is nothing but the total market value of investments of the particular scheme. AUM is only one aspect used in evaluating a fund. It is usually considered in conjunction with management performance and management experience.
Generally investors can consider higher investment inflows and higher AUM comparisons as a positive indicator of quality and management experience. In a nutshell, AUM is a good way to assess a fund’s popularity and performance. But your decision to invest or not shouldn’t be solely based on it.
Expense ratio
The expense ratio is the fee charged by the fund, from the investors for managing their money. In other words, it goes on to reduce your total returns from the fund. This expense ratio has been capped at 2.25% by the SEBI.
As an investor, you should look for schemes with lower expense ratio as the percentage might seem small but can have a deeper impact when compounded over several years. The expense ratio can be co related to the AUM, and it is believed that higher the AUM, the lower the expense ratio.
Direct plans of the mutual fund schemes should be chosen over regular schemes as no distribution commission is paid to the intermediaries in case of direct plans.
Exit Load
Exit load is levied when one exits from a mutual fund scheme earlier than a pre-defined timeline. It is important to check the exit load norms while selecting a fund as our financial needs are unpredictable and in case of an emergency, we might need to withdraw our investment prematurely than envisaged earlier. However, if one invests for the long term, more often than not the exit load becomes nil. To sum up, it is advisable to choose plans with no or minimal exit loads.
Asset Management Company (AMC) Performance
An AMC, also known as the fund house, is the company that manages various mutual fund schemes. There are close to 44 registered AMCs in India, for example, Axis Mutual Fund, Mirae Asset, HDFC Mutual Fund, Kotak Mutual Fund etc. Many decisions are made at the AMC level by the Chief Investment Officer (CIO). Often a few stocks, whether poor performing or not are present across all the schemes managed by the AMC. Thus, it is important to check the track record of the AMC whole selecting a mutual fund.
All the above-mentioned information for each fund can be found online on various portals. I use moneycontrol.com, paytmmoney.com and the AMC websites for my analysis. There are other platforms available like Groww, Coin, Kuvera, Value Research, etc where you can find similar functionalities.
This culminates the two-part series on the process of selecting a mutual fund. This selection process is based on my experience and learnings with my own investments and my interactions with other investors. Though this is not a holy grail for investing in mutual funds, it should suffice to get you started with. Over time you will have your own learnings and can tweak the above methodology to suit your investment style. If you are already an investor and want to discuss more on this, feel free to reach out to me on Linkedin.
