 "MF products galore: How to choose the right mutual fund for yourself")
More than half of India's investors ( 59 per cent) still consider past performance as one of the key benchmarks for investing in mutual funds and tend to redeem their investments within two years even though they are aware of the importance of long-term investing and the power of compounding, according to Axis Mutual Fund Survey.
According to data by AMFI, 22.2 per cent of equity investors stay invested for 12-24 months and in total 48.7 per cent of equity investors redeem their portfolio within two years or less.
One of the most common mistakes that investors (especially first-time ones) make is to evaluate and select mutual funds based on short term past returns. Often, investors are lured with 1–2 year returns that are abnormally high, without realizing that what goes up, comes down and vice versa.
How to choose the right mutual fund:
The right way to select a mutual fund is on the basis of your financial goals. Hence, the first question to ask yourself if “why am I investing?” rather than “where should I invest?”
Approaching your mutual fund investments in this manner will bring a lot more clarity and focus into your investing strategy, automatically ensuring that your investment risks are aligned with your target time horizon.
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"Having established your goals clearly and decided which category (large cap, small cap, index etc) is appropriate, you should now go about selecting a fund within that category that has a long-term track record of outperformance across market cycles. The fund management team should also be high pedigree, and the fund itself must be true to label. The asset management company should be one with high standards of governance, with a great risk management framework," said Aniruddha Bose, Chief Business Officer, FinEdge.
While past returns, popular brands, and star ratings are obvious factors to consider, one should remember that returns cannot be controlled. However, the process of selecting the right mutual fund can be controlled. To do so, one must focus on a combination of parameters, not just short-term past returns. Some of the key ones include but are not limited to stable fund management, true-to-label funds, and capture ratios.
Don't over-emphasise the fund's past performance:
"Retail investors often overemphasize fund selection and underestimate the importance of a robust goal and adherence to the investment strategy. Even while selecting mutual funds for investments, they overemphasize a fund's past performance," said Ajinkya Kulkarni, Co-Founder and CEO, Wint Wealth.
What you should do instead:
Assess the fund's performance relative to benchmark indices like Nifty 50 or Sensex, examining its returns over various time horizons, such as the past 1-year, 3-years, and 5 years.
Performance comparisons must be used only to compare the same type of fund. They are meaningless otherwise. Only when used within the same category of funds do performance numbers tell you anything at all.
"Look for a fund which has a performance over a full market cycle. I like a fund which actually falls less than its benchmark in a falling market and rises little more in a rising market. This means that here is a fund which will not be extraordinary but if it does little better in a falling market and does a little better in a rising market, overall it will do exceptionally well," said Dhirendra Kumar of Value Research.
"If you plan to invest in an Equity Linked Savings Scheme (ELSS) or a tax-saving fund, remember that your investment will be locked in for at least 3 years. Consequently, it's prudent to analyse the historical performance of different ELSS or tax-saving mutual funds to make an informed choice. You can apply this strategy to choose any mutual fund. However, it's crucial to keep in mind that past performance acts as an indicator but doesn't guarantee future returns in mutual funds, given the influence of various factors like the fund's investments, sector-specific performance, and other variables," said Adhil Shetty, CEO of Bankbazaar.
For a more detailed analysis, you can delve into portfolio allocations, the age of the fund, market capitalisation, and the sectors in which your mutual fund invests.
Bankbazaar explains with the following example: Suppose you invest Rs 10,000 in a mutual fund that offers a 12% return over a period of 5 years. Initially, you invest Rs 6 lakh, and over the course of those 5 years, you earn an additional Rs 2.25 lakh as interest. After this time frame, your fund's value would have grown to Rs 8.25 lakh. This demonstrates how your investment in a mutual fund can lead to significant growth in your capital. The beauty of mutual fund investments is that you can start with as little as Rs 500 per month and go as high as Rs 20,000 or even more.
Fund selection can be simple with Index Funds
Fund selection can be simplified by sticking to index funds across categories. Since index funds aim to mimic their underlying benchmark, such as Nifty-50, Nifty-Next 50, etc., we can choose a fund showing minimum tracking error (the annualized difference between the standard deviation of the mutual fund and its underlying benchmark).
"Hypothetically, if NAVI NIFTY-50 has a tracking error of 0.01% compared to 0.03%, NAVI's Nifty-50 index fund will be better aligned with the returns of Nifty-50," explained Kulkarni.
Look at the expense ratio:
The second filter is the expense ratio. Between two index funds tracking the same index, the one with a lesser expense ratio will be cheaper. Since index funds do not rely on the stock-picking skills of a fund manager, the other variables are less relevant than an actively managed fund."
Riskometer: According to the Axis Mutual Fund survey, even though 89 per cent of investors believe that understanding ‘risk appetite’ plays a role in choosing the right mutual fund, only 27 per cent of investors said that they took their risk appetite into consideration before investing. The survey reveals that 53% of investors are not very confident of personal risk assessment while choosing a mutual fund.
It is imperative to understand that each investor has a different risk appetite based on his/her investment profile, financial goal, and needs.
The mutual fund riskometer is a representation of the risk associated with a mutual fund scheme. It is based on a six-level scale, from low to very high, with each level represented by a different colour. A conservative investor may want to choose a fund with a low or low to moderate riskometer rating. If you are a more aggressive investor, you may want to choose a fund with a moderate to high rating.
"Analyze the fund's risk level by understanding the risk the fund manager takes, as indicated by metrics such as standard deviation and beta. Evaluate the track record of the fund manager across different market cycles. Fund size is another crucial aspect; excessively large or minimal funds may face liquidity challenges, so ensure the fund can maintain sufficient liquidity, especially during periods of high redemption pressure," said Soumya Sarkar of Wealth Redefine.
Diversification: Diversification within the fund's holdings is essential. " Check if it spreads across various sectors and asset classes to mitigate concentration risk. Also, compare the fund's performance against its benchmark; if it consistently outperforms, it's a positive sign, but if it lags, exercise caution before investing," said Sarkar.
"See if the portfolio is diversified enough. If yes, then I would say that all the returns have not been a matter of accident, it has been done by somebody's wise selection of securities in the portfolio and building it in a manner which was opportune. This is because there are situations when a fund manager goes right with a specific sector or a specific stock and that could be resulting from a very concentrated portfolio," said Value Research's Kumar.
Management: Value Research believes that when you are buying a fund because you like its track record, what you are actually buying is a fund manager's (or sometimes a fund management team's) track record. What you need to make sure is that the fund manager who was responsible for the part of the fund's track record that you are buying into is still there. A high-performance equity fund with a new manager is like a new fund.
"Avoid fund houses with only a couple of performing funds managed by a sole star fund manager, as fund performance often suffers when they leave. It is important to review capture ratios (up-market/down-market) to assess a fund's performance relative to benchmark and peer funds. Likewise, investors must pay attention that the underlying portfolio composition is aligned to what the name of the fund suggests," said Deepak Gagrani, Founder of Madhuban Finvest .
Cost: Funds are not run for free, nor are they run at an identical cost. While the difference in different funds' cost is not large, these can compound to significant variations, especially for fixed-income funds where the performance differential between funds is quite small to begin with.
"Go to the 'Fees and Details' section to examine the expense ratio and exit load. This is a smart move because why should you pay unnecessary fees to a mutual fund.Expense ratio and exit loads are fees charged by a mutual fund for various reasons. Hence, the lower the better," said Ravi Banagera of Value Research.