Mutual funds are boon to investors who want to reap the benefits of investments but do not want to invest considerable time doing stock research themselves (i.e. want to leave the task to experts). A systematic investment plan into mutual funds puts your investments in auto-pilot mode and leverages the power of rupee cost averaging (i.e. a fix SIP buys more stocks in downturns and less in upswings, thus lowering average cost of stocks in a portfolio). However, it may sound easy to use mutual funds to start your financial journey, but often investors face difficulties w.r.t which mutual funds they should invest in from the basket of mutual funds available. Are you an advanced investor? Check out our stock recommendations here.
In this article we will discuss nuances of mutual fund selection, will do myth busting and look at certain fund performance indicators. I will be recommending certain mutual funds based on my personal assessment as well (for readers who do not want to personally analyse funds) but I strongly encourage readers to use the knowledge I am sharing here and find a mutual fund as per their needs.
Mutual fund performance indicators:
Funds average return over a period of time (1,3,5 years) versus returns from similar funds from other AMCs (Asset management Companies): This benchmarks skills of fund manager versus his peers and compares a fund performance with respect to other funds investing in similar companies. Given equity mutual fund investments should have an investment horizon of at couple of years, we should compare performance of mutual fund at yearly buckets as well.
Funds average return over a period of time (1,3,5 years) versus returns from market index of similar companies: This benchmarks a fund which is actively managed versus investment in a passively managed fund (like ETFs, Exchange Traded Funds) which invests in a category of stocks based on their market capitalisation. For example, benchmarking returns from a mid cap fund with NIFTY mid cap index, this will tell you what additional advantage you are getting by investing in that actively managed mutual fund vs. a low cost passive ETF. A point to note here is that actively managed mutual funds have higher cost charged to investors (which is reduced from returns) and hence only funds which significantly outperform ETFs are worthy of charging additional money from investors.
Turnover %: This metric explains what % of stocks are removed/added from portfolio in a given period of time (usually a year), that is, if a mutual fund invested in 10 companies on 01Jan2019 and on 01Jan2020 of these 10 stocks 7 are same but 3 are new, then turn-over would be ~30% (30% of portfolio changed during a year). This metric is useful to check how frequently your fund-manager is buying/selling assets in mutual fund. A high turnover is generally discouraged (unless the fund is an out-performer or market is highly volatile) because every buying/selling transaction incurs transaction cost which is passed on to investors thus lowering there returns. Also, given investment horizon of mutual funds is more than a year (generally), a high turnover often points towards short sightedness of fund manager. Thus between 2 funds performing equally well, an investor should choose the one with lower turnover.
Stability of fund management team: Every fund manager has a different investment style and hence frequent changes in fund managers brings in the risk of sub-optimal fund performance. An investor should choose a fund with a stable management team.
Stability of asset management company: We often hear about new AMCs launching new mutual funds, however, given mutual fund investments span over years span over years, if an AMC is not able to survive in the market for that long then it will end up selling its portfolio to another company and a new fund management team. This will expose investors to risks of misalignment between investment style of new versus old fund management teams, thus increasing risk of sub-optimal returns.
Star rating by rating agencies: Generally star ratings are backward looking and do not predict future performance, but they do provide a easy indicator with respect to mutual fund health.
Sharpe ratio [for advanced investors]: The Sharpe ratio is calculated by subtracting the risk-free rate from the return of the portfolio and dividing that result by the standard deviation of the portfolio’s excess return. This ratio explains the returns investors are getting for additional risk taken by them, i.e. if I invest in a risky asset (like stocks) versus Fixed deposit, I am taking additional risk (measured in standard deviation), is that additional risk justified by the additional returns I am getting (returns by fund - returns on national savings bond, ~7.5% in India). Funds with higher sharpe ratio are delivering you better returns for the same amount of risk you would be taking in a fund with lower returns.
Other important indicators to check while investing in mutual funds
Size of companies a fund invests in: There are 3 categories of companies available in stock market: Large cap (like Britannia, State bank of India, Maruti Suzuki etc.) , medium cap (like Apollo tyres, Titan, Exide industries etc.) and small cap (like VIP industries, Zydus, Deepak nitrite etc.). The category to which a company belongs depends on the market cap (total market valuation = total available shares of companies * market price) of the company. Generally large cap (also known as blue chips) companies offer more stability, lower risk and thus lower returns. Large cap companies generally need an investment horizon of 1-2 years at least. Mid-cap firms provide a good mix of healthy risk and returns and are for investors willing to take a calculated risk in order to generate higher returns, they are well suited for investment horizon of at least 3+ years. Finally small cap companies are companies which are relatively small/new and have a high potential to grow, thus they can compound investors money over a period of time, but then with high returns comes high risks. Given, small size of small cap companies, the performance of these companies can wildly swing and is hugely impacted by market conditions, competition, government policies etc. Thus the stock of small cap companies have higher intrinsic risk and volatility, this category of mutual fund is suited for investors who are in market for long haul (5+ years at least) and are fine with taking high risk in order to generate high returns. In recent years, small is further sub-divided into small and micro cap, where micro cap are companies in nascent stages and are small caps within small caps.
Type of companies a fund invests in: In this categorisation stocks are segregated into 3 categories, Growth, Blend and Value stocks. Growth stocks comprises of companies which have a healthy growth rate in terms of revenue, earning per share and/or profits. These companies tend to be multi-baggers over a period of time. Value stocks are the companies which are available at cheap valuations due to business uncertainties currently and are trading at a discount to their intrinsic and/or book value. Generally stock price moves towards it's intrinsic value over a longer period of time and hence mutual funds investing in value stocks pick good companies which are temporarily out of favour in market and tend to return back to their natural stock price, thus generating profits for investors. Blend stocks are a mix of Growth and Value stocks, these are high growth companies available for cheap valuation currently.
Avoid overlapping mutual funds: Many a times your investment advisor's incentives are not tied to your best interest, in such cases your advisor can try cross-selling you new mutual funds which gives advisor commission. Also, many a times we might invest in a new fund just because of it's recent performance or branding. While picking a new mutual fund always look at your existing portfolio and make sure that the funds you already have do not invest in same companies already or in same size/sector of companies. If there is a high overlap between the funds you own and new fund you are buying then you should consider selling an existing fund (which raises question on why you invested in a sub-optimal fund to begin with) with overlap. Overlapping mutual funds in a portfolio creates issues with tracking performance, creates redundancies and also creates over-diversification which contributes to lower performance.
Diversification: Generally an investor should hold a diverse set of mutual funds to capture the best of different asset classes, pick mutual funds from different company sizes, types, sectors, asset classes and geographies (i.e. investing in international stocks), to build a powerful portfolio. Click here to learn more about diversification.
Some of the Websites to analyse fund performances:
valueresearchonline.com
moneycontrol.com
Some of personally recommended mutual funds across different categories:
Large cap: Aditya Birla Sun Life Frontline Equity Fund , Reliance Large Cap Fund
Mid cap: HDFC Mid-Cap Opportunities Fund , DSP Midcap Fund - Regular Plan Fund
Small cap: HDFC Small Cap Fund - Regular Plan
Hybrid funds: UTI Regular Savings Fund
Debt funds: Reliance Gilt Securities Fund, Kotak Corporate Bond Fund, ICICI Prudential Ultra short term fund.
International equity funds: Reliance US equity Opportunities fund, Edelweiss Greater China equity off-shore fund, Edelweiss Europe Dynamic Equity Offshore fund, Edelweiss ASEAN Dynamic Equity Offshore fund.
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