How not to evaluate a mutual fund scheme?
A lot of mutual fund advice/research now-a-days is focussed on how investors must evaluate mutual funds. You must have come across a lot of literature on this in a newspaper or on websites of mutual fund houses. Even your distributor / relationship manager / agent must have showered you with a lot of information on how to assess a mutual fund scheme before investing in the same. Unfortunately, in our view that is often not enough. It is like knowing only half of the story, which then leads to mis-selling by self-centred distributor or advisors. As a result, a lot of investors who end up investing in mutual fund schemes which lacks consistency in performance are left very disillusioned with how their investments have performed. All this can be prevented if investors are armed with two golden rules to invest in mutual funds "guidelines on how to evaluate a mutual fund" and just as importantly "guidelines on how not to evaluate a mutual fund". Over here let us discuss the other half of the story i.e., guidelines on how not to evaluate a mutual fund which is generally very less discussed about.
1. Don't read too much into past performance
Read any mutual fund advertisement and there is likely to be a mention of the funds incredible performance over the years. At times the focus on past performance is so overwhelming that it leaves you with the impression that, past performance is all that matters while investing in a mutual fund. However, in our view, past performance is important, but it is just one of the factors that must be considered while investing in a mutual fund scheme. Among other factors that rarely find a mention in advertisements are the fund houses investment philosophy and processes, level of ethics, performance across market phases especially during the downturns of the stock markets.
2. Don't read too much into mutual fund ratings
In our view, mutual fund ratings get more than their share of attention from investors, which is unfortunate. This is especially true since in the Indian context mutual fund ratings are often biased towards returns with little or no room for evaluating among other factors, the fund house's investment philosophy, processes, track record on transparency, consistency, compliance and ethics. Such lopsided ratings cannot be the base for investors to take a decision whether to buy or sell or hold a particular mutual fund scheme. However, ratings can be considered as a reference point while evaluating different types of mutual fund schemes.
3. Don't read too much into CAGR performance
One of the many selling points for mutual funds is their performance in terms of compounded annualised growth rate (CAGR). Any student of mathematics can confirm this "CAGR is just an indicator of growth between two points" (or between two dates as in the case of a mutual fund investment). It tells you nothing about what transpired in the interval and more importantly it tells you nothing about the risk the mutual fund has exposed investors to and the investment process that generated that CAGR. At the end, the CAGR hides more than it reveals which is why investors should not read more in it than necessary.
4. Don't invest in a mutual fund just because its NAV is low
Many a times you perceive investment in a New Fund Offer (NFO) as a good investment just because the NFO is priced at Rs 10. On a similar footing, even existing mutual funds with lower Net Asset Value (NAV) appeal you more as compared to a mutual fund with a higher NAV. In our view, this approach to selecting a mutual fund is absolutely incorrect. Let us understand what constitutes or how NAV of a mutual fund is arrived at. The NAV of a mutual fund is expressed as total of all assets of the particular scheme less the liabilities of that scheme (excluding liability towards unit holders), divided by the total number of outstanding units.
Thus, when you invest in a mutual fund you invest at its existing NAV wherein you buy units at a price (i.e. the NAV). The calculation of the NAV is based on the current market price of all the assets that the mutual fund scheme owns less the liabilities. In other words, the NAV represents the mutual fund scheme's intrinsic value.
Unlike in stocks, wherein the stock price of a company is different from its intrinsic value due to fact that the investors evaluate the company's future profitability and accordingly pay a higher price or lower price as compared to its book value. This does not hold true for open-ended mutual funds - they always trade at their book value; so investors never buy them cheap or expensive in that sense.
5. Don't count on the star fund manager
Unlike other factors like past performance that merit some (positive) consideration, the presence of a star fund manager merits no such consideration. On the contrary a fund house must be given negative marks for attributing its success to a star fund manager. While over the short-term a star fund manager may bring about a dramatic change in the mutual fund's performance, over the long-term he can do more harm than good.
As a mutual fund's performance gets inseparably linked with the presence of the star fund manager, his existence in the fund house becomes a prerequisite for the fund's success. If the star fund manager quits the fund house, it could leave the fund and its investors in the lurch because the existing team is unlikely to be capacitated to deliver on the same lines as the star fund manager.
So what must investors do? Go for fund houses that institutionalise the fund management process by building teams that are guided by well-defined processes where individuals have a limited role to play.
6. Don't question every investment decision made by your fund manager
While it's good to be aware of what your fund manager is up to, it is only in the fitness of things that you let him do what he is good at doing, which is identifying the best investment opportunities ahead of the competition. As an investor you must do what you are supposed to do which is getting your financial planner involved in the process of keeping a tab on your investments. The financial planner (provided he is honest and competent) should be the one to tell you whether the fund manager is investing in line with his pre-determined investment mandate and philosophy. Once you understand the roles defined for all three parties over here "fund manager, financial planner and you", (i.e. the investor) you will not waste your time agonising over views like whether your fund manager is doing the right thing by investing in software stocks in the backdrop of a rising rupee and so on.
Thus, the next time you plan to invest in a mutual fund please take a note of the above 'must avoids' along with the guidelines on how to select a winning mutual fund for your portfolio.
PersonalFN is a Mumbai based Financial Planning and Mutual Fund Research Firm