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Are you invested in the brightest stars of the MF universe?

Published on Tue, Aug 28, 2007 at 13:15 | Source : Moneycontrol.com

Updated at Thu, Aug 30, 2007 at 17:43

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The mutual fund universe is filled with hundreds of schemes. And this universe is expanding very rapidly. The Indian equity markets is giving birth to new schemes every other day.

This is a good development. More schemes mean more choices for an investor. Also, the increasing competition amongst the Asset Management Companies (AMCs) has raised the fund management quality, improved the service standards and spread the investment culture. (Also read - How to build your MF portfolio?)

But as the universe expands to unmanageably large size, it becomes increasingly difficult to spot the brightest of the stars. And the cloud created by the media hype is not making this job any simpler.

So what options does a prospective investor has? One, of course, is to take help of a professional. But this is easier said than done. It is equally difficult to find a well qualified, competent, experienced and an honest advisor. So the next best course of action is to do the hard work yourself.

Identifying the brightest MF schemes is no rocket science. But it does require a fair amount of investment in terms of time and efforts. One has to patiently sieve through the universe using certain yardsticks and separate the brighter stars from the not-so bright ones.

What are these criteria and how does one interpret them?

Type of Fund

Life was simple in the good old days. We had a simple diversified equity fund, an equity linked saving scheme and a few sector funds. Today we have to live with the mid-cap funds, small cap funds, multi-cap funds, large cap funds, emerging companies funds, lifestyle funds, dividend-yield funds, PE funds and a host of sector specific funds too. This is almost a mini-universe in itself. (Also read - Mutual Funds: Your best personal Portfolio Manager)

As a first step, therefore, identify the set of schemes, which meet your investment objectives such as the diversification, return expectation, time horizon and risk appetite.

Say you are a risk taker and have 3-5 years horizon. Then a small-cap fund could meet your needs. Such companies can give spectacular returns but need time to prove their worth in the market. Or if you are a passive investor, index funds would best suit you.

Having chosen the desired set matching with your needs, further yardsticks are applied to choose the specific funds.

Past Track Record

The past performance is undoubtedly the most important criterion. Has the scheme been among the top performers in the past? How does it compare with the benchmark?

There is, of course, no guarantee that a fund, which has done well in past will continue with its' good performance in future too. But, it is a reasonable assessment that a fund which has shown consistent performance over the last 3-5 years period, is most likely to perform well in the future.

Therefore, it is important to assess performance over longer time frame, especially during market downturns. A 3-5 years is a good enough period to look at. A shorter time frame of 1-2 years may not be a sufficient indicator.

Quality of Returns

The fund may have been an excellent performer. But it is possible that the risk it is taking is more than what your risk appetite warrants. The 'quality' will determine how much risk a fund is taking to generate the returns. (Also read - Don't just look at 'Returns', look at quality too)

Equity investing is a risky business and it is important that a fund should be managing risks effectively. This is especially true now when the market has run-up quite sharply and the valuations are stretched. In the event of a sharp correction, it is the quality funds which will usually fall less and also rise up faster when the up-turn begins.

Standard Deviation indicates fund volatility - higher the standard deviation more would the returns fluctuate. Sharpe Ratio is a risk-to-reward ratio, which defines the level of risk a fund takes. A higher sharpe ratio - i.e. higher return per unit of risk - could be a better bet. Beta tells us about the sensitivity of a fund to the market movements. Higher the beta, more is the fund sensitive to market ups & downs. Turnover ratio shows how often the stocks are being bought or sold. Higher turnover means higher trading expenses.

Portfolio Characteristics

Funds come in all shapes and sizes. Some are too diversified and some too concentrated. Some are too small and some too big.

A too small a fund may not be able to adequately diversify, while too large a fund may not find sufficient investment options. The corpus size needs to be commensurate with the investment space. For example, in the recent past we saw a sharp rise in the corpus of the mid-cap funds. But the mid-cap investment arena is not yet very large, making it difficult for these funds to effectively deploy the funds. (Also read - 7 common investment mistakes you should avoid)

Diversification beyond a point may prove counterproductive. Too large a portfolio may mean both dilution in returns and less efficient fund management. On the contrary, too much of concentration in few stocks would tend to increase the fund risk. Percentage holding in the top 10 stocks and the number of stocks in the portfolio will give a fair idea about level of diversification.

Expenses

We all love free things in life. There is nothing wrong about it. But we should be aware that the AMCs are not in the business of social service; they are not a non-profit organisation.

The people who manage your funds and provide you world class services are highly educated and experienced. They, therefore, need to be suitably compensated for their efforts. Hence, we should be willing to pay for their services. You all are also in some profession or the other. How would you feel if you were asked to provide your services free? (Also read - Some Do's and Don'ts of investing)

Having said that, one should be aware of the costs involved. Primarily, there are two expenses. One is the sales expenses i.e. the entry/exit load. This is payable at the time of buying/selling the fund. And, second is the annual fund management expense.

One should evaluate whether these expenses are in line with the industry standards of comparable funds and offer the right value for money. For example an index fund will typically have a lower fund management expense than an actively managed fund.

The Fund House

A fund per se is nothing but a pool of money. It is the AMC behind the fund, which makes the difference.

Who are the promoters? What has been their past experience? How many funds do they manage? What has been the performance of the various funds? Does the fund house enjoy impeccable reputation in the market? Do the key personnel keep changing frequently? (Also read - Beware - Not all financial advice may be genuine)

The fund manager plays an important role, but he is not the only key person. He may be the visible face, but one must not forget that the behind-the-scenes supporting cast - the management which defines the basic investment philosophy, the parameters & methodology, the research group which identifies the suitable stocks, the sales force, the back-office team etc.

The Service Standards

How happy has been your investing experience in the past? Or what have been your first impressions about the client servicing? Is the staff courteous? Is the staff helpful? And more importantly, is the staff knowledgeable?

Many a times the staff may be eager and efficient in taking your money, but are they equally eager and efficient to give back your money when you need it? Have they delayed your redemption proceeds? Do you get your statements on time?

Do they offer other conveniences such as online access to your portfolio, electronic withdrawals & credits etc. (Also read - Not a Fund Investor yet? Four mental hurdles to overcome)

All these will define the service standards, which are also a key factor apart from performance.

One more point, before we conclude - not all bright stars of today will remain bright tomorrow; some not-so-bright stars of today may become the bright stars of tomorrow; not all of your choices may turn out to be the best. But that's life. You win some you lose some.

With these broad parameters in mind, you are now ready to explore the universe of mutual funds.

- Sanjay Matai

The author is an investment advisor and promoter of wealtharchitects.in. He can be reached at sanjay.matai@moneycontrol.com.

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