What to evaluate in a mutual fund factsheet?

Most Asset Management Companies (AMCs) usually publish monthly reports (also called factsheets) that contain critical information related to the portfolios, at times a roundup on debt and equity markets from the fund manager and performance details of the schemes managed by the AMC. The idea is to help investors (both existing and potential) to track the overall performance of the mutual fund schemes so as to take an informed decision. To that end, mutual fund factsheets were always meant to be and served as an investor's guide.

However, in many cases, factsheets are not upto the mark leaving much scope for improvement and even standardisation. We highlight the most critical reference points for the uninformed investor based on data that is more or less standardised across AMCs. For ease of reference, we have divided the article in two parts, the first part discusses how to assess the equity fund factsheet and the second part discusses the debt fund factsheet.

A) Equity fund factsheets

1. Stock allocation: Thankfully, factsheets of most AMCs highlight the portfolio composition well enough, although there is scope for standardisation. For an investor who wants to invest in equity funds, the factsheet can offer some critical insight into the fund management style/approach.

To begin with, consider the top 10 stocks in the funds' portfolio to determine the level of diversification. In our view, a diversified equity fund should have no more than 40% of net assets in the top 10 stocks. This should help the fund negotiate volatility more effectively than its concentrated peers. We like funds that follow a disciplined investment approach and hold no more than 5% of its assets in a single stock thereby ensuring that its top 10 stocks are well-diversified.

Sometimes, a fund could be well-diversified across the top 10 stocks, but investments in a single stock could be so high so as to offset an otherwise diversified portfolio.

Also look at the fund's portfolio over several months to get a sense of the consistency in the fund manager's stock picks. Too much churn in the stock picks (new names every other month) indicates that the fund manager could be punting rather than investing, thereby adding to the trading cost, which ultimately eats into the returns.

2. Sectoral allocation: Just as you evaluate the stock allocation, it is important to consider the sectoral allocation of the equity fund. Diversified equity funds should be well-diversified across stocks and sectors. A fund could be well-diversified across stocks, but may pay the price for not diversifying well enough across sectors. For instance, one of the funds we admire for superior diversification across stocks, learnt the hard way during one of the market slide that diversification across stocks is as important as diversification across sectors. The fund had unduly high investments in infrastructure-related sectors. The crash proved particularly harsh for the fund, as it had failed to diversify across other sectors. So like stocks, being diversified across sectors is just as important; unfortunately, it often takes a sharp dip in the stock markets to highlight the importance.

However, some funds which pursue the top down investment approach, have concentrated sectoral allocations, which suit their investment style. These funds need to be evaluated differently from funds that pursue the bottom up investment style.

While calculating the sectoral allocation, the investor must combine like-natured sectors to understand the level of sectoral diversification. For instance, most equity funds list Auto and Ancillaries sectors distinctly; given the similar nature of these sectors, their allocation must be combined.

Another problem relates to the categorisation of companies across sectors. Different equity funds categorise the same company across different sectors. There is no standardisation. While AMFI (Association of Mutual Funds of India) had introduced certain standardisation processes in this regard, the same is not adhered to across the industry.

3. Asset allocation: Stocks and sectors apart, there is another detail that must catch your attention and that is the asset allocation. The asset allocation table tells you how the fund's net assets are diversified across stocks, current assets/cash. An equity fund's allocation to cash should be noted. Among other reasons, this could be because the fund manager is not comfortable with market levels at that point in time. This fact can be established easily by browsing through the previous month's factsheets. If the fund manager has been in cash for some time, it means he does not find enough stock-picking opportunities at existing levels.

Being in cash could work in the fund manager's favour if the market crashes, but a higher cash allocation works against the fund during a rising market, when being fully invested is what counts.

4. Other data points: In addition to the points listed above, there are some data points that must be marked by the investor.

a) Portfolio Turnover Ratio: Put simply, this ratio tells the investor how much churn the portfolio has witnessed. This ratio is calculated based on the number of shares bought and sold by the equity fund over the review period. A high Turnover Ratio (vis-à-vis peers or other equity funds from the same fund house) indicates that the portfolio has seen above-average churn. A high churn by itself does not necessarily imply that the fund is good or bad, however, it must be in line with the fund's investment philosophy. A growth fund can have a high turnover ratio (although that's not necessarily a good thing as it adds to the trading costs and therefore eats into your returns).

However, a value fund should typically have a lower churn as the fund manager would usually be investing in the stocks over the long term.
Important as it is, the Portfolio Turnover Ratio is yet to be given due importance by the fund houses (maybe they are afraid of 'exposing' their fund managers). How else, do you explain the fact that fund houses either don't reveal the Portfolio Turnover Ratios or when they do reveal them, it is not standardised thereby robbing investors of the opportunity to compare them across fund houses.

b) Expense Ratio: This ratio underscores how expensive your equity fund really is. A high Expense Ratio (regulations cap this at 2.50% for equity and 2.25% for debt funds) indicates that your mutual fund investment is expensive. As per regulations, fund management expenses, which form the largest chunk of the expense ratio, must decline with a rise in Net Assets. So larger equity funds have more scope to reduce their Expense Ratios.

Again, fund houses are not very enthusiastic about sharing this important detail with investors. However, they do declare this ratio every 6 months, which is only because regulations demand that they do so.