4 steps to select the right mutual fund scheme for your SIP

The flow of funds through the avenue has slipped slightly from the record high of Rs 8,641 crore in March 2020. Also, the SIP closure ratio (SIPs discontinued to new SIPs registered) has risen to a record high of 81 per cent in May 2020, up 72 per cent on-month and 58 per cent for fiscal 2020. But, the avenue continues to remain an active investment strategy.

For SIP investments to succeed, two aspects are necessary: investments should be for the long term (merits showcased in the Moneycontrol CRISIL SIP study); and schemes should be selected wisely. This article explores the latter factor.

SIP investments trend

Quality counts

Investors typically select schemes based on their recent performance. This is not fool-proof because some funds can give extraordinarily high returns when markets are up and lose value significantly during corrections.

For instance, a fund that returned at a compound annual growth rate (CAGR) of 19 per cent annually in the past six years is better than the one that gave 28 per cent CAGR in the first three years but dropped to 3 per cent CAGR in the next three, giving net annualised returns of 14.7 per cent in six years.

Hence, it is important to focus on the consistency of returns rather than on short-term above-average performance. Investors should also look at factors such as underlying risks in the portfolio to identify quality mutual funds.

How do we spot quality funds?

The following factors can help investors find high-quality funds:

Relative performance: The importance of consistency notwithstanding, investors should compare a fund’s performance with schemes within the category and the respective benchmarks in different market phases.

Comparison has become easier ever since the Securities and Exchange Board of India (SEBI) re-categorised and rationalised schemes in 2018.

CRISIL’s category level indices can also help investors gauge the relative performance of schemes.

Fund manager: A fund manager’s track record on different schemes managed by him/ her in the same asset management company as well as in the previous company, and across market phases, can give insights into his/ her level of expertise in managing fund portfolios.

A seasoned fund manager, supported by robust investment processes and risk management practices, is better positioned to deliver superior risk-adjusted returns.

Risk attributes: Sometimes, returns come at a cost that might not be visible to the naked eye. So, assess the risk-return attributes of a scheme.

Notably, risk-adjusted measures such as Sharpe ratio, information ratio, which not only capture the upside, but also give due importance to the downside, are important performance metrics to evaluate the relative performance of a scheme versus its peers and the benchmark.

Portfolio parameters: Portfolio components such as sector and company diversification, and liquidity of the underlying stocks, also accentuate the quality of a portfolio. SEBI has capped sectoral and company holdings within a fund’s portfolio; these parameters identify the risk of concentration and illiquid stocks.

Additionally, scheme selection should factor in portfolio management style and assess whether the alpha generated over the benchmark is attributable to sectoral allocation and/or stock selection. Further, it is important to assess whether portfolio performance is derived from skill or luck by assessing the sources of returns.

A recurring process

To conclude, keep these three principles in mind when you start an SIP in a mutual fund.

- Scheme selection is not a one-time process. It should be an annual exercise.

- Periodic reviewing and rebalancing of a mutual fund portfolio weeds out underperformers and replaces them with top performers.

- A review helps investors assess if their investments are on track for creating wealth in the long term. Most importantly, it allows for corrective action.

(The writer is Senior Director – Funds and Fixed Income Research, CRISIL)