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Preface
Many investors fancy investing in mutual funds, especially in an
exuberant market. But, in our
opinion merely fancying and being fascinated is not enough. Only
investing wisely and with the
right insights will help you to make the right investment
decision. If you as an investor do not
have the right perspective, mutual fund investing could be a
conundrum. And with mis-selling
from some mutual fund distributors, you could go down the wrong
path, reaching an unwanted
destination.
Hence through this guide, PersonalFN brings to you the
comprehensive process involved in
selecting winning mutual funds and building a solid portfolio
for long-term wealth creation.
Weve tried to capture our extensive experience in mutual fund
research for the benefit of avid
readers. We hope it will be worthy pearls of wisdom enabling you
to multiply your wealth
through investments in mutual funds.
So, read on and wish you all VERY HAPPY INVESTING!!
Team Personal FN
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Disclaimer
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not constitute or is not intended to constitute an offer to buy
or sell, or a solicitation to an offer to buy or sell financial
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completeness or accuracy and expressly disclaims all warranties
and
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and its subsidiaries / affiliates / sponsors or employees,
personnel, directors will not be responsible for any direct /
indirect loss or liability incurred by the user as a consequence of
him
or any other person on his behalf taking any investment
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is not a specific advisory service to meet the requirements of a
specific client. Use of this information is at the user's own
risk.
The user must make his own investment decisions based on his
specific investment objective and financial position and using
such independent advisors as he believes necessary. All
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shall
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Index
Section I: Introduction 5
The need to have winning mutual funds
Section II: Steps to select winning mutual funds 6
Using Quantitative & Qualitative Parameters
Section III: Steps to build a mutual fund portfolio 13
Process of Elimination & Process of Selection
Section IV: Conclusion 16
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I - Introduction
The exuberant phase of the equity markets are often sunny times
for several manufacturers of
financial products and investors. While some smart investors
prefer to book profits during such
times, there are several who elevate their confidence during
euphoric times. And interestingly
banking on the upbeat investor mood, manufacturers of financial
products too, launch new
financial products. Have you wondered why such financial
products arent launched when
sentiments in the markets are low? Well, the answer in our view
is simple. They (manufacturers
of financial products) want to make hay when the sun shines, by
garnering more Assets Under
Management (AUM) during euphoric times, when investor sentiments
are upbeat.
But, you see, the increase in number of mutual fund schemes and
the regular launches of New
Fund Offerings (NFOs) from mutual fund houses have led to the
dilemma in the minds of the
investors, as to which of them should they invest in and are
they indeed selecting winning
mutual funds for their portfolio. While there is galore of
information to address to this issue,
information overload can also confuse you as an investor and
make the task of selecting
winning mutual funds tougher rather than easier. Yes, there are
star ratings by which one can
go by. But do you know which of them can really stand like rock
stars in your mutual fund
portfolio? Today with importance to star ratings, investment
decisions are guided by them; but
how many investors actually know the methodology involved in it.
It is vital to recognise that
one size fits all approach may not be the right way to select
mutual fund schemes for your
portfolio. Yes, they could perhaps serve as starting points for
identifying a broader set of
investment-worthy funds; but investing in a fund, based solely
on number of stars against its
name may not be the right move. The fact is, not all mutual
funds are same. There are various
aspects within a fund that you should carefully consider before
short-listing it for your
investments.
Here, in this guide, at PersonalFN we have enunciated a
step-by-step approach to select
winning mutual funds and build a robust mutual fund
portfolio.
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II - Steps to select winning mutual funds
You see, select winning mutual funds is a step-wise evaluation
of mutual funds on the basis of
host of quantitative and qualitative parameters. First lets take
the quantitative parameters
1. Performance:
The past performance of a fund is important in analysing a
mutual fund. But, remember
that past performance is not everything, as it may or may not be
sustained in future and
therefore should not be used as a basis for comparison with
other investments.
It just indicates the funds ability to clock returns across
market conditions. And, if the fund
has a well-established track record, the likelihood of it
performing well in the future is
higher than a fund which has not performed well.
Under the performance criteria, you should do the following
Compare funds: A funds performance in isolation does not
indicate anything. Hence, it
becomes crucial to compare the fund with its benchmark index and
its peers, so as to
deduce a meaningful inference. Again, one must be careful while
selecting the peers for
comparison. For instance, it doesnt make sense comparing the
performance of a mid-
cap fund to that of a large-cap. Remember: Dont compare apples
with oranges.
Performance across time periods: It is very important that
investors have a long term
(at least 3-5 years) horizon if they wish to invest in equity
oriented funds. So, it becomes
important for them to evaluate the long term performance of the
funds. However this
does not imply that the short term performance should be
ignored. Besides, it is equally
important to evaluate how a fund has performed over different
market cycles
(especially during the downturn). During a rally it is easy for
a fund to deliver above-
average returns; but the true measure of its performance is when
it performs better
than its benchmark and peers during the downturn. Remember:
Choose a fund like you
choose a spouse one that will stand by you in sickness and in
health.
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Judge the returns: Returns are obviously one of the important
parameters that one
must look at while evaluating a fund. But remember, although it
is one of the most
important, it is not the only parameter. Many investors simply
invest in a fund because
it has given higher returns in the past. In our opinion, such an
approach for making
investments is incomplete. In addition to the returns, investors
must also look at the risk
parameters, which explain how much risk the fund has taken to
clock higher returns.
Judge the risk: To put it simply, risk is a result or outcome
which is other than what is /
was expected. The outcome, when different from the expected
outcome is referred to
as a deviation. When we talk about expected outcome, we are
referring to the average
or what is technically called the mean of the multiple outcomes.
Further filtering it, the
term risk simply means deviation from average or mean
return.
Risk in mutual funds is normally measured by Standard Deviation
(SD or STDEV). SD
signifies the degree of risk the fund has exposed its investors
to, and is calculated as
under:
Where:
SQRT = Square Root
Returns = Point to point rolling returns on absolute basis
(which can be daily, weekly,
monthly, quarterly or annual)
Average returns = Mean of all point to point rolling returns on
absolute basis
Sum = Addition or summation
N = Number of sample size
From an investors perspective, evaluating a fund on risk
parameters is important
because it will help you to check whether the funds risk profile
is in line with your risk
profile or not. If two funds have delivered similar returns,
then as a prudent investor you
should invest in the fund which has taken less risk i.e. the
fund that has a lower SD.
STDEV = SQRT [(Sum ((Returns Average Returns) ^ 2)) / (N 1)]
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Judge the risk-adjusted returns: This is normally measured by
Sharpe Ratio (SR). It
signifies how much return a fund has delivered vis--vis the risk
taken. Higher the
Sharpe Ratio, better is the funds performance. It is calculated
as under:
For you, from an investors perspective, Sharpe Ratio is
important because you should
choose a fund which has delivered higher risk-adjusted returns
in the past. After all there
needs to be an effective risk-return trade off. In fact, this
ratio will tell you whether the
high returns of a fund are attributed to good investment
decisions, or to higher risk.
2. Portfolio Quality:
The portfolio characteristics and investment strategy is an
important criteria for a mutual
fund. The quality of portfolio is what reflects in the funds
overall performance. Funds that
follow long term investment strategy have been successful in the
past.
Under the portfolio quality criteria, you should do the
following
Assess the portfolio concentration: Funds that have a high
concentration in particular
stocks or sectors tend to be very risky and volatile. Hence, you
should invest in these
funds only if you have a high risk appetite. Ideally, a
well-diversified fund should hold no
more than 50% of its assets in its top-10 stock holdings.
Remember: Make sure your
fund does not put all its eggs in one basket.
Assess the portfolio turnover: The portfolio turnover rate
refers to the frequency with
which stocks are bought and sold in a funds portfolio. Higher
the turnover rate, higher
the volatility. And chance are high that the fund might not be
able to compensate the
investors adequately for the higher risk taken. Remember: Invest
in funds with a low
turnover rate if you want lower volatility.
Sharpe Ratio = Annualised Returns Risk Free Return
Standard Deviation
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Average Maturity, Modified Duration & YTM:
These parameters are important while evaluating debt mutual
funds.
The average maturity refers to weighted average time until all
securities in a debt portfolio
of a mutual fund mature. Lower the average maturity; the better
it is in terms of the
interest rate risk and lower volatility.
Modified Duration (MD), reflects the responsiveness of the debt
securities' price with
the change in interest rate. It is based on the inverse
relationship between the price of the
bond and interest rates. By taking this parameter into
consideration, the volatility of the
debt funds portfolio is revealed. Higher the duration; higher
the interest rate sensitivity.
YTM (or Yield to Maturity) refers to the rate of return
anticipated on a debt portfolio, if held
till maturity. It is also commonly referred to as the yield on
the debt portfolio.
3. Costs:
If two funds are similar in most contexts, it might not be worth
buying the high cost fund if
it is only marginally better than the other. Simply put, there
is no reason for an AMC to
incur higher costs, other than its desire to have higher
margins. The two main costs incurred
are:
Expense Ratio: Annual expenses involved in running the mutual
fund include
administrative costs, management salary, overheads etc. Expense
Ratio is the
percentage of assets that go towards these expenses. Every time
the fund manager
churns his portfolio, he pays a brokerage fee, which is
ultimately borne by you as an
investor in the form of an expense ratio. Remember: Higher
churning not only leads to
higher risk, but also higher cost to the investor.
Exit Load: Due to SEBIs ban on entry loads way back in 2009, you
have to now have only
exit loads to worry about. An exit load is charged when you sell
units of a mutual fund
within a particular tenure. Most funds charge exit load if the
units are sold within a year
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from the date of purchase. As exit load is a fraction of the
NAV, it eats into your
investment value. Remember: Invest in a fund with a low expense
ratio and stay invested
in it for a longer duration.
You see, while quantitative parameters depict the outer layer of
a mutual fund scheme which is
visible to everyone, it is also vital to delve a little deeper
in evaluating the qualitative
parameters as well to select winning mutual funds. It is
noteworthy that qualitative parameters
take into account a host of factors mentioned hereunder, to
reflect more consistent performing
mutual funds. Moreover, they (qualitative parameters) go a long
way in maintaining
the financial health of your portfolio, which leads to wealth
creation over the long-term.
The qualitative parameters which you should assess are:
4. Fund Managers Experience:
Well, he's the guy who is managing your money invested in mutual
funds, so knowing his
experience in fund management will be valuable. It is noteworthy
that the fortune of the
fund will be closely linked to the way he manages the fund, and
this is a function of the
experience which he carries in the field of fund management and
equity research. In some
instances, the fund may be managed by a "team" even though there
is the name of a
specific fund manager in the documents. It is important that the
team managing the fund
should have considerable experience in dealing with market ups
and downs.
Moreover, you should avoid funds that owe their performance to a
star fund manager.
Simply because, if the fund manager is present today he might
quit tomorrow; and hence
the fund will be unable to deliver its star performance without
its star fund manager.
Therefore, the focus should be on the fund houses that are
strong in their systems and
processes. Remember: Fund houses should be process-driven and
not 'star' fund-manager
driven.
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5. No. of schemes to fund manager ratio:
Many mutual fund houses frequently launch too many similar
products, so that they could
gather more Assets Under Management (AUM). This eventually leads
to the fund manager
being over-burdened in managing these multiple mutual funds,
which can result in lower
efficiency of the fund manager on focusing on the need of his
investors. Therefore while
you select a mutual fund scheme, ensure that the number of
mutual fund schemes which
he manages do not exceed five.
6. Proportion of AUM performing:
As mentioned earlier, some fund houses constantly engage in an
exercise of increasing their
AUMs, through frequent product launches. Well, that may be good
in a way, but does not
necessarily reveal that a fund house with a larger AUM is good
for you as an investor.
Consider a fund house having an equity AUM of Rs 10,000 crore
across 10 schemes. Now, if
only 6 out of 10 schemes having an AUM of Rs 3,500 crore are
performing while the rest 4
schemes with Rs 6,500 crore corpus are underperformers, then it
can be said that only 35%
of the AUM is performing. This brings out the fact that whether
the fund house is really
doing a good job in fund management or is just an AUM gatherer.
But for you, as an
investor, if your money ended up in the bucket of Rs 6,500 crore
and was under-performing,
then that may not do well to your portfolio.
7. Unique schemes:
Given the backdrop that many fund houses are in the race to
garner more AUM, it is
necessary to critically evaluate new fund launches. Such an
assessment would help you
understand whether the fund house has unique products or is
simply an "old wine in a new
bottle". You see, the higher the number of unique funds, the
better it is. Duplication of
funds by the fund house brings out their incompetence of
managing schemes in a prudent
manner.
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8. Investment systems and processes:
It is noteworthy that the quality of instruments held in a
mutual fund schemes portfolio is
a function of the investment systems and processes followed at
the fund house on which
the fortune of the fund rests upon. It reflects the fund houses
ideology and therefore it is
imperative to pay heed to this qualitative aspect while
selecting winning mutual funds for
your portfolio.
Among the host of quantitative and qualitative aspects which go
in selecting winning mutual
funds, while few can be easily gauged by you as an investor,
there are others on which
information is not widely available in public domain. This makes
analysis of a fund difficult for
investors and this is where the importance of a mutual fund
advisor comes into play. At
PersonalFN, we spend a lot of time and effort in short-listing
funds which are best for investors,
by using various qualitative and quantitative techniques.
So now, after having known how to select a winning mutual fund,
we are sure you would be
interested in knowing how to build a mutual fund portfolio.
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III Steps to build a mutual fund portfolio
Building a mutual fund portfolio is not a very simple task since
many of the mutual fund
schemes seem to be saying (as dictated by the investment
objective) and doing (in terms of
investments) totally different things. Also with plethora of
funds the task of building a prudent
portfolio gets further difficult.
At PersonalFN, we are often flooded with queries from investors
on how to go about building a
portfolio that will involve minimal tracking and churning and
can help them achieve their
investment objectives over the long-term.
Thus for your benefit, we have split this process of building a
mutual fund portfolio into two
steps. The first step, outlined below, is relatively easy as it
involves eliminating the mutual fund
schemes that should not be a part of your portfolio, and second
step is the process of selecting
a mutual fund.
Step 1: Process of elimination
You should not invest in a mutual fund only because it is
recommended by a mutual fund agent;
but you must also question the existence of every mutual fund in
your portfolio so that you are
left only with the very best funds. Also, its important for you
to guard against over-
diversification. Your fund manager (if he is smart) is taking
care of the diversification. There is
little point in diversifying something that is already
diversified.
While eliminating mutual funds, one has to keep in mind the
following points:
Refrain from investing in a sector/thematic mutual fund: Over
the long-term there is
little value that a restrictive and narrow theme can bring to
the table; unless there is a
secular positive trend for such a theme. Also you should keep in
mind that, thematic or
sector funds have a tendency of plunging more during the
downturn. Hence, its best to
opt for a broad investment mandate that is best championed by
well-diversified equity
funds.
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Avoid duplication: If there are two or more mutual funds that
seem to be doing the
same thing (in terms of mandate, style), then you have to ensure
that you are left with
just the best in that category and eliminate the rest. So, do a
peer comparison.
Look for long term performance: Finally, evaluate a funds
performance over the long-
term (3-5 years) and over market cycles. This enables you to
understand whether the
equity fund under review has stood the test of time. Many NFOs
launched through the
onset of the exuberance phase of the market have done reasonably
well, leading
investors to believe they are well-managed funds. But, remember,
it is important to see
how they sail during the turbulent and even bear phases of the
Indian equity market to
ascertain their stability. So, a fund manager may have not
managed a mutual fund
scheme efficiently if there is vehement erosion to the value of
your investment. You
see, it takes a bear phase to separate the men from the
boys.
Step 2: Process of selection
Once the elimination process is performed by you as an investor
diligently enough, the second
step will come naturally. For instance, if you have ignored all
the sector/thematic funds, that
leaves you with just the well-diversified ones. Likewise, if
even those funds that have not
completed a 3-Yr track record, you are automatically left with
those who have a minimum 3-Yr
track record. While selecting mutual funds, you must keep the
following points in mind:
Diversify across market caps: As an investor, ideally you should
have a mix of both
large cap as well as mid cap funds, since both have their
inherent strengths. When both
are well-selected, they can reward the investor handsomely over
the long-term. The
proportion of investments in mid cap funds will depend upon the
risk appetite of the
investor. For example, a 25-year old person could have a higher
allocation towards mid
cap funds, as compared to a large cap fund.
Similarly, it also pays to invest in an equity fund that can
invest in both large caps and
mid-caps depending on the opportunity; these funds are commonly
referred to as
opportunities / flexi cap / multi cap funds.
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Look across investment style: As an investor, you should go for
both well-managed
growth style and value style equity funds. This will help you to
capitalise on
opportunities across the board. Growth funds invest in
well-managed companies that
are fairly valued with a view that they are likely to perform
even better going forward.
Value funds invest in well-managed companies that are
undervalued (temporarily) with
the view that they will achieve their fair value going
forward.
Add stability: Investing in a balanced fund will help in
bringing in stability in the
portfolio on account of the provision in its investment mandate
for partial investment
in debt. You see, they are a good way start your mutual fund
investments.
Do thorough research and analysis: And to top it all, the
selection process must purely
be based on thorough research and analysis. Your agent,
neighbours and colleagues are
welcome to air their views, but remember at the end of the day
its your money, not
theirs.
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IV - Conclusion
Investing is a serious business and essentially is dull and
boring. Information is available in
plenty with many quick solutions. But it is for you to delve a
little deeper and recognise the
nitty-gritties and be a responsible investor while managing your
finances. Yes, we recognise
that you may seek help of a mutual fund advisor as you do not
have the time to run the
exhaustive research process by yourself. But while you do so,
please take enough care to select
a mutual fund advisor wisely. While many mutual fund advisors /
distributors / agents /
relationship managers may claim that they are backed with proper
research process while
offering recommendations, you got to ask them the relevant
questions to judge them. Also, you
got to ensure that their advice is independent and unbiased and
not based on luring
commissions they would earn from mutual fund houses. It is
imperative to engage the services
of a competent and experienced mutual fund advisor who can help
you build a mutual fund
portfolio on the lines we have recommended.
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Contact us
Head Office
Mumbai
101, Raheja Chambers ,
213, Free Press Journal Marg,
Nariman Point,
Mumbai - 400 021.
Tel: +91-22-6136 1200
Email: [email protected]
