Saturday 13 November 2010

Simple thoughts on "How to choose a Mutual Fund"

Simple thoughts on "How to choose a Mutual Fund"

This is often a perplexing question in the minds of investors, especially beginners.

There are just too many mutual funds around. No point in even trying to understand all of them.

First, let's decide about the broad types:

  • Equity Mutual Funds - that invest in shares on your behalf
  • Debt Mutual Funds - that invest in Fixed Income products on your behalf
  • Hybrid Mutual Funds - that invest in both Equity and Fixed Income products
  • Other specialised funds - like those investing in gold, global markets, etc.

The above should give a clue about which ones you wish to consider at this moment in time.

Once you're through with the broad category, how do you choose the specific fund house, scheme, etc.?

Obviously, there are lots of "ranking" websites, magazines, etc. which come up with periodic lists of "top" funds. While many sources are likely to be equally good, ones that I've found useful are ValueResearch Online (valueresearchonline.com) and Economic Times.

Then again, even such "sources" provide only data. How do we find out which ones to choose from among them? I was asked precisely this question by a first-time investor.

Here again, some "don'ts" for the beginners are in order before you decide:

  • Don't go for "Fancy" / "Momentum" funds
  • Don't choose sector funds till you've become comfortable with investing through mutual funds
  • Don't choose a scheme merely because of a fund manager - In India, fund managers come and go and you may not even notice it.
  • Don't go merely / solely by schemes which have done extremely well in the recent past. (Even a reputed source of information like "Economic Times" has published on occasions "Top-5 ELSS Funds based on the last week's performance". Wonder what value that would offer, considering that ELSS funds (Equity Linked Savings Schemes) have a lock-in period of 3 years and one week's performance is of zilch value.
  • Don't choose Fund Houses which have a track record of "Getting caught with SEBI" for all kinds of wrong reasons, Fund Houses which are too new (less than a minimum of 2 years), Fund Houses which are "too small" in terms of "Assets under management", etc.

Now for the actual inputs on how to choose:

  • Identify the top 12-15 funds / schemes in your chosen category from a couple of sources like valueresearchonline, moneycontrol, Economic Times, etc.
  • From these, eliminate those schemes which were launched within the last 2-3 years - You need a track record of reliable performance.
  • Eliminate schemes from fund houses that are "too new" or from fund houses which you don't rely - for whatever reason.
  • Look at the "relative returns vis-a-vis their benchmark indices" over a longer period of 3 years or more in case of equity funds and over a shorter time span of the last 6 months in case of debt funds (especially liquid funds).
  • In case of Equity Funds, a further refinement could be to look at the 3-5 year performance of this scheme from Year 3 or 4 onwards from the date of the initial launch of the scheme. (Logic: In the first couple of years, there could be a positive bias due to "Extra" Fund manager attention. Or there could be a negative bias due to a smaller overall fund size, skewing the returns. By year 3 or 4, the scheme would have become a seasoned war horse and you will know the credentials better.)
  • By this time, you'll typically be left with a maximum of 4-5 schemes.
  • Actually, you can choose virtually any of these 4-5 schemes. Unless you are talking about very large sums of money (as a percentage of your investment portfolio or net worth), it is advisable to invest in a maximm of 2-3 schemes among the 4-5 schemes so identified. If you're investing in equity funds, it is often preferable to park the same in a liquid fund and go in for a "Systematic Transfer Plan" so that you don't end up "Timing the market"

Happy investing!

Regards,

N


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1 comment:

Jaya said...

Thank you so much for this, particularly the inputs on how to refine the search for the best mutual funds. I had not come across some of these tips even on the so-called expert sites!

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