Do you know the most important parameters in selecting mutual funds

Selecting the right mutual fund for your investment needs is not the simplest of endeavors. Investment needs can be varied and there are thousands of products in the market. Despite some negative perceptions about the mutual fund industry propagated by certain sections of the media, we in Advisorkhoj believe that, the mutual fund industry in India is one of the most transparent and better regulated industries in the financial services sector.

Growth of information technology, especially digital media, in our country has enabled access to a vast amount of information in user friendly format for retail investors. However, too much information can often cause confusion. In the first post of this series, Did you know what to analyze and ignore when selecting equity mutual funds, we discussed the difficulties in selecting equity mutual funds, despite the plethora of information available online. Many investors use fund ratings assigned by different mutual fund research portals to identify schemes for investments, but different research firms use different rating methodologies, which can lead to conflicting ratings and as a result, confusion for investors.

It is very important for investors to know, how to use the information available at their fingertips. More information means more analytics, but the interpretation of the analysis and opinions thereof, in terms of future potential of an investment can often be misleading and resulting in investors making wrong decisions. With this is mind, we discussed which data points should investors not base their investment decisions on in our previous post in this series, Did you know which parameters to ignore when selecting mutual funds.

In the third and penultimate part of this series, we will discuss the most important data points or analytical factors, which investors should look at when making mutual fund investment decisions. We understand that different investors have different levels of finance knowledge – so we will try to have simple, easy to understand factors and also, as few factors as possible.

Risk Profile

Different investors have different investment needs – investment goals, investment tenures, risk capacities, volatility appetites etc. Mutual funds offer products across almost the entire spectrum of all investment needs. However, investors should realize that, mutual funds are subject to market risks and that different mutual fund products have different risk profiles – investors should ensure that the risk profile of a scheme matches with their investment needs.

The market regulator, SEBI, has mandated that, risk level of each mutual fund scheme needs to be indicated. Earlier a color coding (blue, yellow and brown) scheme was used to indicate low, medium and high risk level. A few years back, SEBI introduced the Riskometer - the Riskometer is a pictorial representation of the level of risk of a specific scheme.

The Riskometer has five risk levels, as you can see in the picture above. Every AMC has to indicate the risk level of every scheme, existing or to be launched, as per the Riskometer. The Riskometer for every product / scheme is found on the monthly factsheets; it is also found in the AMC websites. Many mutual fund research websites also show the Riskometer for each scheme. Investors should use the Riskometer as the first filter for selecting mutual fund schemes for their specific investment needs.

As per good financial planning practice, investors should first clearly define investment needs – goals, tenure, risk appetite etc. Based on investment needs, investors should then determine which risk profiles are best suited for their specific needs. For example, for very short investment tenures, e.g. less than 1 year, investors should select mutual fund schemes with low risk profile (Riskometer reading). For longer tenures, investors can choose scheme with higher Riskometer reading, depending on their risk appetites.

In our view, Riskometer should be used to determine the product category according to risk profile, e.g. liquid funds, ultra-short term debt funds and arbitrage funds for low risk profiles; short term debt funds for moderately low risk profiles; long term income funds, monthly income plans and equity savings funds for moderate risk profiles; aggressive balanced funds, index funds and large cap funds for moderately high risk profiles; midcap funds, small cap funds and sector funds for high risk profiles. Always remember that, risk and return are directly related.

Fund Manager Track Record

In mutual fund’s performance attribution, the fund manager plays a very important role – sometimes, more important than the market itself. Therefore, the fund manager’s track record of beating the benchmark index across various (sufficiently long) time-scales is one of the most important considerations. Equally important is the fund manager’s track record of managing other mutual fund schemes.

Fund managers employ different investment strategies for different schemes they manage. A particular investment strategy may outperform or underperform versus the market in a certain period, depending on the strategy relative to prevailing market conditions in that period. Just because a scheme has underperformed in a certain period does not imply that the fund manager is not good because the performance may turnaround when the market conditions change in the future, which inevitably will. If a fund manager has underperformed in one scheme, where you have invested, but has outperformed in multiple other schemes, then it should give you confidence in the fund manager’s ability to generate alphas.

In this context you can read value investing versus growth investing in India

Where can you get the information regarding which schemes are managed by fund manager? Some mutual fund research websites have information on which schemes are managed by the fund manager, but not all research websites may have that information. The best information source is the monthly factsheets of Asset Management Companies. It takes a little bit of effort to sift through the factsheets, but to get the best results you need to put in some work.

While on the topic of mutual fund fact sheets, we suggest reading do you know to make sense of mutual fund fact sheets

Fund Manager Tenure

Please note that in the above section, we stressed on the fund manager’s performance and not the scheme performance. If a fund manager has managed a scheme through the performance (returns) evaluation period, then there is no difference between the scheme performance and fund manager performance. But you should realize that, like in every other industry, the mutual fund industry also sees staff turnover / attrition etc. Moreover, like any other organization, AMCs may change / reshuffle fund managers for different schemes in their portfolio, depending on their organizational priorities, keeping investor interest in mind.

If you are looking at 5 years trailing returns of a mutual fund scheme, whereas the current manager has been in the role for only the last 2 years, you may not draw the right conclusion. There is a considerable amount of subjectivity involved in stock selection at the right prices. If there was no subjectivity involved then a computer algorithm could have selected stocks and AMC’s would not have needed fund managers. Different fund managers have varied philosophies and skill sets. Therefore, it is very important that, the performance evaluation period of a scheme is congruent with the fund manager’s tenure.

We, in Advisorkhoj, like to see schemes managed by the current fund manager for a sufficiently long tenure, at least 3 to 5 years. However, this does not mean that a scheme which has seen a change in fund manager in the recent past or may see a change in near future, does not have high potential – if the new fund manager has a strong track record of performance, even if it is with a different AMC, then the scheme is worthy of consideration for your investment.

Fund manager tenure is the reason, why we in Advisorkhoj, do not give too much importance to very long term (10 to 20 years) performance. We have seen that, even though fund manager turnover is not very high in our country, over a very long period, it is unlikely for most schemes to be managed by the same fund manager. So while, 10 to 20 years returns make for great headlines, in our blog, we devote most attention to performance analysis in the last 3 to 5 years.

AMC Track Record

We have previously mentioned that the fund manager plays the most important role, even more important than the market, in your ultimate returns. However, you should understand that, the fund manager is not a one man army. The fund manager is supported by a team of research analysts and sometimes, also by a co fund manager. Therefore, the AMC capabilities in terms of research staff, processes and infrastructure are equally important. For evaluating the AMC performance, you should look at track record over a fairly long time period (maybe even 10 years or more) because capabilities at an institutional level are not built overnight. If multiple schemes of an AMC are top performers in different categories over the last 10 years or so, then you can get the confidence about the AMC’s capabilities.

Further, for many of our investment goals, we invest with a very long investment horizon, say 10 years or even more. The incumbent fund manager may or may not stay in his / her role throughout the duration of your investment tenure. This is where the AMC track record assumes a lot of importance.

An AMC with a strong track record will have the ability to attract top talent to replace outgoing talent. How will you know about an AMC’s track record? As mentioned in our first post, Did you know what to analyze and ignore when selecting equity mutual funds, different mutual fund websites assign star ratings to funds. You can find out whether multiple funds of a particular AMC got 4 star or 5 star ratings on this website, but as discussed earlier, the star ratings assigned by different research websites, may not always be the most reliable indicators.

An easier way, in our view, is to look at top performing funds across different time-scales and different fund categories. In Advisorkhoj, we have developed a tool, Top Performing Mutual Funds, where we rank funds in terms of their trailing returns performance across various trailing periods selected by the user. You can look at the Top 10 funds across various mutual fund categories over different long time periods (5 years and 10 years) – if multiple funds from an AMC stable figure in the Top 10 funds, across different categories over last 5 to 10 years, then it should give some assurance to the investors with regards to the AMC’s track record. Purely as an example, Sundaram Mutual Fund’s different schemes are in the Top 10 list across various categories like small / midcap funds, thematic funds, hybrid debt oriented funds (MIP) etc, over the last 5 to 10 years period. There are a few other AMCs also which can boast of a similar track record.

You may like to read here – which returns to use for selecting mutual funds

Conclusion

There are quite a few blogs online, which suggest how investors should select mutual funds based on trailing returns, standard deviations of returns, Sharpe Ratio, Sortino Ratio and Jensen’s Alpha etc. Many of these concepts are difficult to grasp for the average retail investor and many of these parameters tend to change over time as well. Most of these sophisticated metrics are available on the Advisorkhoj website too, but Advisorkhoj readers like the simplicity of our approach to investments.

In this post, we discussed 4 simple factors to consider, when selecting mutual funds for investments. These factors may be simple to understand, but it may take a bit of time and effort from a practical standpoint and this is where financial advisors can help investors. We also know that, there are investors among our readers, who have more advanced finance knowledge – for them we will also discuss a few additional analytical factors in our next and final blog post in this series. Please stay tuned……