Guide to choosing mutual funds

Moneyjar Team / September 19, 2018
Guide to choosing good mutual funds

Choosing a good mutual fund to invest in is a reverse engineered process. We would like to shed light on this process so that investors can take informed investing decisions.

Even before one begins to assess which mutual funds to buy, it is important to first understand the concept of asset allocation.

In simple terms-

Asset allocation is the act of dividing your investments into asset classes – debt (Predictable Returns, Lower Risk/Lower Returns, eg. Fixed Deposit, PF, Debt Mutual Funds, etc.) or equity (Higher Risk/Higher Return Possibility, eg. Stocks, Equity Mutual Funds, etc.) to balance the risk versus reward by adjusting the % of each asset class in an investment portfolio.

The Asset Allocation you choose is determined by your risk appetite. If the proportion of equity is higher as compared to debt in your portfolio, then the risk is higher and vice versa.

The risk you can take OR you choose to take can be based on multiple factors. Some of them are:

  • Investment Time Horizon

    If you require the money you are investing within 2 years, generally invest only in debt. The longer your time horizon, the higher the proportion of equity you can have in your portfolio.

  • Criticality of Goal

    Along with Time Horizon, if your goal is extremely critical in nature eg. buying a house as compared to saving for a concert ticket, you would generally want to take lower risk i.e. more allocation in debt.

  • Age

    If you don’t have a specific time horizon for your investments, your age can be used as a factor to evaluate how much risk to take. Generally, the risk factor is inversely proportional to your age. As a thumb rule, (1 – Your age) is the proportion of equity you should have in your portfolio. e.g. If you are 30 years old, your portfolio can be 70% Equity, 30% Debt. Bear in mind, this is a thumb rule and is not the most accurate way to determine asset allocation.

An insider fact from the finance industry that is never openly discussed is that –

Asset Allocation explains 90% of your returns. The Individual mutual funds that you choose has very little bearing on your long term returns.

Once you determine an appropriate asset allocation, you can go about figuring out best-in-class mutual funds. The graph below plots different kinds of funds on a risk-reward scale.

 

WHAT YOU SHOULD NOT BE DOING!

Reviewing past performance to assess future returns:

It has been observed that mutual fund companies, financial advisors and distributors etc. are touting lists of mutual funds with only one metric to show – past performance. Either they are incapable of identifying forward-looking factors or they feel that the average consumer might not comprehend.

This dumbing down of the consumer is extremely harmful. We will attempt to shed light on how mutual fund investments should be picked.

If past performance were really the only factor in determining future performance, nobody would ever need financial advice and everybody would make great returns!

Why relying ONLY on past performance can be bad for your investment performance.

  • Mutual funds showing high returns in the past might have taken on an undue risk to achieve good returns. This works fine during an upswing but can easily backfire when markets plummet.
  • If a mutual fund has shown high returns in the near past, there is a risk that the portfolio could be highly overvalued. This would lead to underperformance in the future.
  • A fund’s return is a function of the return of the stocks in its portfolio. There is a good chance that the current portfolio may not even have contributed to the returns in the past as fund managers constantly add and remove funds in their portfolio!

GIVEN BELOW ARE SOME OF THE FACTORS THAT YOU SHOULD CONSIDER WHILE CHOOSING MUTUAL FUNDS:

Factors to look at while choosing Equity Funds:

  • Portfolio P/E and P/B Ratio:

    The Price-to-Earnings and Price-to-Book ratio indicates how much a company’s stock or a fund’s portfolio is valued as a multiple to its earnings and book value respectively. These are good metrics to look at to find relative value in the stock/fund. Generally, the lower these ratios the more undervalued the fund/stock is and consequently, the more margin of safety and chances of outperformance are present. While this may not be a failsafe indicator to figure out the attractiveness of a fund, it gives a decent insight into the fund’s portfolio valuations. Value Investing, the preferred investing philosophy used by Warren Buffet, generally looks for low P/E, P/B portfolios/stocks.

  • AUM Size:

    While a lot of people believe higher AUM is a good thing, with equity funds I would recommend going for a fund with a medium sized AUM: Anywhere between 500 Crores and 5,000 Crores. Funds with an extremely big AUM find it hard to maintain outperformance. They either have to increase the number of stocks or increase the positions in single stocks.

  • Benchmark Hugging:

    Most mutual fund schemes mimic their benchmark index to a large extent as they are afraid to be seen as contrarian in the event of underperformance. This, however, is detrimental to the investor as he is paying the fund manager to produce outperformance from the benchmark.

    At Moneyjar, we research and recommend schemes that tend not to mirror their benchmarks very closely so that they can produce outperformance for our users.

 

Factors to look at while choosing Debt Funds:

  • Yield To Maturity:

    This metric, when subtracted from the expense ratio of the debt fund will give you the possible annualized future return of the fund assuming the fund manager just holds the debt portfolio to maturity. For eg. If YTM of the fund is 8.5% and the expense ratio is 1%, then approximate yield from the fund would be 7.5%. This is a good starting point for trying to ascertain returns from a debt fund, however, there is another important factor to consider – modified duration.

  • Modified Duration:

    This metric determines the sensitivity of the fund to changes in interest rate. Generally, when interest rates move higher debt fund NAV would move lower and vice versa. The higher the modified duration of the fund, the higher the sensitivity of the prices to changes in interest rates. So, if you feel interest rates might rise in the future, it’s better to choose debt funds with lower modified duration keeping all other things equal. In general, funds with a lower NAV like liquid or short-term debt funds are less volatile and safer as compared to bond/income funds.

  • Credit Quality

    This is one of the most ignored factors when it comes to debt funds. Many investors are lured by credit risk funds, which are debt funds that invest in corporate bonds seeing high returns. While they might generate higher returns, do keep in mind the default risk they take. If a corporate bond defaults on payments, it is likely to take a hit on the fund returns. While credit risk funds aren’t bad, keep in mind the risks and don’t allocate all debt investments to credit risk funds.

  • AUM Size:

    Contrary to equity funds, a higher AUM size in debt is generally preferred along with funds from bigger AMC’s. For example HDFC, ICICI and Birla Sun Life as there is more comfort in the risk management systems and implied safety with debt funds of these AMC’s.

 

We hope this provides valuable insight to both beginners and seasoned investors alike!

Financial advisors in India should not be afraid to recommend funds that may not have done well in the past. They might just do great in the future. Letting clients know why you choose a particular fund is better than just mindlessly recommending funds.

No algorithm or automated decision-making system alone can pick great investments as they would rely on past performance. Fund picking is both, an art and a science.

Do visit our online platform, Moneyjar where we pick mutual funds for you to invest in using a similar thought process.

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