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'SIP'ping into the right mutual funds
Apr 15, 2011

Well, to start with this piece of education, please keep in mind that there are no special or dedicated mutual fund schemes for Systematic Investment Plans (SIP). SIP as you know is just a mode of investing in mutual funds to provide you the benefits of the rupee cost averaging and the power of compounding for your hard earned savings.

But understand one thing; selecting an appropriate mutual fund scheme for your SIPs is very crucial. A lot of time and effort is required in selecting the right mutual fund scheme based on various parameters (quantitative and qualitative). Just going by the "Star Fund Ratings" won't fetch you consistent performing mutual funds, as they take into account only few quantitative parameters (such as returns, risk, average AUM (Assets Under Management) etc., thereby ignoring the qualitative parameters.

Also, given the fact there are host of mutual fund schemes available in the markets, you just cannot ignore the skill of selecting the wealth creating mutual fund schemes. Hence, you must take into account the following points while 'SIP'ping into mutual funds in order for you to have the right ones in your portfolio:

  • Performance

    The past performance of a fund is important in analysing a mutual fund scheme. But just going by the past performance would not be the right way to go about selecting a mutual fund scheme.

    Along with the past performance you should also check out the performance of the fund across different market cycles so as to find out the fund's 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.

    However, in order to holistically analyse the term performance you must consider the following aspects carefully:
    1. Comparison: A fund's performance in isolation does not indicate anything. Hence, it is crucial to compare the fund with its benchmark index and its peers, so as to construe a meaningful conclusion. Again, one must be careful while selecting the peers for comparison. For instance, it doesn't make sense comparing the performance of a mid-cap fund to that of a large-cap. Remember: Don't compare apples with oranges.

    2. Time period: It's very important that you have a long-term horizon if you are looking at investing in equity oriented mutual funds. So, it becomes important for you 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 posts higher returns 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.

    3. 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 of us simply invest in a fund because it has given higher returns. In our opinion, such an approach for making investments is incomplete and incorrect. In addition to the returns, one should also look at the risk parameters, which explain how much risk the fund has taken to clock the returns.

    4. Risk: The term risk simply refers to the possibility of the outcome being different than the expected one. When the outcome is different from the one expected, it is referred to as a deviation. Risk in a mutual fund scheme is measured through the statistical measure called "Standard Deviation" (SD or STDEV).

      It is very vital to evaluate a fund on risk parameter because it will help to check whether the fund's risk profile is in line with your risk profile or not (is it suiting your willingness to take risk). For example, if two funds have delivered similar returns, then by sheer prudence, you should invest in the fund which has taken less risk i.e. the fund which has a lower SD.

    5. Risk-adjusted return: This parameter measures the returns generated by the fund for the risk taken, and is evaluated through a statistical measure called Sharpe Ratio (SR). It signifies how much return a fund has delivered vis--vis the risk taken. Higher the SR better is the fund's performance. For evaluating mutual funds, it is important to take this parameter, because it reveals whether a fund is justifying the risk taken.

    6. Portfolio Concentration: This parameter reveals the over-exposure of a mutual fund to a particular company or a sector. By over-exposing a fund to a specific stock or a sector, the fortune of the fund will be closely linked to the stock and / or sectoral bets taken by the fund.

      Funds that have a high concentration in particular stocks or sectors tend to be very risky and volatile. Hence, one should invest in those funds where the top 10 stocks do not exceed 50% of the fund's assets.

    7. Portfolio turnover: This parameter measures the frequency with which stocks are bought and sold. Higher the turnover rate, higher is the volatility. It is noteworthy that the fund might not be able to compensate the investors adequately for the higher risk taken. So, by judging this, you can come to know how frequently the fund manager changes his stock bets.

      You should ideally invest in a fund, with a lower portfolio turnover ratio, as this exposes you to lower volatility.
  • Fund Management

    This is one of the qualitative parameter, while selecting funds for wealth creation. The performance of a mutual fund is largely linked to the fund manager and his team. He's the guy who's managing your money invested in mutual funds, so knowing his experience in fund management will be valuable. It's vital that the team managing your fund should have considerable experience in the field of fund management and equity research, in order to deal with market ups and downs.

    You should not go by "star" fund manager. Simply because the fund manager who is employed with an AMC today, might quit tomorrow; and hence the fund will be unable to deliver its "star" performance without its "star" fund manager. Hence, your 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.

    1. 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 manger being over-burdened in managing these multiple mutual fund schemes, which can result in lower efficiency of the fund manager on focusing on the need of his investors.

      Hence, it becomes imperative to select a mutual fund house where, the fund manager is not over-burdened; otherwise this might just take a toll on the fund's performance.

  • 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. The two main costs incurred are:

    1. Expense Ratio: Annual expenses involved in running a 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 investors in the form of an Expense Ratio. Hence, a higher churning not only leads to higher risk, but also higher cost to the investor.

    2. Exit Load: Well, that's the price which you pay while exiting from your funds, within a particular tenure; most funds charge if the units are sold within a year from date of purchase. As exit load is a fraction of the NAV, it eats into your investment value. Hence, one should invest in a fund with a low expense ratio and stay invested in it for a longer duration.
    So, the next time you plan to invest in a mutual fund scheme, be smart and adopt the SIP route for investments but taking into consideration the aforementioned points. Always remember educating yourself pays a lot in the long term.

  • PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.

    Disclaimer:

    The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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    2 Responses to "'SIP'ping into the right mutual funds"

    anbazhagan

    May 1, 2011

    equity.,balansed,compar,with,fastfund

    Like 

    Jai Prakash Dubey

    Apr 27, 2011

    Dear Sir,
    It is a well composed article on SIPing.
    Still I think that characterstics of various MF categories,
    as to say,Equity,Debt,Sectorial,Thematic etc. should have
    been encorporated to make it more useful and exhaustive.

    Like 
      
    Equitymaster requests your view! Post a comment on "'SIP'ping into the right mutual funds". Click here!

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