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5 Bad Ways to Pick Mutual Funds - And One Good Way - Outside View by PersonalFN

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5 Bad Ways to Pick Mutual Funds - And One Good Way
May 11, 2018

It is a known fact that bulk of household savings lies with banks. Bank Deposits have often been a safe haven for risk-averse Indian savers. However, over the past few years, the trend seems to be changing - aided by a decline in interest rates. Savers have started opening up to market-linked investments like mutual funds.

A recent report by CARE Ratings states, "In FY18 it has been observed that there was conscious migration from bank deposits to mutual funds as deposit rates had come down sharply making them less remunerative. In incremental terms, mutual funds were able to garner a proportionately higher share of household savings."

Not only equity funds, but income and debt funds as well, which compete directly with bank deposits, witnessed a growth of 18% per annum, the report cited. A plausible rationale for this trend - The declining interest rates of bank deposits has been a deterrent for savers, their interest started moving towards debt mutual funds, which have been offering returns of 100-200 bps higher.

This renewed interest in mutual funds is leading to an influx of assets. In FY18, investors allocated about Rs 67,190 crore through SIPs (Systematic Investment Plans) in equity mutual funds. This was a massive 53% increase over the previous financial year. In March 2018, inflows through SIPs touched the highest for a month at Rs 7,119 crore, AMFI data revealed. Total SIP accounts stood at 2.11 crore at the end of March.

Given this trend and the plethora of mutual fund schemes available, investors have been constantly hunting for the top mutual funds, best mutual funds or the top mutual funds for SIP etc. Unfortunately, in this excitement, investors end up making mistakes - mistakes that can ruin their financial health.

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Must read: 10 Mistakes To Avoid While Investing In Mutual Funds Are you making these mistakes?

There are several ways you can select a top mutual fund for your portfolio. To put it simplistically, these routes can be broadly be categorized into good ways and bad ways. The former requires you to dedicate a considerable amount of time if you plan to do it yourself, while the latter is an outcome of our behavioural biases.

Let's face it, none of us would opt for the bad ways of fund selection. But unknowingly, we tend to pick the wrong option.

So here, we highlight the bad ways to pick a mutual fund. If you are adopting any of these methods or a combination of them, it is time to alter your approach and get your existing mutual fund portfolio reviewed.

The Top 5 Bad Ways to Select A Mutual Fund

  1. Not considering your financial situation, investment goals, risk profile etc.

    Getting carried away by the success stories of others and investing in mutual funds without considering your financial goals, risk appetite, and most importantly, your current financial situation will prove to be a big mistake in the long run.

    For example, if you have a time horizon of say 2 years and invest heavily in an equity-oriented mutual fund, your investments will be misaligned with your goals. Likewise, if you want to park some money for about a month, and invest in a long-term debt fund hoping to ride the opportunities in the bond market, you might lose money in a debt fund as well. So pay attention to your financial needs and be careful about the fund category selection.

    Do read: 10 Reasons Why You Need A Financial Plan

  2. Relying solely on past performance

    You may be well aware of the disclaimer "past performance is not an indicator of future returns". Yet, many rely heavily on the recent performance of a mutual fund scheme. If a scheme has performed extraordinarily well in the past couple of years, invest tend to rush in and invest in such schemes without being fully aware of the risk.

    For example, mid- and small-cap funds tend to do extremely well in a market rally. However, when the market faces volatility, they tend to rank among the worst performers. If you do not consider the performance of the fund across market periods and market cycles, you will not be aware of the risks associated with such funds.

    While past performance gives some insights on how the scheme is managed, it should be considered along with other risk-return parameters as well.

    Also read: Equity Mutual Funds With Large AUM-Is Big Better?

  3. Ignoring qualitative parameters

    Mutual Fund schemes need to be picked based on both quantitative and qualitative parameters. While the quantitative factors delve into past performance and risk-return metrics, the qualitative aspects rate the fund manager's experience, investment systems, and processes, among other things.

    Qualitative factors are more important than the historical performance, to judge the future growth potential and long-term consistency of the fund. By adopting a multipronged approach, you will have a list of top funds that have not only done well in the past, but those that have robust investment systems and risk management techniques in place.

  4. Opting for top star-rated funds

    Blindly investing based on the star ratings of mutual fund schemes can prove risky. You need to check the parameters considered by the rating agency for assigning the "star ratings". Like naive investors, if they too only consider returns of schemes, it's better to seek professional counsel.

    A 5-star rated fund today may become a 3-star next year. These ratings are assigned and revised on regular basis. In certain cases, there is a stark contrast in ratings. While some schemes are rated 5-star by one agency, another rating firm has given these a 3-star or 2-star rating. Some rating agencies rank the direct plans and regular plans individually (for some strange reason).

    Most of these ratings focus on quantitative parameters such as returns, risk-return tradeoff, corpus size, portfolio turnover, etc. Some give a high weighting to recent performance or often consider point-to-point returns. But more importantly, most neglect (sometimes completely) the qualitative parameters, which in our opinion, are also of utmost importance.

    Additional Reads:

    Why You Should Stop Looking At Mutual Fund Star Ratings Now

    Mutual Funds With Multiple Star Ratings! Whom Should You Trust?

  5. Taking advice from friends and relatives

    Yes, there is an implicit trust we have in our friends and relatives, which we depend upon. But then you have to realize what is good for them may not be good for you. Friends or relatives may not be able to dedicate the time required to understand your financial needs. At times, we may not be comfortable in discussing our finances in detail. Since you will have different goals and risk-taking abilities, what you invest in should reflect your needs.

    Also if your friend or relative is not a qualified investment adviser, they would rely on other sources for their recommendations. Most of such advice could be run off the mill. For you, it will become difficult to ascertain the reliability of that advice. Hence, it would be best to approach a SEBI-registered investment adviser. You will have to shell out a small fee, but it would be worth it. The advice will be more accountable.

If you are seeking top quality funds for your portfolio, you need to consider Quantitative and Qualitative Parameters to fund selection.

The good way to pick mutual funds

There is a good way to fund selection, and that can be achieved by doing your own research. Here is what you need to consider:

Quantitative Parameters

  1. Performance and risk analysis

    This is to analyse if the fund has shown consistency in performance across various market periods with decent risk-adjusted returns. Under this, the fund needs to be ranked on quantitative parameters like rolling returns across short-term and long-term periods such as 1-year, 3-years and 5-years, and on risk-reward ratios like Sharpe Ratio, Sortino Ratio and Standard Deviation over a 3-year period.
  2. Performance across market cycles

    You need to ensure that the fund has the ability to perform consistently across multiple market cycles. Compare the performance of the schemes vis-a-vis their benchmark index across bull phases and bear market phases. A fund that performs well on both sides of the market should rank higher on the list.

Qualitative Parameters

  1. Portfolio Quality

    Adequate Diversification - The scheme should not hold a highly concentrated portfolio. The portfolio should be well diversified and the exposure to the top 10 holdings should be ideally under 50%.

    Credit Quality - For debt portfolios, you need to ensure that the fund does not hold a high proportion of low-rated (securities rated AA or below) or unrated debt instruments. A fund with a higher credit quality should be ranked higher.

    Low Churn - Engaging in high churning can result in trading and high turnover cost. Therefore, you also need to consider the portfolio turnover ratio and expenses, and penalise funds involved in high churning, i.e. those funds with a turnover ratio of above 100%.

  2. Quality of Fund Management

    You also need to consider the fund manager's experience, his workload and consistency of the fund house. Therefore, you could check -

    The fund manager's work experience - He/she should have a decent experience in investment research and fund management, ideally over a decade.

    The number of schemes managed - A fund manager usually manages multiple schemes. Thus, you need to check if the fund manager is not loaded with a large number of schemes. If he is managing more than five open-ended funds, it should raise a red flag.

    The efficiency of the fund house in managing your money - You need to check if the fund house is consistent in performance across schemes or if only a few selected schemes are doing well. A fund house that performs well across the board is an indication of sound investment processes and risk management techniques in place.

Yes, we know that the above list is a lot for an average investor to look at. It involves a lot of number crunching and much of the data is not easily available at one place. But if you do need to narrow down on the top funds, these factors are of utmost importance.

To know more about selecting winning mutual funds, watch this short video:

8 Steps To Select Best Mutual Funds


In fact, PersonalFN adopts the exact process when selecting funds. Based on a composite score, which has a weight to each parameter, PersonalFN gives its views on each fund recommended under various mutual fund research services.

Yes, the process followed by PersonalFN is much more comprehensive in nature. We do not rely only upon quantitative parameters that are passive in nature. The qualitative parameters we use, helps us project the long-term consistency and stability of the fund house and fund management. What we look for are quality funds that can be consistent performers in the long run.

P.S. - Save yourself the time and energy that goes into fund selection, opt for PersonalFN's Premium Mutual Fund Research service 'FundSelect'

Every month, our FundSelect service will provide you with an insightful and practical guidance on equity funds and debt schemes - the ones to buy, hold or sell, thus assisting you in creating the ultimate portfolio that has the potential to beat the market.

And there's more great news!

FundSelect is turning FIFTEEN.

And on this auspicious 15th anniversary of FundSelect, we intend to make it "ultra-special" for you.

How?

Well, how about getting 1 Year of access to FundSelect virtually Free?

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Check out the exciting offers that can be availed on subscriptions to FundSelect here.

Go ahead and subscribe to PersonalFN's FundSelect NOW!

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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