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You need to know this, if you're investing in mutual funds!! - Outside View by PersonalFN

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You need to know this, if you're investing in mutual funds!!
Jul 28, 2011

At a time when the markets were on an upswing (from August 2006 - the first bull phase under consideration) as the FIIs (Foreign Institutional Investors) pumped in money, everyone was caught in the over exuberance and shunned everything that came along as negatives. The global economy too, seemed too far from a fall and continued to function in an over exuberant way by developing complex financial products. There was such a strong positive ambience laid over the world that it seemed "nothing can go wrong".

Gloom and Boom story
(Source: ACE MF, PersonalFN Research)

But as we all know, 'Everything that goes up has to come down', the overt exuberance too lost its steam and we saw one of the worst downturn in the global economy in the year 2008-09. Thus at a time when nothing seemed to be wrong, the global economy was hit due to its overt exuberant attitude. The sub-prime mortgage crisis (where loans were given below prime lending rates without even scrutinizing the repayment capacity of the borrower) in the United States, the fall of the Lehman Brothers sent out ripples across the globe, and the world economies bled after that.

The point of focus here is that whenever the economy has been in an upswing, the financial institutions have come up with innovative but rather complex products. For the matter of fact even mutual fund houses have launched variety of schemes, with great excitement and fervour and spend millions of dollars on promotions and ad campaigns. We are sure you must have witnessed these ad campaigns with sparkling neon sign boards, full page colour ads in newspapers, etc; which the fund houses undertake to promote their mutual fund schemes and garner more and more AUM (Assets Under Management).

But interestingly, have you ever seen such ads and promotional campaigns when the economy is bleeding or is going through turmoil? The answer is a big 'NO!' And why, because the mutual fund schemes are in a bad shape as regards their performance is concerned and as such there is nothing to boast about. Moreover, you won't even witness your mutual fund distributor / agent/ relationship manager persuading to buy furthermore, as they are all aware that investor confidence is low, and also knowing the fact that you investors would grill them on questions such as why have my funds performed badly when it was showing great performance during the bull phase (or when everything was going good)?" etc.

We recognise that these are valid questions, and your mutual fund distributor / agent / relationship manger is answerable to you. But as a matter of fact very often they refrain from facing you either because they are incompetent in answering such questions or they are merely interested in making hay when the sun shines (making more commissions!) when the markets are roaring and investor sentiments are upbeat.

Remember, while selecting mutual funds for your portfolio you need to assess your investment objective first, and thereafter depending upon the mandate as well as investment strategies, judge whether it can do good to your portfolio. It is noteworthy that the fund's ability to shield its downside depends upon its investment strategy along with the investment process and systems which it follows. This can help you investors ascertain the rationale of investments made by the fund manager of a respective fund, along with the trait which he follows while investing - i.e. buying and holding onto investments or engaging into momentum playing.

Resilience Test
(Quantum Long Term Equity fund was launched in March 2006)
(Source: ACE MF, PersonalFN Research)

Performance across market cycles
Scheme Name BULL PHASE BEAR PHASE BULL PHASE
02-Jan-06 - 09-Jan-08 09-Jan-08 - 09-Mar-09 09-Mar-09 - 29-Jun-11
DSPBR Top 100 Equity (G) 55.15 -45.19 38.93
HDFC Top 200 (G) 46.00 -48.90 53.23
JM Equity (G) 44.39 -64.85 36.66
Quantum LT Equity (G) * 33.71 -47.30 53.91
BSE SENSEX 48.52 -55.34 42.62
BSE Sensex - TRI 51.86 -54.69 44.21
BSE-100 51.46 -58.08 44.10
BSE-200 50.79 -59.00 45.38

Let us understand this in a better way with an example.

In the above graph we have considered four diversified equity funds - DSPBR Top 100 Equity Fund, HDFC Top 200 Fund, JM Equity Fund and Quantum Long term Equity Fund. All of the four funds under consideration performed well during the period from January 1, 2006 to January 9, 2008 (the first Bull phase under consideration).

But when the global economy bled (during the period January 9, 2008 to March 9, 2009) as the sub prime mortgage crisis emerged in the U.S., these funds under consideration did suffer a setback. However, when we analyse intimately we observe that not all of them have fallen so badly. So the question here arises is, what has kept some funds from shielding their downside? Well, it is nothing but their investment strategies, portfolio characteristics and their investment process and systems, which have helped them to preclude their downside risk. For example DSPBR Top 100 Equity Fund in the above graph held its downside well because of its fair diversification in 32 stocks (as per it portfolio as on February 28, 2009), and robust large cap companies in its top-10 stock portfolio (which constituted 40.2% of its total portfolio) such as HUL Ltd., Infosys, TCS, HDFC Ltd., L&T Ltd., Nestle etc.; which remain favourite value buys for everyone even when the equity markets correct.

But quite contrastingly, JM Equity Fund which is also a large cap fund was having fairly a concentrated portfolio (as on February 28, 2009) of only 15 stocks, where even the top-10 stock holdings constituted 63.4% of its portfolio. Moreover the fund didn't refrain from indulging in momentum playing as it included stocks such as United Phosphorous Ltd., Bombay Rayon Fashions Ltd. and IVRCL, which led to it falling more during the bear phase of the equity market. It is noteworthy that its accentuation of returns during the bull phase January 1, 2006 to January 9, 2008, was due to indulgence in momentum playing stocks (in the mid and small cap segment), which in turn took a toll on the returns of the fund as they were battered during the downturn of the equity markets.

So the next time you see any ads or hoardings boasting about a fund's fantastic performance, just don't get carried away with the numbers and instead do some fact finding and research on your own or source it from an unbiased mutual fund advisor.

Remember in order to select winning mutual funds for your long term portfolio do not just bank on the performance criteria of the fund, instead please follow the checklist before taking the decision of investing your hard earned money into it:

Is the fund following its stated investment objective and strategy?

This is very important as you have seen above. If the fund diverts from its investment mandate it could be disastrous for its investors from a long term point of view.

Is the fund well equipped to shield its downside?

Well, if the fund is well diversified across market caps and across sectors it will be well guarded to shield its downside to a considerable extent. On the other hand if a fund has momentum stocks as its composition and is very concentrated then it will not be in a position to limit its downside.

Also, you investors need to consider certain parameters which are crucial in selecting the right mutual funds for your portfolio.

A. Performance of the fund:

Though performance of a scheme is an important parameter which helps us to gauge a fund's past performance, its consistency in delivering returns, etc., it is imperative to recognise that it is not the only parameter. Thus, you as an investor should not jump to conclusion about a fund based on its performance only.

Moreover under the performance criteria, we must make a note of the following parameters too:

  • Comparisons: It is very important to compare the performance of the funds in the same category so as to arrive at a fund which stands out among its peers. Analysing a fund in isolation is of no relevance. Thus, comparing similar funds is vital before you take any investment decision.

  • Time period: When you opt for equity diversified fund for investment make sure your investment time horizon is at least 3 years. Long term investing is the best way to generate wealth. Also, a fund will do well when the stock markets are experiencing euphoria but the core strength of a fund is brought when there is a downturn in the markets. Thus, a fund's performance must be analysed across different market cycles or time periods.

  • Returns: Returns are 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 investors simply invest in a fund because it has given higher returns. In our opinion, such an approach for making investments is incomplete. In addition to the returns, investors must also look at the risk parameters, which explain how much risk the fund has taken to clock higher returns.

  • Risk: You as an investor must know as to what degree of risk you are exposed to when you invest in a particular fund. This risk in a fund is normally measured by Standard Deviation (SD). A fund with a low SD is preferable to its peer with a higher SD (from the same category).

  • Risk-adjusted return: Having a low SD is not enough by itself. A true performing fund will not only keep its SD under check but also generate luring risk-adjusted returns for its investors. This risk-adjusted return is normally measured by the Sharpe Ratio (SR). Thus the SR of your fund will tell you whether it is worth taking risk that level of risk.

  • Portfolio Concentration: Whenever a fund clings to limited stocks in its portfolio, the fortunes of the fund get closely linked to those of the underlying stocks. Thus, a fund having a high portfolio concentration is exposed to higher risks than those funds which have well diversified portfolio across sectors and market caps.

  • Portfolio Turnover: High churning (frequently buying and selling stocks in a portfolio) in a fund's portfolio leads to high volatility. Also, you investors are exposed to high transaction costs incurred by the fund manager due to frequent churning. As opposed to this a fund which follows a 'buy and hold' strategy gives stable returns.
B. Fund Management:

Now that we are aware of the parameters to be looked into while selecting winning mutual funds, remember that fund manager has a lot of influence on the performance of the fund. The style of management, philosophy of the fund manager, etc. is well reflected in the performance of the fund. Also, please remember that those funds which gain popularity just because a 'star fund manager' is managing such fund, does not make it potential candidate in your portfolio. Such funds which are driven by star fund managers may well go down the pit one day when the star fund manager quits a particular fund house and joins elsewhere. Hence it is imperative that due importance to investment process and systems is also given.

C. Costs

It is important for you investors to know what are the costs associated with your investments in mutual funds. It makes perfect sense to go in for a fund which has less cost associated with than fund which has higher costs (even marginally) other parameters remaining constant. The two main costs incurred are:

  • Expense Ratio: As an investor your investment in a mutual fund scheme will attract certain amount of mandatory charge which is known as an expense ratio. This expense ratio helps the mutual fund scheme manage its day-to-day expenses like administration cost, manager's salary, etc. This charge defers from one mutual fund scheme to another with a maximum limit of 2.50%.

  • Exit Load: An exit load is triggered when a particular investment in a mutual fund scheme is redeemed before the stipulated period (generally one year from the date of investment in diversified equity funds). This charge helps you investors to inculcate a habit of long term investing which is important for you to generate wealth.
Hence, the next time you invest in mutual fund schemes to create wealth in the long-term, remember not to get lured by fancy ad campaigns (which often come when investor sentiments are upbeat). It is imperative that you hire the service of a responsible, unbiased and independent mutual fund advisor, who focuses on extensive research while advising winning mutual funds for your portfolio, and also educate yourself to make prudent investment decisions.

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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