How to Select Mutual Funds

Mutual Funds have proved to be a potent avenue for wealth creation over the long term. Indian investors have keenly invested in mutual funds for wealth creation, either via lump sum investments or SIPs (Systematic Investment Plan).

But investors are puzzled about selecting from a wide range of schemes across categories - equity, debt, hybrid, solution-oriented, and others - as well as the various subcategories.

There is also confusion about choosing the direct plan or regular plan, and the growth option or the IDCW (Income Distribution cum Capital Withdrawal) option.

Your choice should be determined by your personal risk profile, broader investment objective, the financial goal/s you plan to address, time in hand to achieve the goal, and tax efficiency.

As regards tax implications, if you are considering the IDCW investment option, you need to be mindful that here the income distribution or dividends are taxable as per your income tax slab. If you are in the high tax bracket, the tax impact will be more.

Whereas in the growth option, the capital gains tax rate is lower for long-term capital gains, thus providing tax efficiency. That said, you also need to consider your liquidity needs when deciding on these investment options.

As regards the Direct Plan or Regular Plan, the expense ratio in the Direct Plan is lower because you are making the investment directly with the fund house.

In the Regular Plan, since your investment is routed through the distributor/agent/broker/bank. To cover the marketing and distribution costs, the fund levies a higher expense ratio.

The difference in the expense ratio of the Direct plan and Regular plan of diversified equity mutual funds can range from 0.4% to 2%, with an average difference of about 1.2-1.5%.

While this may seem small, over the long term, it can make a substantial difference to the overall returns you make from the scheme.

Impact of Expense Ratio on Returns

Note: The table here is for illustration purposes only.

As regards the investment strategy, objective, portfolio, and fund manager, there is no difference between the direct plan and the regular plan. The only differentiating factor is the expense ratio.

The decision to opt for the direct plan or regular plan should be made based on whether you can handle and monitor all your investments on your own without the help of a mutual fund distributor.

If you choose a mutual fund distributor, who may be an agent, broker or bank, keep in mind that most will offer the regular plan by default.

However, if you are seeking services of a 'SEBI-registered investment advisor' who guides you in selecting mutual funds considering your needs, risk profile, and financial goals, the regulatory guidelines mandate a registered investment advisor (RIA) to advise only the direct plan. An RIA cannot act as a mutual fund distributor.

Whether you opt for the direct plan or the regular plan and growth or IDCW option, selecting the best mutual fund schemes is crucial.

So, what are the specific factors you should look at when selecting mutual funds?

1. Investment Mandate and Objective

   This is the first thing you should look at when selecting mutual fund schemes. Every scheme, depending on the category and sub-category, has a distinct investment mandate.

   For example, an equity-oriented fund has the broader mandate of capital appreciation over the long term. But whether it invests in largecaps, midcaps, smallcaps, multicaps, or takes a flexi-cap approach or looks at dividend-yields, needs to be looked at.

   Plus, the kind of style - value, growth, or blend - and strategy also needs to be assessed carefully. In addition, whether it is sector agnostic or follows a sector-orientation or themes.

   All this can be found in the Scheme Information Document (SID) and factsheet. It is important to read and assess if the scheme is suitable for your risk profile, investment objective and time horizon, rather than making ad hoc investments.

2. Investment Philosophy, Processes & Systems, And Fund Management Team's Credibility

   Every fund house has an investment ideology and philosophy. It needs to align fairly with yours.

   Look for the investment processes and systems followed in the endeavour to drive performance and achieve the stated objectives. When it's well defined, it's reassuring as opposed to when it's left to the fund manager's whims and fancies.

   In this respect, the credentials of the fund management team also matter. Check the qualifications of the fund manager, years of experience in fund management, number of schemes the manager handles (ideally not more than 4-5), and the performance of schemes managed so far.

   Avoid laying much emphasis on schemes managed by star fund managers, because tomorrow, when he/she leave the organisation, it may weigh on the performance of those schemes, particularly when there aren't well-defined investment processes and systems to back them up.

3. Historical Returns

   The returns of the mutual fund scheme should be compared with the returns over various periods, like 6 months, 1 year, 2 years, 3 years, 5 years, and so on.

   For up to one year, evaluate the absolute return. For periods over one year, check the compounded average growth rate (CAGR), or even better, the compounded annualised rolling returns.

   The rolling returns provide a realistic picture of the performance, eliminates the risk of recency bias, and evens out the lopsidedness due to volatility.

   Also, check how the scheme has performed across bull and bear market phases. Most funds will fare well when markets are rallying, i.e. a bull phase, but the true test that separates the men from the boys is a bear market.

   A well-managed scheme would ideally fall less in a bear market compared to its category average and the benchmark index. If a fund has not performed well in any of the market cycles, it might not turn out to be a good investment.

   With that in mind that while you are checking the past returns, do not give a high importance to it, as past returns are in no way indicative of how future returns would be. Mutual fund investments, as you know, are subject to market risks.

4. Risk-Reward Ratios

   'The essence of investment management is the management of risks, not the management of returns.'

   - Benjamin Graham

   The risk a mutual fund takes to generate returns can be assessed by the standard deviation (SD).

   The SD measures the volatility, i.e. how much the fund moves up and down when generating returns compared to its benchmark.

   It tells you how a fund's return would deviate from the average expected return and depicts how risky the fund is. If the volatility is high, the SD will be high.

   If 'Fund A' has an SD of 17% and 'Fund B' has an SD of 14%, it means 'Fund B' is more volatile compared to 'Fund A' and will be a riskier fund, suitable for investors who are willing to take a higher risk.

   If the fund is taking a higher risk, it should be able to justify it by way of higher risk-adjusted returns.

   How do you assess the risk-adjusted returns?

   Well, broadly evaluating three ratios: Sharpe ratio, Sortino ratio, and Treynor ratio.

   The Sharpe ratio (SR), named after an American economist, William F. Sharpe, is calculated by taking the difference between the returns of the investment and the risk-free return, and then dividing it by the SD of the portfolio.

   For the risk-free return, usually, the 10-year G-sec yield is considered. The higher the Sharpe ratio, the better the fund's ability to reward investors with higher risk-adjusted returns.

   The Sortino ratio, named after Dr. Frank A. Sortino, is similar, but it only takes into consideration the downside risk. It's calculated as the difference between the returns of the investment and the risk-free return, and then dividing this difference by the downside SD.

   It's particularly a useful measure to evaluate funds in depressed market conditions. If a fund has a higher Sortino ratio, it means it has managed the downside risk better and optimised returns.

   The Treynor ratio, named after Jack L. Treynor, unlike the above two ratios, uses beta. This ratio is calculated as the difference between the returns of the investment and the risk-free return and then dividing this difference by the beta. Beta is a measure of systemic risk.

   Beta measures the fund's relative performance to its benchmark index. A beta of more than 1 denotes that the mutual fund scheme is more volatile than its benchmark, while less than 1 means it's less volatile. If equal to 1, then it's almost equally volatile as the benchmark index.

   Checking the Treynor ratio helps in understanding if the fund is adequately compensating investors vis-a-vis the systemic risk. The higher the Treynor Ratio, the better.

   When information is available at your fingertips, you don't need to calculate these risk-return ratios. All you need to use is an online mutual fund screener to check them.

   [Read: The Best Way to Use a Screener for Mutual Funds]

5. Portfolio Characteristics

   What drives returns and inflicts risks is the kind of portfolio the fund holds. Hence, in the case of equity funds, it's important to assess the top 10 stocks, the top 5 sectors, their total weight in the total portfolio, the portfolio turnover (churning), etc.

   Similarly, in the case of debt funds, check the average maturity, modified duration, and credit quality of debt papers, among a host of other aspects.

   If the underlying portfolio has worthy characteristics and is managed well with conviction and a nimble approach, it will reflect in its performance.

   The portfolio details can be accessed by visiting the factsheet of the schemes. To check the portfolio overlap between two schemes from the same category and subcategory, an online mutual fund overlap checking tool can also be used.

   This will help prevent concentration risk and potentially improve the risk-adjusted returns.

6. AUM of the Fund Actually Performing

   A higher AUM is generally seen as a barometer for a fund's stability, consistent performance, and investor faith. But there is also a flip side to it in terms of scalability, flexibility, and alpha generation.

   You should not invest in a scheme just because it has a high AUM. It has no relationship with the returns a fund could generate. It's important to check how much of the fund's AUM is performing.

   In the case of small cap mutual funds, a high AUM can make it challenging for the fund manager to manage the portfolio, as entering and exiting the less liquid small companies will become difficult.

   A high AUM may be favourable in liquid and debt funds, as the fund becomes less vulnerable to redemption pressure from a chunk of investors.

   Whichever scheme is under consideration, it needs to be an efficient asset manager, not just a gatherer of assets. Hence, check if the AUM of the fund is actually performing.

7. Expense Ratio

   Like with any investment you make, there is a cost of investing involved in mutual funds. In the case of mutual funds, it's the expense ratio.

   The expense ratio encapsulates investment management fees, brokerage/transaction costs, administrative expenses, sales & marketing expenses, registrar fees, custodian fees, audit fees, etc.

   The expense ratio is charged as a percentage of the fund's daily net assets. A fund's expense ratio has a direct bearing on the scheme's net asset value (NAV). The NAV of a mutual fund scheme is disclosed after deducting the expenses. The lower the expense ratio of the scheme, the higher its NAV.

   To keep the cost of investing low, it makes sense to go with the direct plan offered by mutual funds. That said, a fund with a low expense ratio isn't necessarily apt for you. You need to evaluate a host of quantitative and qualitative factors as discussed in this article.

Conclusion

The exercise of selecting mutual funds for your portfolio goes beyond weighing just the returns. It's holistic and overarching.

Invest in not just the best schemes out there but also the ones that are suitable for you. And don't overcrowd your portfolio with too many of them.

If you are not sure how to go about it or lack confidence, seek the services of a SEBI-registered investment adviser who can guide you in the journey of wealth creation.

Be a thoughtful investor.

Happy investing.

Disclaimer: This write-up is for information purposes and does not constitute any kind of investment advice or a recommendation to Buy / Hold / Sell a fund. Returns mentioned herein are in no way a guarantee or promise of future returns. As an investor, you need to pick the right fund to meet your financial goals. If you are not sure about your risk appetite, do consult your investment consultant/advisor. Mutual Fund Investments are subject to market risks, read all scheme-related documents carefully. Registration granted by SEBI, enlistment as IA with Exchange and certification from NISM in no way guarantee performance of the intermediary or provide any assurance of returns to investors.