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Session 17: How to Select Mutual Funds

We are glad to have you with us for our Seventeenth Session - How to Select Mutual Funds

Alright so now let's get started with our learning session today and see how to select mutual funds prudently.

With a plethora of mutual fund schemes within each category - thanks to frequent New Fund Offers (NFOs) - the task of picking the right mutual fund can be rather mind boggling. It often creates a dilemma in the minds of the investors, as to how they should rightly select and invest in winning mutual funds.

While there is information galore to address this issue, we think that "information overload" could actually confuse investors and make the task of selecting mutual funds tougher rather than easier. Many investors also do feel that 'any' mutual fund can help them achieve their desired goals. But, let us apprise you that each mutual fund scheme is unique and caters to a certain risk profile and investment objective. Selecting mutual funds involves a rigorous process, where both quantitative and qualitative parameters are considered, as it is imperative to have consistent performers in your portfolio; those that can stand by you in sickness and health.

So, in this session of money simplified let us see the vital aspects, which you as an investor must study rigorously, in order to select winning mutual fund schemes for your portfolio.

Factors to consider while selecting mutual fund schemes

  • Performance (...You see, past performance of a fund is important in analysing a mutual fund. But, remember that past performance is not everything, as it may or may not be sustained in the future. It is important to take a note of the following :

    • Returns (...Yes, 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 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, one also needs to look at the risk parameters that explain how much risk the fund has undertaken to clock higher returns.)

    • Risk (...Risk in case of mutual funds is measured by Standard Deviation (SD) and signifies the degree of risk the fund has exposed its investors to. It is vital to check the risk a mutual fund scheme has exposed its investors to in order to have funds which fit in line with your risk profile as an investor. For example, if two funds have delivered similar returns, then a prudent investor will invest in the fund that has taken lesser risk i.e. the fund that has a lower SD.)

    • (You also need to check the...) Risk-adjusted returns (...clocked by a mutual fund scheme. This is measured by the Sharpe Ratio (SR). It signifies how much return a fund has delivered vis-à-vis the risk taken. In fact this ratio also tells us whether the high returns of a fund are attributed to good investment decisions, or to higher risk. Higher the Sharpe Ratio better is the fund's performance.

    • Compare fund's performance (...This is because a fund's performance in isolation does not indicate anything. It is crucial to compare the fund with its benchmark index and its peers, so as to deduce a meaningful inference. And while comparing, one must take care so as to not compare apples with oranges.)

    • (Also note the...) Time period (...on the basis of which you are judging the performance. It is imperative to have a long-term horizon (of at least 3-5 years) if you wish to invest in equity oriented funds. 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. So, choose a fund like you choose a spouse - one that will stand by you in sickness and in health.)

  • (Then also check the...) Portfolio Characteristics (...where you need to evaluate aspects such as...

    • Portfolio concentration (...This parameter reveals the over-exposure of a mutual fund to a particular company or a sector. Funds that have a high concentration in particular stocks or sectors tend to be very risky and volatile. Hence, investors should invest in these funds only if they have a high risk appetite. Ideally, a well-diversified fund should hold no more than 50% of its assets in its top-10 stock holdings.)

    • Liquidity of the portfolio (...It is also vital to take note of how liquid a mutual fund scheme's portfolio is, by taking a look at the quality of equity instruments and debt papers held by the fund. Liquidity reveals the ease with which the portfolio - equity and debt - can be converted into cash. Hence, higher liquidity is always preferable.)

    • Portfolio turnover ratio (...This is also a parameter which you should look at. This parameter measures the frequency with which investment instruments in the portfolio are bought and sold. It also depicts whether the fund manager of the respective fund holds his portfolio with conviction towards the long-term fundamental portrayed by the security, or does he indulge in mere momentum playing. Higher the turnover rate, higher may be the churning, which may lead to excess volatility. The fund might not be able to compensate the investors adequately for the higher risk taken. So remember to invest in mutual fund schemes with a low portfolio turnover ratio if you want lower volatility.)

    • Average Maturity, Modified Duration, Yield To Maturity (...These parameters are important while evaluating debt mutual funds.

      The average maturity refers to weighted average time until all securities in a debt portfolio of a mutual fund mature. Lower the average maturity; the better it is in terms of the interest rate risk and lower volatility.

      Modified Duration (MD), reflects the responsiveness of the debt securities' price when the interest rate scenario changes. It is based on the inverse relationship between the price of the bond and interest rates. By taking this parameter into consideration, the volatility of the debt portfolio can be revealed.

      YTM refers to the expected rate of return anticipated on a debt portfolio, if all instruments in the portfolio are held till maturity. It is also commonly referred to as the yield on the debt portfolio.)

  • (Other parameters that may be crucial in identifying winning mutual funds are...) Fund management team (...You see, while the trustees assign the job of managing investors' money to the Asset Management Company (AMC), a check over the experience of the fund management team may ensure that you are giving your hard earned money to competent and deserving hands. It is imperative that the team managing investors' hard earned money has considerable experience in dealing with market ups and downs. Here it is vital to check the fund manager's experience and performance, because he is the one who manages your money.

    The true test of the fund manager lies during the bear phase. This is because the respective mutual fund schemes managed by the star fund manager must display limited downside risk during the turbulence of the equity markets, thereby attempting to protect wealth erosion. And indeed if the fund manager has delivered a luring performance, then you got to ponder over the question of what should you do if the fund manager leaves the organisation. While this may sound a bit too much of long- term thinking, in our opinion it is imperative in case where the mutual fund house is not process and system driven, whereby the fund manager has been given the leeway to manage a mutual fund scheme based on his individual conviction and fund management traits.

    While you are forming a view of the fund management team, you should also see...)

    • Number of schemes the fund manager is managing (...It is noteworthy that in the race to garner more AUM, many mutual fund houses frequently launch too many schemes. This results in the fund manager being overburdened with managing multiple schemes, which could result in lower efficiency of the fund manager on focusing on the need of his investors. So a fund manager ideally should not solely manage more than 4 to 5 schemes, as any number beyond this would reflect increasing pressure on the fund manager, which may result in reducing efficiency and replicating the portfolio, which consequently may defeat the unique mandate of each scheme managed by him.)

  • (Then you also need to look at the...) Cost of investing (...where you need to evaluate the expense ratio and exit load...)

    • Expense Ratio (...You see, like any other organisation, a mutual fund house also incurs annual expenses such as administrative costs, management fees, etc. to run its business. 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 the investors in the form of expense ratio. So remember to invest in a fund having low expense ratio and stay invested in it for a longer duration.)

    • Exit load (...Likewise, you should also be checking the exit load that respective mutual fund schemes would charge. An exit load is levied when you sell your units of a mutual fund within a particular tenure. Most funds charge the investor if the units are sold within a year from the date of purchase. As exit load is a fraction of the NAV, it eats into your investment value. Thus it is imperative that you invest in a fund with a low exit load, and more importantly stay invested for the long-term.)

Points to Consider while Investing with a Fund House

(Now apart from the factor which we just learnt of, here are some broader points for you to know while investing with a fund house.)

  • Fund sponsor with integrity (...As you have learnt in one of our earlier learning session that, sponsors are individuals or entities who initiate the process of forming a mutual fund. While SEBI would grant permission to start a mutual fund only to a person of integrity, with significant experience in the financial sector and a certain minimum net worth; it imperative for you to be satisfied (by your own judgement) on these aspects.)

  • Judge the credibility (...In order to judge the credibility of a mutual fund house, you must read two things in the offer or information document, which are:

    • Investor grievances (...You see, every fund has to disclose the status of investor grievances in the statement of additional information /offer document / prospectus of the fund. The mutual fund house has to reveal the number of queries and complaints received towards a particular scheme and the complaints addressed. This information shows investors, how proactive and responsive a fund can be towards investor grievances.)

    • Penalties & pending litigation (...Likewise every fund has to disclose the penalty imposed on the mutual fund house or the fund sponsor for any economic offence or violation of any securities' laws. Also they have to disclose any pending litigation or proceedings towards the mutual fund, fund house, trustees, associated companies, or the directors of the mutual fund house.)

  • (Then you must also check the broader...) Investment philosophy, processes and systems followed at the fund house (...It is noteworthy that, processes and systems followed at respective fund houses, have a major impact on individual mutual fund scheme's performance. Thus, it is important for you as an investor to delve a little deeper in understanding these aspects before entrusting your hard earned money to respective fund houses, in mutual fund schemes managed by them.)

  • Investment style ( also what you must watch out for. Generally, every mutual fund house has a forte in a particular fund management style i.e. value, growth, opportunities, etc. Thus it is vital to assess the same, in order to see what suits your need.)

(So before we end our learning session today, here are some key takeaway points...)

Some Key Takeaway Points!

  • Care should be taken while selecting mutual fund schemes ( as to have the appropriate ones that can help you meet your financial goals.)

  • (Remember...) Each mutual fund scheme is unique and caters to a certain risk profile and investment objective

  • (Therefore...) Have mutual fund schemes from the respective categories as per your investment objectives

  • Both quantitative and qualitative parameters should be considered for selecting mutual funds ( it is imperative to have consistent performers in your portfolio)

  • Analysing past performance is important, but is not everything

  • Returns is one of the parameters to assess mutual fund scheme, but not the only parameter

  • Risk parameters should be gauged by assessing the standard deviation (...If two mutual fund schemes within a category have delivered similar returns, then as a prudent investor you should invest in the fund that has taken lesser risk i.e. the fund that has a lower standard deviation.)

  • (Risk taken should commensurate with the returns generated by the mutual fund scheme; so...) check the Sharpe Ratio (...Higher the Sharpe Ratio better is the fund's performance.)

  • Compare mutual fund schemes prudently with its peers and benchmark (...because a fund's performance in isolation does not indicate anything.)

  • Performance of a mutual fund scheme should be judged over a longer time horizon (...of at least 3 to 5 years)

  • Evaluate mutual fund schemes over bull and bear phases of the markets

  • Check the portfolio characteristics, (...wherein see: portfolio concentration, liquidity of the portfolio, portfolio turnover ratio, average maturity, modified duration and YTM)

  • Know the fund management team well (...wherein assess the expertise of fund managers by taking a view of number years of experience in fund management and educational qualifications.)

  • Ascertain the cost of investing ( checking the expense ratio and exit load levied by the mutual fund scheme)

  • (Also...) Ascertain the taxation aspect of a mutual fund scheme (...before investing)

  • Do not rely heavily on star ratings (...for picking mutual fund schemes. Do your own home work and select those that fit your requirement. You see, most star ratings are on the principle of "one size fits all"; which is not the case in reality.)

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Disclaimer: The contents of this document are only for informative purposes and are not to be used or considered to be an offer to sell or buy units of Franklin Templeton Mutual Fund schemes. This video is for information purposes only, provided on an 'as is' basis. Nothing in it should be construed as personal financial advice. You are responsible for your own investment decisions and you should seek advice concerning suitability from your investment adviser regarding any of the investments mentioned. The video is for personal non-commercial use only and may not be copied, stored, redistributed or broadcast in any way. We recommend you read the complete Terms of Use.

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