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16 October, 2021 20:51 IST
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Fund selection Indias Most Comprehensive Finanacial Destination
Looking deeper : The offer document
Having shortlisted schemes the next step is to look at each of them in greater detail and also make a qualitative evaluation. One place to look at is the offer document of the scheme. The offer document of the scheme tells you its objectives and provides supplementary details like the track record of other schemes managed by the same fund manager. Some other factors could be the portfolio allocation, the dividend yield and the degree of transparency as reflected in the frequency and quality of their communications. Does the scheme provide prompt and personalised service or does the scheme maintain transparency? All this can be looked at from the frequency and quality of the communication from the fund house.
Compare your scheme

Money is dear money. You wouldn't put your dear money into any investment without fully convincing yourself. With a comparison with other schemes you can convince yourself whether the scheme you have chosen is best for you. Of course, while shortlisting schemes through the advanced search you have already performed a comparison for some of the criteria on which mutual funds are judged. Time you enriched the comparison.

For example, in debt funds, it is useful to compare the extent to which the growth in NAV comes from interest income and from changes in valuation of illiquid assets like bonds and debentures. This is important because as of today there is no standard method for evaluation of untraded securities. The valuation model used by the fund might have resulted in an appreciation of NAV. The expenses ratio can be compared across similar schemes to find out whether the fund is prudently managing its expenses. The size of the fund plays an important role here and a smaller fund generally has higher expenses per net assets managed.

The NAV, returns and performance are important criteria that establish the merit of a fund but the only differentiating factors. It is prudent to also compare the risk-adjusted returns and the corpus size of the fund. The risk-adjusted return will help in evaluating what returns one can theoretically expect in the worst of condition. The risk is measured through volatility of the returns which is nothing but the standard deviation from the average returns.

What are those factors that make schemes risky? And to what proportion is each scheme exposed to each of these factors? Identifying these factors or in other words, establishing the risk profile and then comparing it across schemes helps in creating, though theoretically, a relative scale of safety among the schemes compared. For debt funds, one of the factors could be the periodic changes in the interest rate environment, which affects credit quality of the portfolio and brings about fluctuations in the NAV. For equity funds, it could mean the volatility of the NAV with the ups and downs in the market or the percentage exposure to smaller companies.


Benchmarking a fund

All mutual funds schemes have different objectives and therefore their performance would vary. But are there some standards for comparison? Schemes are usually benchmarked against commonly followed market indexes. The relevant index can be chosen after taking into consideration the asset class of the scheme. For example BSE Sensex can be used a benchmark for an equity scheme and I-Bex for an income fund. But if you switch the benchmarks, conclusions could be misleading.

Benchmarking also requires a relevant time period of comparison. Ideally, one should compare the performance of equity or an index fund over a 1-2 year horizon. Short-term volatile price movements would distort any comparison over a shorter period. Similarly, the ideal comparison period for a debt fund would be 6-12 months while that for a liquid/money market fund would be 1-3 months.

So if a comparison reveals a scheme to be out performing its index, does it mean it is going to deliver super returns? Not necessarily. In several cases it is noticed that the funds performance is volatile and driven by few scrips. In other words, the fund manager has taken significantly higher risks to achieve higher returns. That brings us back to the oft-repeated moral in the investment market: The funds that have the potential for the greatest returns also have the greatest potential for losses. From an investor's point of view, while looking at impressive returns in the past, he cannot derive confidence and comfort in the fund managers' ability to repeat the performance in future.
What is a fund's prospectus ?

All funds are supposed to put up for public a rather technically worded document called the prospectus. This long not-too-exciting tome usually starts off with a statement declaring the purpose a fund follows for a particular scheme.

Reading along, somewhere the prospectus will also tell you how to apply for the scheme and how to redeem units. Being a tome, it has voluminous information that can also confound you. The smart way then is to run through the prospectus and extract for yourself convincing answers to these six vital questions that all investors need to know before they buy a fund.

Checking the claims made by Mutual funds.

It is surprising to find fund marketers come up with statistics to show how their particular fund has done extremely well. Following are some of the pitfalls that an investor needs to look into before arriving at a decision. Check the following details before arriving at any decision.

Period of declared returns: Always look carefully at start and end dates - they can always be chosen in a way that shows the fund in a favorable light. A better approach would be to choose a reasonably longer period and compare the performance across the similar schemes of different players.

Concept of out-performing: Sustained periods of low absolute performance are a cause for concern. It is okay to look at returns vis-à-vis market indices; but if a particular scheme produces absolute returns less than the cumulative returns for a fixed deposit of a bank, then the latter option is better when evaluated on the parameter of risk adjusted returns. This is because generally it is safer to invest in a fixed deposit of a bank than to invest in a debt fund.

Promise of long term performance: Lack of performance is often explained away as temporary with promises of good performance in the long term. The long term is seldom defined whether it means 3yrs or 10 yrs. Also the longer the period, the longer is the uncertainty- in other words, the premium on returns an investor gets has to discounted against the risk of uncertainty of returns. A small premium in compounded returns over returns of risk free instruments like PPF wouldn't justify investment in a mutual fund.

Rupee cost averaging: This term finds place in the literature of practically all mutual funds. What it basically implies is that a price risk at the entry level can be eliminated to some extent by buying units at various points of time. But this assumes that the NAV will rise eventually. If it does not, you are worse off than by not adopting this strategy.

In the long run equities are better than other asset classes: Historically the equity class did give better returns than bonds, golds and other assets. But if the long term horizon is assumed to be 7 yrs, then in the Indian context, the equities have practically given near zero returns. After hitting the 4600 levels in 1992, the BSE Sensex is still hovering around the same levels as of today.
Do most funds underperform in the market ?

Globally it is true that most fund managers underperform the asset class that they are investing in. This is largely the result of limitations inherent in the concept of mutual funds:

Fund management costs: The costs of the fund management process that includes marketing and initial costs are charged at the time of entry itself in the form of load. Then there are the annual asset management fee and operating expenses. The performance of a scheme net of these expenses lead to a relatively lower performance vis-à-vis the index stocks.

Churning cost: The portfolio of a fund is never static. The extent to which the portfolio changes is a function of the style of the individual fund manager i.e. whether he is a buy and hold type of manager or one who aggressively churns the fund. Such portfolio changes have associated costs of brokerage, custody fees, registration fees etc. which lowers the portfolio return commensurately.

Large size: When a large body like a mutual fund transacts in securities, the concentrated buying or selling results in adverse price movements. This causes the fund to transact at relatively higher entry or lower exit prices.

Time lag for investment: Most mutual funds receive money when markets are in a bull run and investors are willing to try out mutual funds. Since it is difficult to invest all funds in one day, there is some money waiting to be invested. Further, there may be a time lag before investment opportunities are identified. This causes the fund to realize lesser returns vis-à-vis the index stocks. Also for open-ended funds, there is the added problem of perpetually keeping some money in liquid assets to meet redemptions.

Change in composition of index stocks: The composition of the indices has to change to reflect changing market conditions. The BSE Sensex stock composition has been revamped twice in the last 5 years, with each change being quite substantial. Another reason for change of index composition could be Mergers & Acquisitions.

Herd mentality: Apparently, the only way a fund can beat the index is through investment of some part of its portfolio in some shares where it gets excellent returns, much more than the index. This will pull up the overall average return for the scheme. In order to obtain such exceptional returns, the fund manager might have to take a strong view and invest in some uncommon stocks. Unfortunately, if the fund manager does the same thing as several others, chances are that he will produce average results.

The tendency of the fund managers to buy the popular stocks, which are favourites among their peers, leads only to average performance as the index.

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