How to select mutual fund schemes?

Step 1 – Which asset class?

  • There are various asset classes – equity, debt, gold, real estate. First understand the risk appetite of the investor and then investor’s investments should be distributed between different asset classes. Based on investor’s needs, the asset class which is most appropriate for the investor should be decided.

Step 2 – Which scheme category?

  • There are various scheme categories with their own investment strategy and style. Further, different investors have different needs – some may want long term growth , some may want periodic income , some may looking for an avenue to park funds with high liquidity.
  • An investor’s needs and risk-taking ability must be understood. Based on that, the scheme category most appropriate for the investor should be recommended.

Step 3 – Which scheme?

  • Select a particular scheme within the category based on performance and other parameters.

Step 4 – Which option?

  • Select right option within the scheme e.g. growth, dividend re-invest, dividend payout.

9.1  How to choose between categories of a scheme?

Once the investor has chosen the asset class in which he will invest based on his need, he can select which scheme category is most relevant for him based on the risk he can take and his investment horizon. Example – An investor who wants low risk in equity funds will choose index funds, those who can take higher risk will choose growth fund.

Core Portfolio vs Satellite Portfolio –

  • An investor should have a core portfolio which he must invest as per long term goals and a satellite portfolio which he must invest to take advantage of short-term opportunity.
  • Example – if a particular sector is expected to perform well for the next two years then the investor can invest money out of his satellite portfolio into that sector fund to take advantage of increase in value. At the same time, his core portfolio will be invested in schemes like diversified equity funds, short term debt funds, monthly income plan which will generate returns in long term.
  • What percentage of his portfolio would the investor divide as core and satellite would depend on the investor, but it could be something like 80 percent in core and 20 percent in satellite. If investor can take higher risk, he can increase the percentage of satellite portfolio, if he wants less risk, he can reduce the percentage of satellite portfolio.

Different types of funds are –

A.  Active or Passive

Passive Funds

  • Example – Index Funds, Exchange Traded Funds.
  • The portfolio of these funds has the same stocks as the index and in the same weightage.
  • The fund manager has no role in creating the portfolio, hence the expense ratio of these funds is also less.
  • There is no risk that funds might get invested in a scheme being managed by an under-performing fund manager.
  • Suitable for investors who want some equity component in their portfolio but do no have the aggressive objective of beating the benchmark.

Active Funds

  • Example – Any other equity fund like diversified equity fund, sector fund.
  • The aim of these funds is to beat the benchmark. These funds charge higher expense ratio because the fund manager actively manages them.
  • These funds take higher risk than index funds to beat the benchmark, hence their returns should be higher. However, there is no guarantee that the returns will be higher.
  • Suitable for the seasoned investors who can take higher risk and wish to beat the benchmark.

B.  Open-ended vs Close-ended

Open-ended

  • Benefit of liquidity – Investor can redeem his units at current NAV whenever he wants.
  • Exit load – If the investor redeems or switch his unit out before the load period, an exit load is levied. The maximum load that can be levied is 7 percent as per SEBI, though in most cases it does not exceed 5 percent.
  • Since, open-ended schemes require more liquidity, the fund managers maintain part of their portfolio in liquid assets which can dilute returns.
  • Further, the open-ended schemes carry a risk that there might be large fluctuations in net assets because of heavy re-purchase which puts pressure on the fund manager in maintaining his portfolio.

Close-ended

  • Close-ended schemes also offer liquidity but through stock exchange where the units can be sold. However, units of close-ended mutual funds are not actively traded on mutual funds.
  • The price of units on stock exchange may be lower or higher than the NAV. Towards the maturity of the scheme, the price on stock exchange will match the NAV.
  • Close-ended schemes give the fund manager freedom to invest in stocks that will take some time to give returns or which are relatively illiquid but have good prospects. This is because there is no pressure of redemption.
  • Disadvantage – Exiting from close ended scheme is not very easy. Investor may face difficulty in finding buyer for the close ended scheme. There could be no buyer or very few buyers for close ended schemes in stock exchange where the scheme is listed. Another disadvantage is they must match the maturity of the scheme (when the scheme will pay them back the money) with when they will require the funds.

C.  Diversified, Sector or Thematic

Diversified Funds

  • Diversified funds invest in many sectors. If the fund is actively managed then the fund manager ensures that the funds are invested in better performing sectors.
  • Funds that are diversified not only across sectors but also market segments (large-cap, mid-cap, small cap) will be suitable for the core portfolio of an investor.
  • If an investor wants to reduce his risk even more then he should invest in a diversified fund that has invested only in large-cap stocks.

Sector Funds

  • Sector funds are risky because they invest in only one sector. If that sector performs poorly, the scheme will perform poorly.
  • Only experienced investors should invest in these funds because skill and knowledge are needed to identify the entry and exit time. To earn returns in the sector funds an investor should enter before the up-cycle in the sector starts and exit before the sector starts to perform poorly.
  • These funds are suitable for satellite portfolios.

Thematic

  • Some investors like to invest as per an investment theme (e.g. infrastructure) rather than just one sector (e.g. cement, steel). Thematic funds are appropriate for such investors.

D.  Large-cap vs Mid-cap vs Small-cap Funds

 Large-cap

  • Large-cap funds invest in large-cap stocks. These are the companies with large capitalisation.
  • They have a good track record of surviving competition and recession. They have stable revenues and profitability for long period of time.
  • When the economy starts to boom, these stocks become very expensive. At this stage, investors start to explore the mid-cap and small-cap stocks.

Mid-cap and Small-cap

  • Mid-cap and small-cap funds invest in mid-cap and small-cap stocks. These companies are in initial stages of growth. When the economy is booming, these companies earn good profit and generally are able to give better returns to the investor.
  • However, during downturn in the economy, their value erodes fast and they generally give poor returns.
  • Over a long period of time, some mid-cap and small-cap companies will become large-cap

E.  Growth vs Value Funds

Growth Funds

  • Growth funds invest in the stocks that are expected to grow at rates higher than the market.
  • These perform better in the bull market, but normally fall harder in the bear market.

Value Funds

  • Value funds invest in those stocks which are relatively cheap because, as per research of the fund manager, the market has not fully appreciated their value in the present which will rise in the future.
  • Suitable when the investment horizon is long.
  • These funds perform better during a downturn in economy, because these stocks were cheap to begin with so the fall in their value will not be much.

F.  International Equity Funds

  • When an Indian investor invests in International Equity Funds, he takes two exposures
  1. In the international equity market
  2. In the exchange rate of rupee – If the investor has invested in America, and the US dollar becomes strong, the value of investment in rupee terms will rise. If the US dollar becomes weak, the value of investment will fall.
  • The investor might invest in International Equity Funds for the following reasons –
  1. To earn attractive overall returns – Investor believes that returns from international equity + exchange rate movement will be high.
  2. Asset Allocation and Diversification – the investor’s portfolio will be diversified across countries.
  3. Opportunity in International Markets – If the investor identifies opportunity in international market, this will be the best mechanism to use it.
  • Such funds can be part of satellite portfolio of the investor.

G.  Monthly Income Plans (MIPs)

  • MIPs have large portion of debt securities and small portion of equity securities in their portfolio. Equity securities can range from 5 to 30 percent of the portfolio.
  • Investors should evaluate the equity portion regarding the following points –
  1. In which segment does the fund invest – large-cap, mid-cap, small-cap, multi-cap
  2. Do the stocks represent diverse sectors?

H.  Fixed Maturity Plans (FMPs)

  • FMPs are suitable when –
  1. The investor’s investment horizon matches scheme’s maturity.
  2. The investor is looking for returns superior than fixed deposits.
  3. The investor is looking for more stable returns than conventional debt schemes.
  • FMPs are not suitable when –
  1. The investor might require fund at any time. In such a case, he should invest in open-ended debt scheme.
  • The investor should not merely look at when he needs the funds to choose a scheme, he should carry out all other risk evaluation as well like checking the modified duration and credit rating.

I.  Diversified Debt Funds or Income Funds

  •  Diversified debt funds invest in a mix of Government and non-Government securities.
  • Government securities provide safety as there is no risk of default by Government. Non-Government securities provide higher yields, though they carry credit risk and default risk.
  • The fund can change its portfolio based on market condition to benefit from yield spread and credit spread.
  • This can be part of the core portfolio of the investor.

 J.Short Term Debt Funds

  •  Short term debt funds invest in securities with a tenor of 1 to 3 years.
  • If there is expectation that the interest rates will rise, the investor should invest in short term debt funds as the fund manager can invest funds at higher rates as short term bonds mature.
  • Some short term debt funds may take some exposure to long term securities to benefit from increase in value if there is expectation that the interest rates will fall.
  • While evaluating these funds, two things need to be checked –
  1. The extent of exposure in long term securities
  2. Credit risk
  • Short term debt funds can form part of the core portfolio of the investor with low risk taking abilities.
  • These can be used to park funds.

 K.  Liquid Schemes

  •  Liquid funds are comparable with saving bank accounts. These funds invest in money market securities of up to 91 days.
  • Purpose – Liquid funds are not meant for earning returns. They are highly liquid and have negligible volatility hence they are ideal for parking funds for a short period.
  • Ultra short term debt funds also serve the same purpose though they invest in securities of longer period.

L.  Floating Rate Funds or Floaters

  •  Floating rate funds invest in floating rate instruments. They hold their values even if interest rates fluctuate. Their NAV remains steady.

Suitability of Debt Funds

  •  Some debt funds focus only on earning interest income. The returns are stable. However, some schemes might invest in securities of lower credit quality to earn higher interest rate.
  •  Other debt funds may aim to earn returns from both interest income and gain in value of security. The fund manager manages the duration of the security. If he expects, the interest rate will go down, he increases the modified duration. However, longer the duration, more volatile will be the returns. Further, the fund manager’s call on the interest rate may be wrong leading to loss in value.
  •  Hence, there are various strategies when it comes to investing in debt funds. The investor needs to decide which strategy suits him, and those choose the correct debt product.

Hybrid Schemes

  •  An investor who wants to invest in both debt and equity can do so in two ways –
  1. Invest his money in equity schemes and debt schemes, or
  2. Invest his money in hybrid schemes which invest in a mix of debt and equity securities.
  •  The investor who invests in equity and debt schemes has a wider choice. Plus, he can decide how much he wants to invest in equity and how much in debt. Further, equity will be taxed as equity and debt as debt.
  •  If the investor, however, chooses to go hybrid way, his scheme selection becomes simple. Investing in just one scheme can give him exposure to both debt and equity. The equity component of the scheme will provide gain in value and debt component will provide stability of returns. This is suitable for investors who want exposure to equity but lower risk.
  •  However, the investor needs to keep certain things in mind –
  1. He will not have control on the mix of equity and debt.
  2. The scheme may be taxed as equity or debt depending on the structure of the scheme.
  3. There is a variant of hybrid scheme called flexible asset allocation scheme which can drastically change the debt and equity component. They carry high risk. If the fund manager takes a wrong call, the scheme’s returns would suffer

Gold Funds

  • Gold ETF and Gold Sector Funds are different from each other. Investors should know this.
  • Gold sector funds invest in the shares of the companies involved in gold mining and gold processing.
  • Gold ETF, on the other hand, tracks the price of gold. This is because NAV of Gold ETF reflects the value of gold held by the custodian.
  • When gold prices increase, the shares price of companies with large reserves of gold would increase much more than increase in the value of gold. Further, their share price will not be affected by the value of gold alone. Other factors impact profitability as well.

9.2  How should an investor select a scheme within a scheme category?

  •  The investor should check whether fund manager follows the promised investment style or not. Example –
  1. In a Value Fund, if a large portion of portfolio comprises of fully valued frontline stocks – fund manager is not being true to the promised investment style.
  2. In a Short Term Debt Fund, if a large portion of portfolio comprises of long term debt securities to generate better returns, the fund has taken more risk than was promised to the investor – fund manager is not being true to the promised investment style.
  3. In an MIP, if aggressive equity positions have been taken to generate better returns, the fund has taken more risk than was promised to the investor – fund manager is not being true to the promised investment style.
  •  Investors in non-gilt debt schemes should check –
  1. Credit quality
  2. Sector concentration, even if securities have high credit rating
  •  Investors should identify on the basis of past track record, which fund managers and AMCs were better able to predict the change in market trends.
  •  Other factors to consider –

a.  Fund Performance

  • A fund’s performance should be compared with its benchmark and its peers.
  • For equity, performance of at least 5 years should be checked and in the case of long term debt performance of at least 3 years.
  • Funds should ideally outperform the benchmark during bull phase and fall less during downturn.
  • Fund provide performance in terms of CAGR of the scheme and its benchmark.
  • Depending on the type of the scheme, funds provide performance of 1 year, 3 years, 5 years and since inception. For liquid funds, performance of 7 days, 15 days and 1 month is provided as that is more relevant.

b.  Fund Portfolio

In case of equity funds, following should be checked –

  • Diversification across stocks and sectors
  • Market segments in which the fund invests
  • Cash holding
  • Length of stock holding
  • Churn in portfolio
  • Strategy of stock selection and portfolio management

In case of debt funds, following should be checked –

  • Average maturity of portfolio
  • Credit risk
  • Contribution of interest and capital in total return
  • Liquid holdings

c.  Fund Age

  • A fund that has existed longer is preferable to a new fund. An older fund will have a track record which can be studied.
  • Fund age becomes more important in equity, where there are many investment options.

d.  Fund Size

Fund size must be seen in terms of where the investment will be made. Example –

  • For diversified large-cap equity funds, large fund size will be better because it will help in diversification and economies of scale.
  • For a sector fund or mid-cap fund, small size will be better because it will be better able to take advantage of market opportunities.

e.  Portfolio Turnover

Portfolio Turnover Ratio = (Value of Securities Purchased+Value of Securities Sold) ÷ Average Size of Net Assets
  • Hence, if ?10,000 crore securities were sold and purchased and the average size of net assets is ?5,000 crore, portfolio turnover ratio is 200%. This means that investments are held in the portfolio on an average for 6 months (12 months ÷ 2).
  • Whether 6 months is short, long or adequate would depend on the investing style of the fund manager. For a value investment style, 6 months is too short. However, if the fund manager is aiming to take advantage of short term market opportunities, then this period of holding is fine.

f.  Scheme Running Expenses

Investors must carefully consider the expense ratio of a scheme particularly in –

  • Debt – because the returns in debt are usually low
  • Index fund – since fund manager has no role in the return of index fund

Mutual Fund Research Agencies

  • Mutual fund research agencies study the schemes on various parameters not limited to return, risk, risk adjusted return. On this basis they award rankings and ratings to the schemes.
  • Different research agencies have different methodology. Some follow star rating system, others something else.
  • Since ratings are based on performance, it can be often seen that a scheme which was best rated in one quarter might not be best rated in the next. In such a case, investor should not redeem money from the existing scheme and move to the new best rated scheme. This would be a wrong strategy, not just because cost of switching between schemes would involve transaction cost, but high rating alone does not guarantee future performance.
  • What an investor can do by looking at such ratings is that he identifies those schemes which have consistently had a good rating over a long period. Then he should evaluate such schemes as per his own criteria and then finalise the scheme.
  • An investor must also remember that it is not just performance but also exit load that can affect his returns.

9.3  Which option is better within a scheme?

  • There are three options within a scheme – dividend payout, dividend re-invest and growth.
  • Taxation and liquidity are the factors which influence what option an investor chooses.
  • Under growth option, money grows in the fund on gross basis. In dividend payout, money flows to the investor.
  • Normally, dividend payout is chosen by those investors who want regular income. However, dividend will be paid only if there is any surplus to distribute.
  • Further, dividend payout attracts dividend distribution tax. For investors falling in low tax bracket, like pensioners, this is unnecessary taxation. Hence, investors who would like regular income should instead choose SWP (SWP attracts STT in equity schemes and capital gain tax implication).

9.4  Sources of Data to track Mutual fund Performance

  • To evaluate a mutual fund scheme, a person would need quite a lot of data.
  • Many AMCs and mutual fund research agencies provide tools on their website for free through which an investor can analyse the performance, risk measures, ratings of a scheme.
  • Mutual funds provide product literature like Fund Factsheets, Product Notes and Brochures which contain the following –

a. Suitability – By perusing product literature an investor determine suitability of the product by studying the following –

  • Scheme Objective – Whether it is wealth creation or regular income generation or liquidity.
  • Asset class in which the scheme will invest
  • Holding period
  • Riskometer which tells the risk to the capital invested

b. Returns – Cumulative returns that the scheme has generated over different holding periods. The comparison of returns with benchmark help in assessing the performance of the fund manager.

c. Portfolio Description

    • In case of equity, portfolio description will tell the investor –
      • Extent of diversification across stocks and sectors
      • Strategy of stock selection – is it based on market capitalisation (large-cap, mid-cap, etc) or valuation (growth vs value, etc.)
    • In case of debt, investor can determine –
      • Tenor
      • Credit quality
    • In case of hybrid, investor can determine –
      • Allocation to different asset classes
      • The way different asset classes are managed
  • Fund Factsheet
    • Fund factsheets are official communication by a mutual fund.
    • Factsheets are not mandatory but mutual funds still issue them.
    • Information in factsheets is subject to SEBI’s advertisement guideline.
  • Factsheets contain
    • Fund’s objective, performance, portfolio.
    • Fund manager’s views on economy and market.
    • Basic information about schemes like – Inception date, corpus size, current NAV, benchmark.
    • Comparison of fund’s performance with benchmark for different periods.
    • SIP Returns
    • Portfolio allocation to different stocks and sectors
    • PE, risk measures such as Beta, SD, Sharpe, etc.
    • Credit rating, average maturity in case of debt funds
    • Minimum investment amount, plans and options
    • Load, expense ratio
    • Availability of systematic transaction facility
  • Periodic Updates about market and Economy

Mutual funds issue periodic updates to help investors better understand their schemes and get information about the current investment climate. These contain information like –

  • Level of Market Indices and Yield
  • Analysis of corporate results
  • Industry-wise analysis of earnings and demand forecasts
  • Level of government spending and fiscal deficit
  • Inflation rate – its impact on profitability and production costs of companies, and monetary action taken to deal with inflation
  • Change in interest rate – its impact on growth of companies, and affect on consumption and demand of goods and services
  • Activity of domestic investors and Foreign Institutional Investors
  • GDP details
  • Economic and interest rate data of international market which will affect exports from India
  • Commodity prices, Prices of raw material and other inputs

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