How to select a mutual fund?

Whenever I meet clients who are new to investing I can make out who has been their adviser for their earlier investments. It could be a cousin, neighbor, or a banker. They leave a lot of trail. The greatest thing that they do is emphasize on recent history. Though we all know that today was not like yesterday, we like to believe that tomorrow will be like today!

Taking a cricketing example, analyzing the diet, the mind frame, using past data – ground wise, time-wise, team-wise, etc. we cannot predict how much Yuvraj will make in “Today’s match”. Past data is useful only to predict style. So in case you are creating a team for a test match you choose Rahul Dravid and in case you are choosing a team for a T-20 match, you choose Yuvraj. Just as you cannot look ONLY at the rear-view mirror and drive, looking ONLY at the past performance while selecting a mutual fund is a poor habit.

What is it that the investor should look at while investing in a fund?

  1. The amount of risk that a fund manager has taken: a retail investor looks for the return. However as an investment professional when you look at returns, you should look for “risk-adjusted- returns”. Risk is measured using standard deviation or beta.
  2. Look at the processes of the fund houses: If it is a good fund house, it will have a proper process in place. What it means is that one or two persons leaving will not harm the fund performance.
  3. Look at the quality of people that it employs. The quality of fund managers, and far more importantly their longevity in the organization are both important factors.
  4. Are the funds true to label: If a fund says it is a large cap fund, I would want that fund to be buying only large cap shares. Similarly if it is a small cap fund I want it to be buying only small cap fund. And I hate a fund that sits on cash! How much cash to sit on, and when to invest is the fund holders’ call. The manager is there just to implement. So if I invest Rs. 5000 in a large cap fund, I want him to buy shares worth Rs. 5000 not sit on Rs. 3000 of cash.
  5. If you must look at returns look at a much longer period – enough to cover bull markets and bear markets. This tells you whether your fund manager has been through business cycles. Also over a longer period you will neither have “54% return of a bull run” or the “-33% return of a bear run”. An even better thing to do is use the monthly moving average and compare the “risk-adjusted-return” i.e. return divided by standard deviation. Thanks to “regression to the mean” concept you will find many funds near each other.
  6. Please remember, the winner does not take all! So if you were invested in the fund which came in 2nd your returns will still be a nice rounded number! If the best performing fund gave 22% return over a 5 year period and the second best fund gave 21.23% return over the same period it should not bother you. Unless of course your brother-in-law had invested in that fund, and you ignored his advice. It will not make an iota of difference to your wealth.

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