How to select a good mutual fund

Introduction

For a common investor the following factors should be considered when selecting equity oriented mutual funds. For debt fund selection the factors may vary a bit. 

 

Though the below mentioned factors may not be comprehensive, they would be a good starting point from where a person can increase her/his awareness about how to pick mutual funds.

Scheme philosophy

Whenever a mutual fund scheme is launched there is a specific mandate (philosophy of investing) based on which investing is done by that mutual fund. This mandate outlines the debt-equity mix and the type of instruments that the fund would invest. 

For example, the prospectus of a mutual fund will always mention the stock universe that fund invests in viz, large cap, mid cap, small cap, sector funds etc.

Fund management team

A critical component that determines performance of a mutual fund is the fund manager and her/his team. Finally it is their skills which are responsible in the decisions made regarding investing.

We have to look at both aspects -- 'Fund Manager' and 'The Team' behind her/him. If the fund manager has been around for a while, by looking at past performance we can get some idea about her/his abilities.

Even though the fund manager is the key decision maker and is finally responsible for the fund performance, her/his team too is important. To this end the process followed in short listing and selecting investment opportunities is important.

A good process would ensure that the performance of the fund does not depend only on the skills of a single person, but rather is a team effort.

Past performance will not guarantee future returns

Even though past performance may or may not be sustained in future, it is still a primary criterion which a lot of investors consider before they select a fund for investing.

By looking at past performance with respect to the benchmark or peers we can analyse how well the fund has performed. Performance comparisons must be used only to compare the same type of funds.

Hence the performance of a mid cap fund cannot be compared to that of a large cap fund. By looking at various periods we can analyse how the fund has been managed.

This in turn gives us an idea about the capability of the fund manager and her/his team. Also we can study how the fund has performed in terms of risk adjusted returns. 

Understand the risk profile carefully

Each category of fund has different amount of risks associated with it.

For example, mid cap funds have a higher risk associated as compared to a large cap fund. So the selection should be done on the basis of the investor's risk profile and the time horizon of investment.

The greater the horizon, the more is the risk taking ability. To create wealth in the long run some amount of investments into assets with higher risk is necessary.

Fund size: An important factor to consider

When the fund size grows very large and the opportunities to deploy this amount are limited then the funds may tend to under perform its peers.

Also due to a large size, the fund may lose its flexibility to move into and out of investment options without the effect of impact cost.

Too small a fund a size and the cost burden becomes higher. Hence, a medium sized fund would be ideal to balance between the flexibility for a fund manager to invest and the sharing of expense costs.

The above is a general observation, but there are some exceptions like Reliance Growth Fund which is still able to be among the top performers in spite of a huge fund size.

How often are you analysing your portfolio?

Most mutual funds generally declare their portfolios once a month.

By analysing the portfolio we can come to know a few things about the fund. Among them an important aspect is whether the fund is being true to its mandate.

Also we can study certain characteristics of the portfolio like proper diversification, which type of sectors is the fund having more exposure to, quality of the portfolio (not too many unknown companies) and how much cash is the fund sitting on, etc.

By looking at portfolio turnover ratio (PTR) we can analyse the amount of churning (buying and selling) done by the fund -- higher the PTR, more are the costs in terms of brokerage paid to the broker.

Cost aspect: Important in the long run

In the current scenario, when the returns in equity mutual funds are extraordinary, expenses charged by the fund may seem to be insignificant. But this definitely becomes an important factor over the long run.

Expense structures are declared by the fund each year. It is towards all costs of running the fund, including salaries paid to the fund manager and profits earned by the mutual fund house for running the business.

 

The above factors may enable a person to take a more informed decision on selecting a mutual fund scheme. But finally the success of making good returns is dependent on how focused and disciplined the person remains towards creating wealth and meeting her/his goals in life.