Investment Product & Scheme Selection - Chapter 6

Investment Product & Scheme Selection - Chapter 6

One of the basic questions that investors must ask themselves is why they have created a particular mutual fund portfolio and whether it fits into their long term goals. Here we look at a framework for mutual fund selection across 5 important points.

Framework For Mutual Fund Selection

Does the fund fit into my investment objective?

The fund that you select must fit into your overall investment objective. Are you trying to adopt a conservative or aggressive approach to investing? What are the objectives of the fund and has it been consistent in sticking to these objectives. For example, if you are invested in a debt fund for stability and income stream, then there is no point in buying a debt fund that adopts a more dynamic approach to rates management. Similarly, if you are looking at equity performance at par with the index then you are better off with index funds.

How has the fund performed in risk-adjusted terms?

When it comes to mutual funds, consistency of past performance matters a lot. 15% return with low volatility is more preferable and attractive compared to 17% returns with high volatility. You need funds that outperform the index funds over a longer period of time otherwise you are better off staying invested in index funds and ETFs. More importantly, also look at returns in risk adjusted terms. That is where the Sharpe and Treynor ratio come in. 16% return with acceptable risk is better than 19% return with high risk.

Experience and longevity of the fund management team

Why does longevity of the fund management team matter? It brings about consistency in investment strategy and a better synchronization between the dealers, traders, researchers, the CIO and the CEO. Teams stay on if they are happy and if the fund is performing well; otherwise they look for alternate opportunities. Funds that perform better over a longer period are funds that have stable fund management teams as it ensures continuity of decision making.

How much is the fund loading on to you

There are some costs that are billed directly to you and there are other costs that are billed to your NAV in the form of expense ratio (TER). In the past there were entry loads, which are not applicable any longer. But exit loads are still charged if you exit a fund before a certain time. Then there are costs like transaction costs for the fund, operational costs, administrative costs, marketing costs etc which tend to get debited to the NAV of the fund. Fund managements are required to explicitly disclose the expense ratio and the break-down in a transparent manner. Equity funds have an expense ratio of 2-2.5% while index funds have much lower expense ratios. Expense ratios make a big difference to returns.

Has the fund been ahead of the investment curve?

This is a qualitative and also subjective but essential. Has the equity fund manager managed to move into winners early and move out of losers early? Your fund manager may not catch every trend in the market but as long as he gets the key trends it is good. In case of a debt fund, has your fund manager been able to tweak the maturity of the portfolio based on interest rate expectations. The bottom-line is that the fund management should be ahead of the curve; that is what differentiates a good fund manager from an average fund manager.

Selecting A Mutual Fund – Choices To Make

Mutual funds are important because they are an integral part of financial planning. Mutual funds offer variety, flexibility, choice and professional management; making them ideal for financial planning. But that also means that the choice of a mutual fund has to be a lot more organized and systematic. Let us look at the process flow for selecting a mutual fund. Before you start the process, you need to subject yourself to risk profiling and identify if you have the capacity for high risk, medium risk or low risk.

Step 1: Set out your life goals in detail

We all have dreams like a comfortable retirement, a home, a luxury car, children’s education etc. But all these dreams cost and when you convert these dreams into monetary units they become goals. Once you have the goals laid out, the next step is to prioritize your goals based on the importance. That is the first step to investing in mutual funds.

Step 2: Get your asset allocation right

What exactly is meant by asset allocation? You have a goal in the future and you have resources today in the form of income and savings. You need to use these resources to start SIPs in different types of funds and peg each of these funds to specific goals. Tagging is important and is a key aspect of asset allocation.

Step 3: Select the scheme category in equity

Equity funds are the best bets for long term goals like retirement, children’s education etc. But which equity scheme to select. Clearly, thematic funds and sector funds are too risky and are best avoided. Diversified funds are the best bet but if they are large caps then upsides could be limited. You can serious look at multi-cap funds for equity allocation.

Step 4: Select the scheme category in debt

Here your approach has to be a lot more conservative. You opt for debt when the goals are intermediate and have an expectancy of around 3-5 years. Ideally, keep the duration in the medium range so that the trade off between risk and returns are there. Credit risk exposure should be at a bare minimum.

Step 5: Selecting a specific scheme based on its performance

This is where you get down to actual fund selection. You can take a view based on fund house, fund strategy and team longevity. But the most important is historical returns. Ideally, look for rolling returns so that the vagaries are smooth. Focus on funds that are not only outperforming the index but doing so on a consistent basis.

Step 6: Selecting the right option; dividend versus growth

Dividend reinvestment plans are not in vogue so we shall only focus on growth and dividend. If the intent is long term wealth creation then the focus should be on growth plans. What if you need regular income? Dividend plans can be tax inefficient. Instead, opt for a growth plan and sweep funds out through systematic withdrawal plans (SWP).

Step 7: Selection the right plan; Regular versus Direct

Post 2013, investors have a choice between regular plans and direct plans. In regular plans you route your investment through a broker. Sales commissions are billed to you and you get the benefit of customized advice. In direct plans, the effort is yours but you save 100-125 basis points in cost. This can make a big difference to overall returns.

Should You Invest In International Funds

If you are not satisfied with domestic diversification, you can look to diversify your risk globally. You can effectively participate in other markets through international funds offered by domestic AMCs. However, there are risks you need to be familiar with. When you invest in equities abroad, you end up taking a combination of 3 risk exposures:

  • An exposure on the international equity market movements
  • An exposure to the exchange rates of the rupee vis-à-vis other foreign currencies. If the investor invests in the US and the Dollar becomes stronger during the period of his investment, he benefits. But if the US Dollar weakens (i.e. Rupee becomes stronger), he loses or the portfolio returns will be lower.
  • Apart from these points, there is also the international political risk that cannot be ignored.


Investors must consider investing abroad for any of the reasons below

  • The overall effective returns (international equity + exchange rate movement) will be attractive after considering the local cost of funds and also the potential movements in the rupee / dollar.
  • It is a call to diversify the domestic asset class risk by purchasing global assets to make the best of low or negative correlations.
  • International schemes can be a good and smart strategy to benefit from a particular opportunity and hence best suited to be part of the satellite portfolio of the investor. Allocation to the global assets can be kept at the bare minimum.

Portfolio Specific Factors In Mutual Fund Selection

One of the key things that have improved in mutual funds in the last 2 decades is the level of transparency and disclosure. If you open the fund fact sheet of equity and debt funds, there is a wealth of information available to help you make a well thought through decision. Here are some factors to look at in fund selection.

How is the portfolio of the fund?

The fund portfolio must be evaluated based on the risk and the risk of the scheme. What to look for in the portfolio? In case of equity funds, the level of diversification across sectors, themes and stocks is important. The monthly portfolio shifts can also tell you about the strategy adopted for selecting securities and managing it. For debt funds, look at the average maturity and duration of the portfolio, the credit risk profile and the share of interest and capital gains in total returns.

Track record of the fund

Mutual funds are about trust and trust is best left to experienced hands with integrity. Also, look at performance. A new fund managed by a portfolio manager with a lacklustre track-record is avoidable. Fund age is especially important for equity schemes, where there are more investment options, and divergence is high. Age of the fund adds credibility.

Corpus of the fund

The size of funds must be seen in the context of the fund purpose. For an equity fund or index fund, a large corpus will be an advantage. But for a small cap or mid cap fund, a large corpus can become a handicap. A small sized fund, in such cases, is more flexible and better able to take advantage of market opportunities.

Keep an eye on portfolio turnover and churn

Churning can be expensive and can also entail a huge opportunity cost. Purchase and sale of securities entails broking costs for the scheme. Frequent churning of the portfolio would not only add to the broking costs, but also be indicative of unsteady investment management.

Portfolio Turnover Ratio is calculated as Value of Purchase and Sale of Securities during a period divided by the average size of net assets of the scheme during the period. Thus, if the sale and purchase transactions amounted to Rs 10,000 crore, and the average size of net assets is Rs 5,000 crore, then the portfolio turnover ratio is 20%.  Be cautious of very high portfolio turnover ratio.

Scheme running expenses

The key theme of mutual fund investing is to be frugal about costs. Any cost is a drag on investor returns. Investors need to be particularly careful about the cost structure of debt schemes, because in the normal course, debt returns are much lower than equity schemes. Similarly, since index funds follow a passive investment strategy, a high cost structure is questionable in such schemes. You need to sum up all these ideas to make your mutual fund selection.