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Making the Right Choice

The most important point is not which fund but who you are.

Last month, India’ investments regulator, the Securities and Exchange Board of India (SEBI), announced a range of new rules and regulations that will apply to mutual funds. The headlines next day (and analysts’ commentary thereafter) were mostly preoccupied with the incentive system that SEBI has put into place to encourage mutual funds to expand to smaller towns and villages. However, there was another item in SEBI’s announcement that may eventually end up being of greater import to how we invest in mutual funds and how we invest and how we choose the funds that we invest in. SEBI’s announcement said that it had decided to “...evolve a system of product labeling.”

To understand why this is important to you, think of the way the choice of a mutual fund is typically made. When an investor wants to decide which fund to invest in, he tends to ask exactly that, “Which fund should I invest in?” And as an answer, he expects exactly that too—the name of the one fund that he should invest in, the ‘the best one’, according to some vague definition of best that he has in his mind. However, this is not the right question, or at least its not the right first question to ask.

The correct place to start this quest for the most suitable fund to investment is to ask what type of fund to invest in. Choosing a good fund to invest in is a top down activity—first you need to know what is the right kind of fund and then you come to which specific fund to invest in. Think of the original question that you asked, “Which fund should I invest in?” The most important bit of this question is not ‘which fund’ but ‘I’. The question is not which fund but who you are. There are scores of mutual funds that are worth investing in. The point is, who is investing? Are you retired salary earner who is dependent on the fund for a monthly income? Are you a young person on a first job who’s saving up for a marriage or a house? Are you a middle-aged businessman who wants the highest returns possible but doesn’t mind a bit of risk? Or are you the CFO of a company looking to park some cash for a few weeks? Depending on your circumstances, your financial goals, the time-horizon of your investments, different types of funds will be suitable. Only after the type of fund is defined does the question of which specific fund come up. There’s an old joke that if the race is between five horses and five humans, then there’s very little point in trying to figure out which human is the fastest. It’s important to get the category right. If the category is wrong, then choosing the best within that is pointless.

Here’s an illustration of what I’m talking about. Suppose you have just sold some real estate and have a large sum of money that you don’t need for about a year. Having decided to park the money in a mutual fund for the period you ask someone which is the best fund around without defining your actual need. You are suggested a good mid-cap equity fund which has a five star rating from Value Research, into which you promptly invest the entire sum. A year down the line, the stock markets have remained shaky and your treasure has shrunk by perhaps 10 or 20 per cent. Did you choose a bad fund? No, the fund you chose was fine. It’s just that the type of fund was unsuitable for the purpose. For a predictable time horizon of one year, a Fixed Maturity Plan (FMP) would have provided a reasonable return with negligible risk.

Conversely, suppose you are putting aside a certain sum of money from your monthly income for long-term savings, which you may not need at least for a decade or more. In such a case, choosing anything but an equity fund is pointless. The period is long enough for the volatility of the equity markets to be damped out. Since you will be investing gradually in a monthly SIP, you will be able to make earn returns that are actually better than the overall gains of the equity markets. However, for such a purpose, a fixed income fund would be most unsuitable. In a high inflation environment like India, fixed income rarely beats inflation and your money effectively becomes less over the years.

But how do you figure out which fund is of what type and what are the various types suitable for? That’s the problem that SEBI is trying to solve with the effort to evolve a new system of fund labelling. You see, fund companies rarely state in unambiguous terms what type a fund fits in. They’ll do so in broad terms that are statutorily required like whether a fund is an equity fund or a balanced or debt fund. However, and specially in equity funds, basic marketing wisdom dictates that the sellers try and differentiate their products as much as possible. Therefore, fund companies typically describe the investment approach of their funds as being unique. This is an attempt to de-commoditise the fund—the fund company is now able to claim that the fund should be evaluated only by its own claimed characteristics and not by comparing it to any other fund.

However, there’s very rarely anything genuinely new under the sun. What is needed is an unambiguous labelling system that can tell you which fund is of which kind and therefore suitable for what type of investment goal. Of course, what SEBI will now evolve is a statutory labelling system. Fund analysts like Value Research analyse the entire universe of mutual funds and fit them into logical categories that help investors make apples-to-apples comparisons. Hopefully, SEBI’s official labelling system will control the excessive differentiation and confusion that it has caused among investors trying to choose funds.