How to become an expert mutual fund investor: Cherry-picking funds | Value Research This is the sixth in our seven-part series where we share all that you need to know to make profitable mutual fund investments.
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How to become an expert mutual fund investor: Cherry-picking funds

This is the sixth in our seven-part series where we share all that you need to know to make profitable mutual fund investments.

An indispensable ingredient for turning your goal planning into a successful story is to choose the right mutual funds. Some funds take more aggressive positions on the equity or debt side to enhance returns. Of course, this has an impact on their inherent risks and volatility. Hence, investors need to be careful while choosing funds. The ones that have ranked among the top performers in the last one year or so may potentially also lead you to greater swings and risks.

So, here is a broad checklist of parameters on which you should focus while picking a good fund. You can get most of this information on the respective fund pages on our website - www.valueresearchonline.com. We believe these broad dimensions should be good enough to help you choose suitable funds for your portfolio:

Performance

  • When it comes to a fund's performance, consistency over an appropriate time period is most important. Don't get blindly carried away by blockbuster returns but be guided with consistency with which the fund has performed over the years. Just an above-average fund with greater consistency can very well turn out to be a far superior fund in the long run than the ones with blockbuster returns in fits and starts.
  • Another important thing is to define this appropriate time period because different types of funds have different suitable return periods. For equity, look at returns over five- and seven-year periods on a rolling basis to gauge consistency. In the case of core fixed-income funds such as short-duration and corporate bond funds, look at returns over one- and three-year periods. For an even shorter investment horizon like in the case of liquid funds, look at one- and three-month returns.
  • It is noteworthy that you should use rolling returns during your assessment, as they take into account a series of returns. In other words, it is the trailing return looked at multiple dates (instead of just one) over a period of time. This keeps the recency bias and luck factor out of the picture by focusing on the fund's return consistency.
  • In the case of debt funds, table-topping performance will usually come with outsized risk. We would suggest that you aim for a fund that has been able to consistently deliver better returns than those offered by a fixed deposit or other small-savings avenues with a high-quality and well-diversified portfolio. The objective with debt funds should not be to earn maximum returns but to protect the downside.
  • While the above points lie at the core of performance evaluation, looking at shorter time periods can help you understand the character of a fund and its behaviour during different phases of the market. Pay attention to bull and bear phases or simply use calendar-year returns to check how the fund has performed across different market cycles. For instance, there are funds that fare better in bear markets given their investing style. Those will be preferable for investors who get easily unnerved in down markets.

Portfolio
Here's what you need to do in the case of equity funds:

  • Consider how the fund spreads its assets across the market-cap spectrum. Is the fund more aggressive or conservative than peers in terms of its mid- and small-cap allocation?
  • Look at how well it diversifies across stocks by checking allocation to the top five and top 10 holdings. Also, check the concentration at the sector level and the number of stocks owned by it. If you are investing in just one or two funds on the equity side, avoid the focused variants to ensure enough diversification.
  • Get an idea of the fund's preference for the growth style (companies with high earnings growth) vs value orientation (stocks that appear to be undervalued). The funds with a higher price-to-earnings ratio as compared to their peers reflect tilt towards the growth style and vice-versa.
  • Note that the above-mentioned points do not make a fund good or bad but they give you insights into a fund's risk-return profile. Different fund managers have practised different styles with great success. But doing this analysis should help you get an idea of the management style of a fund and if it aligns with your investment ideals. Moreover, this will help you bring different style flavours to your portfolio while selecting funds. For instance, it's not a bad idea to have a value-oriented fund in your portfolio of three-four equity funds to ensure style diversity.

Here's what you need to do in the case of debt funds:

  • Pay attention to the portfolio quality, as measured by the credit ratings of the holdings and their maturity profile. In our opinion, a good core fixed-income fund shouldn't go too aggressive on either of these parameters.
  • High exposure of a fund's assets to AA & below and A+ & below-rated papers exposes you to greater risk. So, it is worth considering a fund that always invests at least 75-80 per cent of its money in sovereign or top-rated papers and that doesn't go too far down the rating curve. Likewise, we prefer funds that usually keep average maturity in the range of two to five years or thereabout. The one that stretches it too much beyond this range can be much volatile for a fixed-income investor on account of the interest-rate risk.
  • Also, be wary if there is an excessive concentration in individual bonds or issuers. For this, check the top holding and per cent exposure to the top three issuers. It is important for investors to get diversification across different issuers, as this limits the magnitude of your potential downside. The concentration risk has recently smashed a few debt funds with defaults, eroding their AUMs substantially. A reasonable degree of diversification enables a fund to sail through hard times without creating much impact on its investors.
  • Further, in the case of debt funds, the risk-o-meter can be a handy guide. Be cautious with funds that are outliers on the risk-o-meter as against their peers in the same category. If a fund shows 'high risk' on the meter, while most of the other funds in the category are 'moderately high', it means the fund is riskier on account of factors like credit quality or maturity as compared to other funds following the similar investing mandate.

Then, over a period of time, as you monitor your chosen funds, look out for any big style drifts. For instance, if a diversified fund starts consolidating big time into only a few holdings or an otherwise value-oriented fund starts taking aggressive bets in high-valuation stocks, be watchful as it is uncharted territory for that fund. Big style drifts may or may not work out and more importantly, they may alter the fund's risk-reward profile, which you didn't sign up for. Thus, one needs to be cautious.

Fund manager

  • Preferably, go with funds where the same fund manager has been at the helm for the past several years and hence is responsible for the fund's long-term performance. So, check the history of the fund manager to see how many times the fund manager has changed and the tenure of the current fund manager.
  • In many ways, a fund with a new fund manager is like a new fund. You don't know the management style of the new manager. There have been instances in the past where a change in the fund manager was followed by big changes in the way the fund was managed. However, note that it is not necessarily a bad development always. There have also been cases where the new fund manager brought about a welcome turnaround. So, don't just jump out with a change in fund manager but start paying close attention.
  • Sometimes, a fund manager is saddled with the burden of managing several funds, which is also less than desirable as it may affect the funds' performance. So, make a list of other funds managed by the current fund manager and their AUMs to check if he is overburdened.

AUM
There are some fund categories where rapid changes in the fund size can be problematic because of their investment strategy. Therefore, such funds are best avoidable. On the equity side, a sharp rise in the AUM of a mid- or small-cap fund can significantly dent its ability to generate outperformance. On the contrary, in some of the debt categories, a rapid decline in the AUM can cause big problems if the fund is unable to liquidate its holdings quickly enough. This was exactly what led to the Franklin debacle in March 2020.

Expenses
Expenses have always been an important consideration in fund selection, as a high expense ratio over the long term may significantly eat into your returns. But they have perhaps never been as important as they are in the current setup.

At a time when actively managed equity funds are struggling to beat indices and debt funds' returns are touching historic lows, expense ratios play a big role to squeeze out little extra returns. In fact, in some debt categories, expenses can be a game-changing factor between an above-average fund and a bottom-quartile performer. So, don't ignore the expense ratio. In our framework, we dislike paying much more than 1 per cent for equity funds and about 30-35 basis points for a core fixed-income fund in the context of direct plans.

Others

  • Look out for any other factors that can shake your convictions over the fund. For example, is the AMC entangled in some other matter that may be unrelated but adversely impacts its credibility? Or is there any ownership change?
  • On the contrary, are there instances that reinforce your confidence? For example, in fixed income, funds that have enabled side-pocketing provisions in their schemes are more favourable as they can serve existing investors better if there is any default/downgrade in its portfolio constituents.

Also in 'How to become an expert mutual fund investor' series:

Part 1: Know thyself

Part 2: Begin with the end in mind

Part 3: Balance is the key

Part 4: Avoid hitting bumps

Part 5: Don't forget the reverse gear

Part 7: Be a sage


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