6 Tests to conduct before selecting a mutual fund

Open any mutual fund website and you can find a lot of data about how the particular fund or scheme of the AMC has outperformed the market. There could be an analysis of how the particular fund has beaten the market index. There could also be a comparison between a particular fund and the other funds in the category to highlight the superiority of a particular fund. There could be an elegant table or chart which outlines how that particular fund could have created wealth for an investor over a period of time. As a smart investor, it is your job to conduct 6 basic tests before deciding on buying a mutual fund.

1. Beware of point-to-point returns

This is the easiest way to get carried by a mutual fund’s performance. For example if you take the starting point as September 2013, then the returns over the next one year for most funds would have been phenomenal. That is because September 2013 marked the bottom of the Nifty around 5200 and the bull rally began from that point. The reality is that investors hardly get the opportunity to invest in mutual funds in a lump-sum at the bottom of the market. While that may be technically correct, it is practically not possible!

2. An SIP is more indicative than lump-sum investment…

From a more practical standpoint, assuming that investors would invest in lump-sum at the bottom of the market does not really make sense. A SIP would be a more practical method since investing in a rule-based manner on a regular basis is a practical scenario. An SIP tends to be more agnostic about the crests and the troughs of the market. The SIP works more on the principle of rupee cost averaging, which is what every mutual fund investor would like to do and what every retail investor finds easier to do.

3. When you benchmark; test the benchmark…

The common technique of measuring a fund’s performance is versus an index. If the index returns 11% and the fund returns 14% during the same period, that is a clear outperformance. But you need to be cautious about the benchmark that you are using in this case. For example, if you are evaluating a diversified mutual fund, then comparing with the Nifty or Sensex adds little value. But if you are evaluating a sector fund, then comparing with the Nifty or Sensex can actually be misleading.

For example in the last 6 months, a pharma fund would have generated a return of 20% against a Nifty return of 4%. That is not a 16% outperformance because your benchmark is wrong, in the first place. The concentration risk and sector level risk is much higher in a pharma fund than in the Nifty. A pharma fund should be ideally compared to a Pharma Index to get a more credible picture. Similarly comparing a low risk fund with a high risk fund, purely on the returns criteria may be misleading. The high risk fund may be generating higher returns through higher risk, and not by the skill of the fund manager.

4. Always target a fund for the long term…

You can argue that it is hard to predict the long term in volatile market conditions. But the history of mutual funds is replete with proof that the full benefits of a mutual fund investment can be realized only over a longer time frame of 4-5 years. An AMC that talks about outperformance in 6 months, 1 year or even 2 years is not giving the exact picture. A mutual fund gets to cover a full cycle of market vagaries only over a period of 4-5 years. That is the most appropriate time frame to evaluate the performance of a mutual fund.

5. Be conscious of the risks in a mutual fund…

Sorry to say, but mutual funds are not risk free. In fact, they are anything but risk free. Equity mutual funds may be safer than direct equities because there are professional managers to manage the risk. But equity funds are still vulnerable to the vagaries of the market. Even G-Sec funds are not risk-free even though they invest in government securities. These funds are exposed to interest rate risk i.e. bond prices will come down if interest rates go up. And funds that invest in corporate bonds run a default risk, over and above the interest rate risk. For that matter, even liquid fund can become risky in extreme market conditions when there is an overall liquidity squeeze in the system.

6. Stick to the tried and tested Mutual Fund AMCs…

In the Indian mutual fund industry we have seen many funds either getting liquidated or sold out to bigger players. Among the older names, Centurion Fund, Alliance Mutual Fund, Kothari Pioneer, Zurich, Lotus and Fidelity were the prominent names that merged out with larger names. Similarly, AMCs like Dundee, CRB and Sahara had to wind up due to different reasons. If you look at the AUM of mutual funds, the top 6 names are dominated by big business houses or by very large financial institutions. HDFC, ICICI Pru, Reliance, Birla, SBI, UTI are all cases in point. As a mutual fund investor, a pedigree gives you that added advantage of safety and security. Secondly, an AUM in excess of $10 billion gives the requisite scale and flexibility to operate in uncertain market conditions.

Mutual funds offer an easy and transparent way to grow your wealth. The above 6 tests will help you make a more informed decision. It could be your starting point.

For all your mutual fund queries SMS ‘ASKMF‘ to 575758 and we will get back to you.

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