Mutual Fund Scheme Selection : A Do-It-Yourself Kit

By Jayant Pai | [email protected]

Choosing good mutual fund schemes is not an easy task for beginners. The same applied to me too. I too have undergone many teething troubles before finally honing in on a few rules which work for me. Initially, I relied on the advice of others, but my entire investing approach changed when I subscribed to a highly reputed magazine meant for serious investors. Today, my scheme selection process is a distillate of of several intrinsic and extrinsic factors. Here are a few of them:

Know yourself : No scheme is good or bad in itself but only you can determine whether a scheme is suitable to you or not. I am rather conservative by nature. Hence I know I will be uncomfortable if I choose aggressive schemes, however, popular they may be. That is why I prefer schemes which are managed conservatively.

Choice of fund house : The ‘DNA’ of every fund house is different. Hence, while ‘marketing compulsions’ may induce fund houses to offer a variety of schemes, only those which are are aligned with with its core investment philosophy will be successful.

Again, choose a fund house which suits your personality. Over the years, I am comfortable with houses like HDFC, Franklin Templeton and Quantum.

Reading the numbers : I used to get overwhelmed with dozens of risk-and-return metrics. Now I only rely on a few :

1.Understand the classifications : While constructing a portfolio it is preferable that large-cap mutual funds dominate. However, definitions of what is large-cap, mid-cap etc. differ. .You could choose any credible agency’s definition and adhere to that. For instance, Value Research considers stocks comprising the top 70% of the market-capitalisation spectrum as “Large-Cap”.

2. Benchmark : In case I observe that a scheme has chosen an inappropriate benchmark, I measure its performance with a more relevant one. For instance, I would prefer to compare a multi-cap fund’s performance (say, having only 45% in large-cap stocks) with that of the CNX 500 rather than the Nifty Fifty, even if the scheme has chosen the latter as its benchmark.

3. Portfolio characteristics : Being conservative, I prefer that my fund’s composite Price/Earnings Ratio as well as Price/Book Ratio are either at a discount to that for the broad indices or at the most, a premium of 5-7%. I never invest in a scheme by judging it on the individual constituents in its portfolio. I prefer to look at the portfolio as a whole.

4. Expense Ratio : I prefer schemes whose expense ratio is less than the category average. I am not obsessed with always choosing the one with the lowest ratio.

5. Portfolio Turnover : I prefer schemes which follow a buy-and-hold strategy. Hence I usually choose schemes where this turnover is below 50%. This does not imply that that those with a high turnover are necessarily bad. Its just that I am not comfortable with them.

6. How to tackle the ‘Greeks’ : This one is for hard-core scheme trackers…I will first check the R Squared (The correlation that the fund has with its chosen benchmark). It should be above 0.80, otherwise the correlation is a weak one. I then check the Beta (The sensitivity of the fund’s NAV to its index) and finally Alpha (The extent of outperformance with its chosen index).

7. Risk and Return : While long-term performance is important, I also look at comparative improvement in performance figures over periods of one year or less. This is especially so, if the fund manager has changed recently. Also, I prefer schemes where the Standard Deviation of returns is not over 25% or less than the category average.

8. Diversification profile : I like to choose funds where the top 10 holdings do not exceed 40-45% of the portfolio. Also, I like fund managers who have the courage to purchase beaten down and under-owned sectors although as a rule, I avoid sector funds.

Of course, while it is virtually impossible to find a fund which conforms to all parameters, it must meet at least 75% of these.

Finally, it is preferable to rely on the websites of independent and unbiased research. agencies such as Value Research and Morningstar while scouting for good schemes. They have got powerful websites and learning how to use them efficiently will obviate our need to re-invent the wheel.