The Art and Science of Selecting Right Mutual Funds

Being in the investment advisory line for more than 20 years, I am still amazed at the way the mutual funds are selected.

There is an underlying belief among people as well as in the financial media that successful investment is all about selection of right mutual funds.

Further, the factors that people generally focus on to select good funds makes the portfolio destined for underperformance.

So, here is few important pointers which will help you construct a solid portfolio without bothering to choose the so called best mutual funds-

1) Focus on Your Financial Plan- First and foremost, prepare your financial plan. Articulate your financial goals, Optimise your savings, and understand your risk profile. Your financial plan will be a unique expression of your priorities, values and desires. Because of these factors, your financial plan and portfolio may be quite different from your friends.

2) Focus on Asset Allocation- Your financial plan depending upon your priorities, values, desires and risk profile will suggest a certain asset allocation to achieve your financial goals. Asset allocation ( distribution of assets between equity, debt and gold) is 90% responsible for your investment success. Yes, it’s not the selection of funds rather the right selection of asset allocation which mainly contributes to your portfolio performance. So, should you focus more on asset allocation or fund selection?

3) Selection of mutual funds- Once you make your financial plan and set the asset allocation, now comes the turn of selection of mutual funds. The problem is that, people don’t do the first two steps properly and straight away jump into this step. That would be a big mistake which could set the portfolio for perennial underperformance.

So, after carefully completing the first two steps, let’s see how the right funds should be selected-

•  Focus on proper diversification of your portfolio- Choose the funds in such a way that you cover the entire spectrum of the market. So, on the equity side, you may choose funds with large cap, mid cap, small cap, multi cap, hybrid and even international focus. Similarly, on the debt side, choose funds with long duration, medium duration, short duration and ultra-short duration oriented funds. Idea is to make the portfolio truly diversified.

•  Focus on fund managers with good track records and fund houses with established processes- Take some time to check the resume of the fund managers. What are his/her qualifications and track records? Also, you may like to avoid fund managers who jump from one fund house to another quite frequently. Similarly, choose the fund houses which follow clearly demonstrable values and not get swayed by the momentum of the market.

•  Focus on valuation of the funds- One of the important barometers is to see the PE ratio ( Price to earnings or PE ratio shows the relative valuation) of the funds. Funds with very high PE ratios tend to perform poorly in the distressed market condition and may take much longer to recuperate the losses.

•  Focus on consistency of the fund rather than on the recent past performance- Most of the people are obsessed with choosing the funds which are superlative performers of the last year. Media perpetuate this frenzy. But here is the secret- mutual funds follow what is called “reversion to the mean concept”. This implies that funds which have performed above average tend to perform below average in the coming time frame. Thus, it’s important to see how consistently the fund performed over a long period of time and not just in the past one year. If at all, one should stay away from hot funds of the year.

•  Avoid New Fund Offers (NFOs)- One more misconception which refuses to go away among people is to consider NFOs as a good investment opportunities because they start with the NAV of Rs 10. See, starting NAV is just a base price without showing the underlying valuation of the fund. So, for that matter, NAV has no role to play in the fund’s performance. In addition, NFOs tend to spend quite a lot on marketing which eventually goes from investors’ pockets. Besides, they have no track record to show their fund management process and performance.

• Focus on expense ratio- All things equal, prefer funds which have lower expense ratio. After all, the expense of managing funds comes from your kitty only.

•  Index Funds- If all this seems too complex and tedious, simply invest in index funds. These are low expense funds which simply mirror the wider market indices. Thus, they are also called the passive funds. In the US, most of the actively managed funds don’t beat the index funds and this trend is beginning to emerge in India also.

        Manoj Pandey

        CFP