Follow these and the your chances of earning higher returns will improve...
Illustration: Dominic Xavier/Rediff.com
There are different approaches to managing money and creating wealth. So the first filter in selecting a fund is deciding on the type of fund you would like -- value or growth; or even based on the market cap.
Once you have arrived at that, it is time to pick the one from the peer set.
The five questions mentioned below should help. However, do note that none of them make sense in a vacuum. They have to be viewed holistically to arrive at the final call.
1. Are you getting swayed by short-term performance?
It's easy to overdose on data when choosing funds. Numbers can be interesting, but only a few really help you make good selections.
Unfortunately, many investors have a hard time figuring out which stats to use and, all too often, make the mistake of leaning too heavily on a fund's returns over the past year.
A fund's performance in a year may actually be attributed to sheer luck. There are funds which have topped the chart in one year only to tumble abysmally the next.
Always take the long-term track record into account.
Look at the annualised returns over various time periods. Look at the calendar returns to see how it fared in various years and if its performance is extremely volatile.
Is it a bear market bellwether that gains by not losing too much ground? Or a bull market galloper that crumbles in a downturn?
2. How have returns been under the current fund manager?
Most investors are looking for high returns, so if you're investigating a fund, it's natural to want to know how it has performed in the past relative to similar funds.
Directly examining a fund's percentile ranking within its category over a long-term period, such as 5 or 10 years, is also a good start, but a fund's past history doesn't always reflect its current situation.
You must pay attention to how the fund has performed since the current management team took over.
If a fund has a great 10-year record but the manager responsible for that record has recently left, you should naturally be more cautious.
Conversely, though less common, a fund with poor or mediocre long-term returns may look more promising if a new manager with a good track record has recently come on board.
3. What risks has the fund manager taken to deliver that return?
Some funds just prefer taking huge stock bets or huge sector bets. They may also have a high turnover ratio. You need to look under the hood and take a good look at its portfolio.
Do note, we are only referring to diversified equity funds here. A sector fund is a different bet.
By and large, most investors are better off avoiding high-risk funds. That's because it's tough to stay put when a highly volatile fund gets whacked, even though holding steady might be the right course of action.
4. Have you looked at expenses?
This one's simple: You improve your odds of success by investing in funds with low fees.
Over a 10-year span -- and you should consider investing for such periods when the fund in question is an equity product -- the expense ratio will have a significant impact on overall returns.
The expense ratio is the percentage of assets that go towards annual expenses such as administrative costs, fund management fees, agent commissions, registrar fees, marketing and sales expenses, brokerage fees, and other expenses to run the business.
A high expense ratio will affect the returns. Let's say an equity fund charges 2.50 per cent. In a year, if the fund loses 14 per cent, after charging expenses, the investor's value is down 16.5 per cent.
The next year, the fund gained 20 per cent. After expenses, the investor gained 17.5 per cent.
All mutual funds returns are calculated on the net asset value, or NAV, after accounting for the expense ratio.
The NAV is the return to the investor after expenses are deducted.
A word of caution: When you compare expenses, do so in the right context.
Don't compare the expense ratio of an index fund with that of an actively managed one; or an equity one with debt. Stick to the peer group.
5. Are you ignoring stewardship?
Some funds watch out for shareholder interests, and others treat investors as if they were second-class citizens.
For instance, let's say during a bull run a lot of money is being poured into a micro- or mid-cap fund.
An ethical fund house could take a call to close for new investments (barring the systematic investment route) if they feel that the move will better serve existing shareholders.
Similarly, look at the calibre of the fund manager and his team. Is he known to stick to the fund's mandate?
Is a sound process in place?
If the fund manager packs his bags and heads for the exit, will the fund house flounder or will the transition be smooth?