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A 10-step guide to evaluating mutual funds

May 19, 2007 12:40 IST

Mutual funds are a convenient way to invest in the stock markets (as also debt and money markets). Indian investors are already beginning to realise this. That's the good news; the bad news is that a lot of investors seem to think that any mutual fund will do the 'trick'. The trick over here is to clock higher returns any which way.

While generating an above-average return is every fund manager's mantra, it is not achieved that easily and when it is achieved it is not necessarily done in the right manner.

Which brings us to the question - what must investors do to ensure that they are invested in the right fund? With so many funds in the industry and many more being launched every month, this is not an easy task. Multiplicity (as also duplicity) of mutual funds apart, there are many elements within a fund that an investor needs to consider carefully before short-listing his investment options. To facilitate the decision-making process, we present a 10-step guide to investing in mutual funds.

Fund sponsor's integrity
In this age of financial irregularities and misconduct, it is a tough call to come across fund houses that haven't been embroiled in some controversy or the other. While major financial scams involving mutual funds are yet to make their presence felt in a India, it is quite common in developed markets like the US.

That is why it is important to go for a mutual fund sponsor with an impeccable track record in terms of compliance and investor welfare. Equally important is requisite experience with a well-established track record in fund/asset management.

A competent fund management team
The team managing the fund should have considerable experience in dealing with market ups and downs. It should be competent enough to take the right investment decisions based on experience under varying market conditions. More importantly, these investment decisions must be in adherence to the investment mandate (so mid cap funds must be invested in mid caps and large cap funds must be invested in large caps and funds that must be fully invested in equities at all times must not go into cash).

At the end of the day, it is the fund management team's responsibility to deliver performance over the long-term across market cycles vis-à-vis peers and the benchmark index.

Well-defined investment philosophy
For many fund houses, the investment philosophy revolves around whatever goes with the chief investment officer. In other words, the CIO defines the investment philosophy of the fund house. Actually it should be the other way round, the fund house must have a well-defined investment process that the CIO must abide by at all times.

Sure he can introduce an element of individualism based on his experience, but this cannot override the fund house's philosophy. This will ensure that the investor's interests are aligned to the fund house and not a maverick fund manager/CIO.

Another important aspect of the fund house philosophy is related to asset mobilisation. How is the fund house accumulating new assets (either from existing investors or fresh investors)? Is it doing this by launching senseless NFOs (new fund offers) or is it concentrating on improving performance of its existing funds and drawing investors over there?

If it's the former (i.e. the NFO route), then the AMC has got it wrong in our view; getting investors to invest in existing funds by establishing performance over the long-term (at 3 years for equity funds) is the right way to accumulate assets. As and when existing funds have established their performance over 3-5 years, the next NFO can be launched.

Get the fund nature right
A mutual fund can be classified in two categories i.e. open-ended funds or close-ended depending on whether new investors will or will not be allowed to invest.

Open-ended Fund
An open-ended fund never closes its doors to investors (unless the fund house decides to do so under exceptional circumstances like for instance, when the fund's net asset base grows too large to be managed effectively). On the same lines, existing investors can exit from an open-ended fund whenever they please (the only exception to this is the tax-saving fund or the equity-linked saving scheme – ELSS as it is known). It is evident that liquidity is the key advantage of investing in open-ended funds.

Close-ended Fund
A close-ended fund on the other hand opens the door to investors only during the NFO period. After that, it is closed for further investment over a pre-determined tenure (usually 3 or 5 years). Upon maturity of the tenure, the fund may or may not convert into an open-ended fund.

Get the fund category right
Funds can be classified into different categories based on where they invest your money.

Equity Funds
These funds invest in the stock markets and are suitable for investors with a high risk appetite. Over the short-term, investors could lose considerable money depending on the performance of stock markets. Over the long-term (at least 10 years) equities are known to generate above-average returns (particularly in the Indian context) vis-à-vis other assets like bonds, gold and real estate.

Debt Funds
These funds invest in debt markets (corporate bonds, government securities, money market instruments). More than capital appreciation, debt/debt funds are a good way to safeguard your assets over the long-term and to diversify across asset classes.

Balanced Funds
Balanced funds (or hybrid funds) invest in equity and debt markets. However, to retain their equity-oriented nature (from a tax perspective) balanced funds are required to invest a minimum of 65 per cent of net assets in equities. In our view, with nearly 2/3rd of assets in equities, balanced funds are virtually equity funds in disguise. There was a time when balanced funds needed to maintain just 51% of assets in equities, then was the time they were really 'balanced'.

Another mutual fund offering in this category is the monthly income plan. MIPs invest mainly in debt markets (usually 75-80 per cent of assets); the balance is invested in equity markets. For investors primarily concerned about capital preservation (although over the short-term MIPs can erode capital) with the secondary objective to clock capital appreciation, MIPs are worth a look.

Fees and charges (recurring)
Asset management companies charge investors a fee for providing fund management expertise. Like all other services, fund management costs money; there are salaries to be paid to fund managers and their team of investment analysts, then there are fees to be paid to the custodian and the registrar among other service providers.

These expenses (as indicated by the Expense Ratio) are incurred by the fund on a recurring basis (annually). Such expenses are not to be considered lightly, higher expenses erode returns and over the long-term can make a lot of difference to the fund's performance.

The load (one-time)
In addition to the recurring expenses, most funds also levy a one-time upfront charge at the time of investment. This is known as the entry load. To understand how this works take an investor who invests in a mutual fund with an NAV (net asset value) of Rs.10.00.

If the entry load is 2% the investor will have to pay Rs.10.20 to buy a single unit. The additional payment of Rs 0.20 (per unit) goes towards meeting the mutual fund agent's commission. Some funds also have a practice of imposing an exit load. In such a scenario the investor recovers his money after accounting for the exit load. For instance, if the investor sells his unit at an NAV of Rs 20.00 and incurs a 2% exit load, he will receive Rs 19.60.

The tax implications

The mutual fund tax structure is certainly not meant for lay investors. Even accomplished tax experts antagonise over it and wish that the finance minister simplifies it, rather than complicating it in every budget.

Put simply, there are several dichotomies in the mutual fund tax structure.

i) Investing in equity and debt funds have different tax implications.
ii) Within debt funds, liquid funds and other debt funds have different tax implications.
iii) Within debt funds, investments by individuals/Hindu Undivided Families (HUFs) and corporates have varying tax implications.
iv) Within debt funds, investments made from a long-term and a short-term perspective have varying tax implications.

As you would have figured by now, investing in mutual funds can be a 'taxing' proposition.

Evaluate the fund's portfolio
Service levels of fund houses vary. Some fund houses regularly update investors on details like stock allocation, sectoral allocation, asset allocation, Portfolio Turnover Ratio and Expense Ratio among other details. Most fund houses provide a lot of these details at monthly/quarterly frequency through mutual fund factsheets.

However, this information is not quite as standardised as it should be, so the investor has to be careful while making a comparison. Making a comparison would typically include evaluating a fund's portfolio in terms of diversification across top 10 stocks and leading sectors (in case of equity funds) to ensure that the fund is not taking on more risk than necessary. It is evident that this is no mean task and requires considerable effort and patience on the investor's part.

Evaluate the fund's performance
Every fund is benchmarked against an index like the BSE Sensex, Nifty, BSE 200 or the CNX 500 to cite a few names. Investors should compare fund performance over varying time frames vis-à-vis both the benchmark index and peers.

Carefully evaluate the fund's performance across market cycles particularly the downturns. A well-managed fund should not fall too hard (relative to the benchmark and peers) during a market downturn even if it does not feature at the top during a stock market rally.

By, a financial planning initiative. It can be reached at also publishes a free-to-download financial planning guide, Money Simplified. To get a copy of the latest issue -- Real Estate & You - please click here.