How to pick mutual funds smartly

When making a buy or sell decision on a fund, it is essential to look beyond profits.

When it comes to fund managers and market strategists, this year's hero usually turns into next year's zero.

William Bernstien makes that statement in his book titled The Investor's Manifesto. Bernstein is an American financial author, theorist and neurologist. His words are worth noting.

Irrespective of whether the decision is to invest or to liquidate, performance often becomes the sole deciding factor -- an error that many investors commit unknowingly. While we vociferously advocate that returns remain an important indicator of how a fund has been able to deliver historically across varied market cycles, it is not the only factor. A more holistic approach is needed when evaluating a mutual fund from an investment perspective.

Top performing fund? Don't live in the past!

Historical returns do provide an insight into what the fund has done in the past, but its predictive powers are definitely limited. A fund's impressive performance is not guaranteed to be repeated in the future.

It is not without reason that the regulator, the Securities and Exchange Board of India, insists on the disclosure along the lines of: Past performance of the Sponsor/ Mutual Fund/ Investment Manager is not indicative of the future performance of the Scheme(s).

Why?

For one, performance could change if there is a change in the fund manager. It could change for better or for worse. Having said that, in most cases, it is not the issue of a fund manager change. It could simply be plain market dynamics; the stock bets that worked in the past may not work going forward.

For instance, if the fund manager was stocking up on value stocks and the market favoured them, it would have worked to his benefit. If growth stocks were on a roll and value stocks were being punished, he would suffer. The stock bets that worked in the past need not work going forward.

Companies that were part of the portfolio and propelled the fund's overall returns in the past may have either changed significantly in terms of their structure and/or their ability to generate similar levels of return. In contrast, the constituents of the fund itself could have changed affecting the return profile of the fund.

Hence, while returns can be used as a starting or reference point, taking investment decision solely based on them could lead to financial disaster.

Top performing manager? But for whom?

Fund managers tend to have different styles, investment horizons and philosophies. Investors on the other hand tend to have varying investment goals and risk appetites. Since there is no concept of 'assured returns' or a 'one size fits all' solution in the mutual funds industry, evaluating a manager's style and comparing the best 'fit' with individual investing preferences becomes essential.

A so-called top performing fund manager may be a disastrous fit for your portfolio. Let's say he manages his fund in a volatile fashion, and while he delivers admirably, the highs and lows could churn your stomach. In that case, you should be avoiding his fund.

Understanding the styles and the differences across the investing patterns of different fund managers helps gauge the suitability of funds managed by them and prevents investors taking on additional unwarranted risks as part of their portfolio. It also encourages a higher level of investment discipline. Not all strategies are suitable for all investors. For example, large cap funds are typically considered as being lower risk as compared to a mid or small cap fund. You need to check whether the fund falls in the large-cap category, flexi-cap category, or mid-and-small cap category. You would also need to look at other parameters such as concentrated portfolios against highly diversified ones.

Investors need to first assess their requirement and then the fund's suitability to meet their individual goals.

Don't ignore costs

Additional costs and increased fund expenses can eat into the income that an investor really makes. In John Bogle's words, "The miracle of compounding returns is overwhelmed by the tyranny of compounding costs." A higher expense ratio will tend to lower investment gains thus nullifying and/or lowering actual earnings. Bogle is an author and founder of the Vanguard Group.

Furthermore, the tax structure in India can have an impact on fixed income funds that are redeemed before the three-year period, thus making the income from such funds taxable.

An exit load as defined by the fund documents is another factor to consider while redeeming investments. With all these different facets of costs coming into play, it becomes important to take into account the actual income vs the percentage returns that a fund is able to deliver.

In conclusion...

Investors often exit a fund due to its underperformance just in time to see its returns take a 360 degree turn. While maintaining a long-term view is important, it is important to understand the reasons for short term aberrations and their possible impact over the long term.

Investment decisions should be based on a combination of fundamental strength backed by quantitative support. Look for consistency of returns and whether or not the fund manager's style is in sync with the fund's mandate. And don't expect a blockbuster performance every year.

William Bernstien's words yet again: Mutual fund manager performance does not persist.