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Investing With Simplicity

Dhirendra Kumar

The following is a set of simple common-sense principles that should help you select funds that can earn a generous portion of the market's return, although, all too likely, less than 100 per cent. There are odds against beating the market but these principles will help make an intelligent fund selection and save against a significant failure. Intelligent investing is not complex, though that is far from saying that it is easy. These simple rules should make it easier for you to make intelligent fund selections for your investment program.

1. Select Low-cost Funds

   Costs play a crucial role in shaping long-term return of any investment. Seriously, costs matter. As the dust settles and our funds travel through the cycles of the market, which they haven't yet, a low expense ratio will increasingly become the most important reason for a fund's success. So, carefully consider the role of the expense of a fund in shaping its returns. And regarding cost, soon little things will mean a lot. With the average fund portfolio turnover of 120 per cent per year for the top 10 equity funds, I wonder if it's long-term investing? As these turnovers carry transaction costs that reduce returns by as much as 1/2 to 1.0 percentage points on top of the fund expenses. So its time to consider funds with low turnover.

2. Consider carefully the added cost of participation

   The sales load is supposed to be a cost for an investor who needs the personal assistance and guidance in allocating their assets and selecting funds. Many investors need them. But given the structure of the fund distribution, does one really get that for the cost? And many of the fund investors today do not need it anyway - as mutual funds' appeal being its simplicity and the new generation fund investor being self-reliant, intelligent, informed who takes his decisions without an intermediary salesman. Assuming the funds are properly selected, a no-load fund is the least costly way to own mutual funds. A no-load fund will consume the lowest possible proportion of your future returns. Avoid funds with steep entry load, as it can be a significant drag on a mutual fund's performance.

3. Do Not Attach Great Importance to a fund's past performance

   The fund's past "track record" is an alluring lure to most investors - new and experienced. The track record may be a helpful pointer in a horse race, but can be highly misleading in case of funds. There is simply no way to forecast a fund's future absolute returns based on its past record. And even if one can accurately forecast future market returns, there is no way that relative fund returns can be forecast. The secret lies in over-coming the lure. Haven't you recently come across the two-month return of SBI Sector Funds, boldly announcing the fantastic return over the past 60 days? It is likely that top performing funds can lose their edge. Funds persist in promoting their most successful past performers for understandable reason as it brings in lot of new money and new fees to the AMC. But this strategy defies investment rationale and leads investors in wrong direction. Ignore past performance numbers, and shut your eyes altogether to short-term performance.

4. Use Past Performance to gauge Consistency and Risk.

   Past performance does play an important role in your fund selections. While you should disregard a single aggregate number showing a fund's past long-term return, it can help learn a great deal about the nature of its past returns and the all-important consistency of return. Careful analysis of past performance can also reveal a lot about risk - the key element in investing. As relative fund returns can vary randomly from one period to the next, relative fund risks carry a reasonable degree of consistency. To guard your assets, don't ignore risk.

5. Beware of Superstars

   The emergence of private sector funds has lead to the emergence of Superstar portfolio managers. And the fact is that there are precious few. And even the temporary superstars we have are more likely to have a limited longevity, as they haven't been through a full market cycle yet. Not their mistake, as the first private fund was flagged just over five years ago. And the unknown old star managers of UTI and other bank-sponsored funds have not come up to stake a claim on the performance credit, for obvious reasons. And unfortunately, the star will never be known before he becomes one. Look for good managers and rely on their professionalism, experience, and tenacity rather than stardom.

6. Beware of Huge Funds - Prefer an Index fund to a Goliath

   Funds can get too big for their own peril. Hope you have not yet forgotten the Mastergain and Morgan Stanley. Avoid large funds letting themselves grow to seemingly infinite size, beyond their power to differentiate their investment results from the herd and irrespective of their investment goals. As something too big is also complex. And you cannot relate to the fund's style, management philosophy and portfolio strategy. And going by the performance of the large equity funds of UTI, which have delivered returns identical to a broad based unmanaged Index. Why not choose a relatively low cost index fund.

   A broad-based market index fund should be able to grow without any size limits. A giant fund, say the Rs 2,000 crore Masterplus investing in large-cap stocks, with very little portfolio turnover, can be managed effectively, albeit not for truly exceptional returns. For a fund investing aggressively in infotech stocks, even Rs 300 crore might be too large. Kotahri Pioneer Infotech, the blockbuster till now started as a Rs 7 crore fund just an year ago. And on 30th September '99, it has Rs 120 crore under management. I wonder whether it is as easy or difficult to manage the fund, given the breadth of Indian Infotech Industry.

   Besides this, many of our star fund managers who can easily be termed as momentum riders. And growing size of a fund can be a serious handicap in pursuing the momentum strategy. The present and potential size of a fund is important. Huge size can and very likely kill possibilities of investment excellence. For a vast majority of the stellar returns in recent years, the best years have been when they were small. Vigorous growth in terms of size for an equity fund should be a warning to an intelligent investor.

7. Avoid Over-diversification

   To my understanding, a single balanced fund with 65% equity allocation and 35% debt allocation can meet the needs of many investors. And a pair of equity and debt funds with a custom-made balance can meet the needs of many more. I seriously wonder, what is the optimal number of funds for investors to own? To keep it simple, I think not more than three or four. Owning too many equity funds easily results in a dangerous combination of over-diversification and excessive cost. There is no rationale for owning as many as 20 diversified funds in a portfolio and thereby owning at excessive cost, perhaps 2,000 stocks. Perhaps a simple balanced portfolio with three equity funds and a debt fund would suit the needs of investors seeking active equity management and willing to accept marginally better or worse than market returns.

8. Build, maintain and hold your portfolio

   Once you decide on your long-term financial goals, define your risk-tolerance and carefully select funds that meet the above rules, then follow this. Hold tight. Stay the course. Sleep Tight. Complicating your investments will merely add to the clutter and you will also run the risk of diluting your plan with unnecessary irrational emotions.

   You can tightly hold your investments only if you own the right ones. And the right fund is not the one you don't understand, or the best past performer, or the one I tell you, or is managed by a star manager. But surely a low cost fund with consistent performance is more likely to be a long-term Star Fund.

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