Mutual funds are often touted as a useful vehicle for small investors as it allows an investor to hire an expert to go through a plethora of parameters for evaluating among the thousands of stocks listed on stock exchanges.
However, with so many mutual funds to choose from, the investors are no better off than they were without the mutual funds.
The following discussion is an attempt to look at some of the parameters to decide how to select mutual funds for investments:
The standard approach is to look at the past performance of the fund, the risk associated with the fund (as represented by the standard deviation), etc. the conduct of the fund house, services of the fund house, the adherence to or the deviation from the objectives of the scheme, if any, etc.
Looking at these parameters is important, but there is another perspective that needs to be looked at. Every fund house or every fund manager has a particular style of working, certain values, and certain appetite for risk. Some funds are aggressive while some are conservative.
Some funds believe in taking certain risks, whereas the others would keep away from those. While none of the approaches is wrong, it is upto the investor to decide what suits him / her the most. There is nothing like "one-size-fits-all" in investments.
How does one determine whether a portfolio manager is taking high risk or low?
Let us start with the discussion with equity funds. Investors can look at some parameters like standard deviation, beta, portfolio turnover, stock or sector concentration, exposure to illiquid / unlisted stocks, etc.
Standard deviation and beta indicate the risk associated with price volatility, which essentially indicates the uncertainty regarding the returns that the portfolio would generate in future. Both these factors need to be used to compare two or more funds. The fund with higher standard deviation or beta is riskier than other funds.
Often, the portfolio managers knowingly take certain risks in order to generate higher returns for the portfolio. Some of the approaches that the fund manager may adopt are taking higher exposure to certain companies or sectors where they have very high conviction about brighter future.
However, since short term movements of stock prices may not be strongly related to the strengths of the stocks or companies, the short-term risk could go up if the prices do not move favorably. If the concentration is high, the risk goes up even further.
On certain occasions, the portfolio manager enters and exits some stock positions at a high frequency in order to take benefit of the momentum. Such aggressive entry / exit strategy focuses on momentum rather than stock picking. Some of the fund houses publish the portfolio turnover ratio of funds in the fact sheet. Between two funds, the one with a higher turnover ratio is considered to be riskier.
In case of the debt funds, one needs to look at credit quality of securities, average maturity of the portfolio, exposure to certain kind of sectors or securities, exposure to liquid / illiquid securities, etc.
The objective of debt funds is to provide regular income with high safety of the investment. In such cases, if the fund has higher exposure to low quality securities, the investor is exposed to higher risk. The quality of the portfolio can be assessed by looking at the credit ratings of the debentures that the fund has invested in.
If a high allocation is made to securities with AA (or equivalent) or higher rating from credit rating agencies, the portfolio is considered to be safer. Average maturity (or duration of the portfolio) determines how the portfolio would react to the changes in interest rates.
Longer maturity (or duration) denotes the fund is riskier compared to one that has shorter maturity (or duration). Debt securities that are less liquid or illiquid offer better returns to the investor if held till maturity.
Liquidity of the investments is a major consideration especially if the fund in question is an open-end fund. This is applicable for both equity as well as debt funds.
Poor liquidity of the underlying instruments may present a bargain to a buyer, but when it comes to selling, the same illiquidity may turn against the holder of the stock or debenture.
Liquid funds are used by the investors to park their short-term investments, such that the money is safe at all times and available when needed. In such cases, exposure to illiquid securities, market price fluctuation, and credit risk become some of the important factors to look at.
As mentioned earlier, it is important for to remember that in all cases, the portfolio manager takes a higher risk only with an objective to enhance portfolio return. It is very important to understand this relationship between risk and return. Such an understanding allows the investor to weigh the upside and downside with the investment goal and the appetite for risk.
Information about the parameters mentioned above can be obtained through one's financial advisor.
At the same time, it is important for an investor to be aware of one's own ability to take risks. It is observed that the investors' risk preference oscillates between low risk to high risk depending on external factors like the state of the stock markets, the state of the economy, etc.
As Leon Levy puts in his book, Mind of the Markets: 'The reason why most get it wrong in stock markets is that there is a gap between the actual risk and our perception of the same. Most of the times, the risk is at the highest when it is perceived to be at the lowest and vice versa. The risk of terrorist attack was actually the least after WTC event, but the whole of US was terrified.'
Such an oscillation from high safety to high risk and back is harmful to the investors' wealth, and health.
The author works with a leading mutual fund company. The views expressed are his personal views.
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