7 Steps to Select Right Mutual Fund

Selecting Right Mutual Fund is like selecting Right Life Partner. Any wrong decision can wipe out your personal wealth. What makes it more difficult is volatility in performance of mutual fund. Some people select Mutual Fund only on the basis on their rankings. In my post on Misleading Mutual Fund Ranking i highlighted disadvantages of same. I would like to ask my readers, if mutual fund rankings are 100% correct then all portals or financial advisers should suggest same set of mutual funds to their clients or readers.  You will find large variation in the rankings of Mutual Funds. Second problem is volatility in performance. A star performer fund this year might be worst performing fund next year. It is advisable to review the investment portfolio every 6 months. In short, undertake the exercise of selecting right mutual fund every 6 months. Third problem with Indian investor is that they invest without evaluating the investment objective. Reason being investment objective help to decide in which mutual fund class the investor should invest. Lastly, it is absolutely necessary to understand in which direction economy will move in next 12 months. I agree and understand that it is very difficult exercise but atleast, you should have reasonable idea. For example, even if you are investing in debt funds considered to “safest” then also you have to select short term, long term, gilt or income fund. Selection will depend on how the interest rate movement is projected for next 12 months. If interest rates are projected to fall as in current scenario then it is wiser to invest in long term debt fund. Whereas during increasing interest rate scenario, short term debt funds deliver good returns.

7 Steps to Select Right Mutual Fund?

(a) Investment Objective: As i mentioned that first we need to understand investment objective i.e. why we are investing?. Investment objective might be long term, short term or linked to any event like kids marriage. Secondly, depending on investment objective the risk factor can be decided. In short, as an investor how much risk i can take with my investments. Many financial advisers suggest that Debt Funds are risk free. I beg to disagree as they can also potentially deliver near zero returns or negative returns in short term if not selected properly. This step help to decide macro level selection of mutual fund type. Assuming i decided in favour of Equity as my investment objective is long term and a portion for short term objective.

(b) Outlook for Economy: Depending on next 12 month’s outlook for the economy, you can select sub-class of mutual fund. Let me admit that no one can get it 100% right. Even so called investment gurus cannot predict correctly. Its purely judgmental power or assessment of current situation. I would like to quote example of PSU stocks. During H1 of 2014, all the investment gurus were gung-ho about PSU stocks or mutual funds with heavy exposure in PSU stocks. The reason for this euphoria was anticipation of revival / focus on PSU’s by new government. People invested left right and center in PSU Stocks or PSU oriented mutual funds. End result, after 6 months the returns were negative as Govt decided to close sick PSU’s instead of reviving them. Infact recently i read that govt has provided funds to only 9 PSU banks which are performing well. Going forward, Govt funding will be performance based which will further stress non-performing PSU’s. Therefore you should only listen to your mind in this regard. Now assuming that based on my assessment, i anticipate that Large cap and Banking stocks will do good in next 12 months. For my short term objective, i shortlisted long term funds under debt category as interest rates will drop in coming months.

After 1st two steps, i will shortlist Mutual Fund Sub-Classes in which i will be investing. It is always advisable to shortlist atleast 2-3 sub-class for investment to diversify risk.

(c) Rankings: Mutual Fund Rankings should be 3rd in order. You will observe that particular mutual fund ranked 5 star in rankings of portal X is ranked 2 star on portal Y. It is quite confusing and everyone has its own way of ranking mutual funds. Normally mutual funds are ranked on multiple factor with highest weightage to returns. The best strategy is to pick up 2 rankings which you trust the most and select mutual funds within shortlisted sub-class which are ranked 4 star or 5 star. Now check in this list which mutual funds are common between 2 rankings. This is your final shortlist on ranking front. Personally i trust Mutual Fund rankings of CRISIL and Value Research Online. Though there are variations between two but i observed that these two rankings are unbiased and are done with an objective. “It is my personal opinion”.

(d) Assets Under Management (AUM): In my opinion, Net assets of any scheme gives fair idea of confidence level of investors in the mutual fund scheme. This confidence is built over a period of time. Secondly, fund houses deploy their best fund managers for flagship mutual fund schemes with high AUM. Therefore on this parameter you may drop mutual fund schemes with below average AUM in particular mutual fund sub-class. It will help to zero-in schemes which are there in market from some time and have seen complete learning cycle to make right investment decisions.

(e) Exit Load: It is important to check Exit Load of the mutual fund scheme as you might need money before investment horizon. I made this mistake and invested in a debt scheme A without checking exit load. The exit load was 3%, within 365 days. I liquidated after 10 months. The returns from the scheme was 4.5% and 3% was deducted as exit load. Anyways i learnt from my mistake. Now i always check exit load before investment. From the shortlisted list, you may drop schemes with stringent exit load criterion which does not suit your requirement. Try to retain the schemes with minimal exit load requirement.

(f) Expense Ratio: While calculating returns from the scheme, it is advisable to check the expense ratio as expense ratio eats into returns from the scheme. Normally schemes with expense ratio of upto 1.5% are considered OK as per industry experts. Higher expense ratio may not impact good performing mutual fund schemes too much but will hit hard when fund start performing badly.

(g) Consistent Performance: For mutual fund rankings or most of the analysis, one year return of any mutual fund scheme is considered. It is critical to check consistency in performance. For that you should also check 3 year and 5 year returns of the scheme. It will help to understand whether mutual fund scheme is fad or consistent performer. You may find lot of schemes with 4 star rating with highest return on  1 year criterion but delivered poor returns in last 3 years / 5 years. Such fads should be excluded from your shortlist.

After this exercise you are left with GEMS in your portfolio. Instead of investing lump-sum, you can invest through SIP in 3-4 good mutual fund schemes. Though mutual fund is projected as safest way to invest in stock market but it is not true. All investments are subject to market risk and timings play very crucial role in your returns. No one can time the market but it is advisable to study the trend before investing. Through this post, we tried to minimize as much risk as we can by following proper selection process. Happy Investing !!!

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