How to choose a Mutual Fund?

And friends, this topic has come from one among you. Thank you for all your encouraging comments and remarks on our videos. We've been receiving a lot of commendable comments and requests, and this was one of the requests. And this goes out to you all. There are more than 4500 different mutual fund schemes that are available in India currently representing 40 + mutual fund companies.

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Right. It's a plethora of schemes and choices that confuse any layman. Now the question is, how do you choose a mutual fund? This is what we're going to look at today. First up, choosing a mutual fund has two components to it. One, we as investors, and the other the mutual fund offerings that are available out there.

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Internal

We as mutual fund investors need to answer 3 questions before we decide to go look for a mutual fund. First, what is the goal that we are hoping to reach by investing in this fund? Very, very important, the first question that we need to answer ourselves. If you're choosing a near-term goal, like you're going to fund something in the next year, then the type of scheme is entirely different from what you're going to do if your choice of investment is a long-term investment.

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So clearly you need to look at what your goalposts are. That will be the first thing that will determine the kind of mutual fund that you should pick up. Second one needs to look at one's risk appetite. What is my propensity to take risks? Broadly, investors can be bucketed into three categories, what is called an aggressive investor, a balanced investor, and a conservative investor.

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These are the 3 categories of investors. Very, very simply put, the rule of thumb is somebody willing to take risks to get a higher return, maybe even 20% return, but is also willing to forego 20% on this principle at any point in time. So it's okay to see a loss in this portfolio of about 20%, 25% in his journey to make profits.

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So that's the profile of the aggressive investor. On the contrary, the conservative is somebody who does not want to see even ?1 from his portfolio go down. So he's a very careful, very considerate investor. For him, the returns may be more moderate. He's not looking at a 20% return. He's just looking at returns that are slightly better than what the bank offers. That's good enough for him.

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Now, such an investor will be termed as a conservative investor and the type of investments that he will be doing will be very different from the aggressive investor. The balanced investor: somebody who comes between these two willing to take a little risk, but is also conservative to a certain extent. So it's a combination of these two.

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So extremely important. Even before you consider investing, what is your goal, what is your temperament? And then look for schemes that fulfill your temperament. The third important internal factor that we need to look at is what is the tenure of my investment, is it for my retirement 20 years down the line, am I planning my kid's education 5 years down the line, or am I doing this as an emergency fund that I can withdraw at any point in time, depending on what the tenure of the investment is?

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The nature of the scheme that you can pick up will be very different. So first up, internally, if you're able to assess your risk appetite and the tenure for which you want to stay invested, if these are captured, then you can look at the external, which is what the different types of schemes available. There are a variety of different schemes available.

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External - SPFRI

For today's episode, I am going to look at only equity schemes as a choice. And within that, I’ve created a framework that I call SPFRI. The framework will broadly give you five criteria by which you can look at mutual fund schemes and evaluate which ones work best for you. Now, although the framework starts with S, I'm going to start explaining the P.

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P

Whenever you see a mutual fund ad on the television, you always find the disclaimer to be in that says Past performance is not indicative of the future. Yes, absolutely. The past is unlikely to repeat in the future. But really when you start investing in a scheme, the first thing you will have to look at is the past performance of the peer group.

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Now any website or fintech will give you a peer group. And what do I mean by peer group? If you're analyzing large-cap funds, you want to know a bunch of five different large-cap funds that you can choose to start analyzing. Now, this can be available for today's discussion. We have chosen to go with one such website which is called Advisorkhoj.com

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Advisorkhoj.com gives a bunch of data points and that's what we've used in today's video to explain this framework. Coming back to the performance, any mutual fund scheme will give you a bunch of performance highlights. How the scheme has performed with the benchmark. The benchmark of every scheme must be defined as per SEBI and as prescribed by the Association of Mutual Funds of India.

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There are more than 67 categories of mutual funds and each of those 67 categories will have a benchmark. So, for example, a large-cap fund will have a benchmark which is Nifty50 or Sensex as a benchmark. So you can look at the past performance of the scheme based on how the scheme has performed against the Nifty 50 and you can do this over different periods.

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You can look at one-year, three or five-year, and ten-year periods, which will give you a sense of how consistently the fund manager has performed and how well he has done or how badly has done, depending on the timeline. There is also one more criterion that can be adopted is that some of the fund houses also compare their performance with the peer group.

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What do I mean by that? If there are 25 large-cap funds, then your performance of that one scheme can also be compared with the rate of the average performance of all the other 25 in the category of large-cap firms. So while one is the benchmark performance, the other is also category performance. Just to know whether you are performing above average or below average.

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So past performance is the first place to start with. So let's say you're examining large-cap funds. It's a great idea to look at the large-cap funds you are looking at and how they compare with the benchmark index as well as the category of funds that they are. Once you have gone beyond past performance, you have “F” which stands for Fees.

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F

Mutual fund companies are in it for the money. And my friends, they earn a revenue, a fee by advising you. So what is that fee? That fee is defined as the total expense ratio TER and that's defined by SEBI as a percentage of the assets that they manage. That definition of how much they can charge, I will run through in a separate chart at the end of this, but the fees will be a point that you need to look at before you go ahead with your investment options.

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Now fees for direct funds would be much lower than regular funds, primarily because they offer a direct means of investing towards that end. But friends, low fees don't need to mean great performance. You need to evaluate some of the best-performing funds which are fund managers. Managed funds also charge you reasonably good fees. The idea is as long as the fund manager is delivering great value fee is something that one needs to be willing to pay for higher performance.

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?So F stands for fee, but also one needs to look at whether you want to go direct or regular, which will look at the fee in comparison to the overall return.

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R

The third one “R” stands for risk-adjusted return. What do we mean by this? Could just about any return come out of the fact that you are a fund manager taking a set of bets on risks on that portfolio?

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Now, the funds that one needs to invest are funds that give you the best risk-adjusted return. So for every unit of risk, how much more is my fund manager able to generate a return? How does one generate a higher return when markets are going up? And how does one preserve capital when the markets are going down? Both these are examples that one needs to do before one picks up your fund for which we have something called the market cap ratio.

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You know, the market capture ratio will give you a sense of how a particular fund has done on an upmarket and how it is done on a downmarket. And the difference between that will give you a number. Now, there are various ways of looking at risk-adjusted returns as a Sharpe ratio. That is a downward probability ratio, and so on.

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But this is a simple part, a simple way we thought you could look at from that perspective of understanding how a particular scheme is performed from a risk-adjusted return. As I mentioned, there is a detailed table that we will examine on a risk-adjusted return.

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I

I stands for index. Now every fund that you invest in except index funds or ETFs is designed to try and beat the index.

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The fund managers are all in that place to see whether they can outperform the particular index. This is available with a very simple metric and it's available in the fact sheet itself. So it's great to look at this metric and see if the fund that you're investing in is performing superior to the index at various points in time.

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It's quite likely at various points in time that sometimes the index is better performing than your fund manager. But as long as in the medium and long term, you are getting an alpha which is at least a percentage or two more than the index, I think it's well worth looking at this fund. So performance over index is what we look at as I. So that's another measure. There's a table available. Please examine that table from that perspective.

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S

S which was the first letter of SPFRI, S now stands for themes which are overlapping with one another. Now what do I mean by that? Let's say you want to invest in large-cap funds and you want to invest in two large-cap funds.

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Now, it's important to understand why in a mutual fund we invest your money. Many multiple equity stock portfolios. You don't want both schemes to have identical portfolios. You want both portfolios to have a very different portfolio so that you can diversify your investment. However, the scheme overlap is an extremely important criterion for you to look at when choosing your schemes.

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There are cases where there is almost 80-90% overlap between the two schemes. Know what that does to your portfolio? It doesn't diversify your portfolio enough. So if something were to happen to the market, both your schemes would underperform or both your schemes would perform brilliantly. Now that's not what we want, right? We want schemes that have two distinct portfolios.

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Of course, there will be an overlap to a certain extent, but the overlap should not be too much. That's the idea. So you need to look at what the scheme overlaps. So like I said, once, choosing a mutual fund is a reasonably simple exercise. If you consider your internal factors of goal, your risk appetite, and the tenure for which you want to put that money away.

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?If that's sorted, then you come to the external, which is in the external fund space and you want to pick up funds based on the SPFRI. You look at the performance of the fund, the past performance, which is the only data point you have right? You don't have anything more. You look at the past performance.

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?You look at the current portfolio statements. Mutual funds have to reveal the entire portfolio, 100% portfolio of their investments. So you have 100% disclosure on your portfolio, both of which you can see. You need to look at the fee structure and find out if it's by your liking.

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?How does the performance of the fund go against the index? Are they outperforming the index consistently? Does the scheme overlap and there will be overlaps? But is that overlap significant? That's the other thing that one needs to look at. So if you've looked at all these factors, I'm sure you will be able to choose the fund that's appropriate to do.

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One of the ways to check historical performance is either to use a point-to-point return or look at rolling returns as a way. In the chart that you see now, we have used a three-year rolling return as the way basis of computation.

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Why are rolling returns superior to point-to-point? Because as compared to a point-to-point return a rolling return has more data points about average for a three-year rolling return. You will have data points from November 2018 to November 2000, December 2018 to December 2021 every three years on a month-on-month basis. Daily for three years right up to the 25th of August, which is the date on which this chart was taken, has been analyzed right through in terms of returns.

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Now, because this is the entire average of this period, this is likely to be far more superior than just taking a point to another point. So this is why we choose the rolling return as a much more refined version of checking performance. So what we have done here is look at five large-cap funds evaluated as I mentioned, that we're using from the advisorkhoj.com tool to examine this.

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And there are two aspects one can look at. One is what is called the return statistics percentage and the return distribution percentage. Both of these will give us key insights into the performance of these schemes. I just want to give a disclaimer. We have no interest in promoting one scheme against the other. This is just to understand how the tool works and how this function works. Nothing more, nothing less.

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So as you can see in this chart, the return statistic shows the average return during the last three-year rolling returns of each of these schemes. From this, it is evident that Nippon is among the highest and Canara Robeco is also 18.1. Between Canara Robeco and Nippon, you would find that the maximum minimum range is much more benign for Canara Robeco rather than the Nippon.

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The point has a wide range. The maximum is high. The returns have tended to be up and down in a much larger sense as compared to Canara Robeco, which has been up and down. Yes, but in a much more narrow sense. So what this gives us a sense is that even between funds that give you the same returns, one can find out which fund has had a more predictable journey.

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In that sense, by no means Nippon is not a good fund, Nippon is a great fund, too. However, the data tends to indicate that the band of high and low for Canara has been much narrower than for Nippon, which is what it is and the large-cap category as a whole. How is that performed? In the category return statistics that is about 14.35 during those three years, whereas most of the funds that we have chosen here have outperformed in that category.

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?So this is one side, the return statistics percentage. The other is the return distribution percentage. The return distribution talks about percentage returns in different categories, and different buckets. So how much percentage of time in the last three years has the fund delivered? 0 to 8%. 8 to 10%, 10 to 12%. 12 to 15% and 15 to 20% and greater than 20%.