There is no such thing as the best mutual fund scheme. We explain how we go about identifying a set of schemes which collectively enable you to build a high-growth corpus for your financial goals.
Different types of mutual fund schemes are suitable for different risk appetites and investment objectives.
We recommend that our customers first understand the categories of mutual funds that suit their needs.
Past performance alone is not reason enough to invest in a mutual fund; some other factors also need to be considered.
The right mutual funds is a necessary, but not a sufficient condition for realising financial goals.
Mutual funds are not a one-size-fits-all product. There is considerable variance in terms of the types of securities they invest in, their risk profile, expected returns, target investor type, etc. Accordingly, investors should not look for the ‘best’ mutual scheme to invest in, but rather try to identify a combination of mutual fund schemes that best allows them to build a corpus for their financial goals.
At Clarified, we follow a well laid out methodology for selecting the most suitable mutual funds for your investment portfolio. Our methodology entails a two step approach: the first step is to identify the mutual fund categories, the scheme option, and the scheme plan that are appropriate for you; the second step is to look within the shortlist created in step one and identify a set of mutual funds most likely to help you achieve your financial goals.
Step 1: Identifying the suitable types of mutual funds for you
According to Value Research, a mutual fund research site, there were a total of 1,013 open-ended mutual fund schemes in India as of March 2018. These schemes could be divided into five groups - equity, debt, hybrid, solution oriented, and others - which could be further subdivided into 36 categories. Scheme objectives and investment strategies can vary dramatically from one category to another.
Furthermore, every mutual fund scheme gives the customer the option to either reinvest the gains or opt for periodic dividends. And then there are Regular and Direct plans of mutual funds: the former are bought through mutual fund distributors and deduct a distributor commission from your corpus every year, whereas the latter are bought directly from the Asset Management Company and you don’t have to pay a distributor commission.
In step one, we dive into the process of selecting the mutual fund categories, the scheme option, and the scheme plan appropriate for your portfolio.
Scheme Category: The first thing we do while selecting mutual fund schemes for you is identify the categories of schemes that would add value to your investment portfolio. Of the five groups of mutual fund schemes - equity, debt, hybrid, solution oriented, and others - we usually select from equity and debt schemes to create goal oriented portfolios.
Among equity schemes, our preference is for Multi-cap Funds (including Value Funds); they offer the investor exposure to the broader market by allowing the fund manager to invest across sectors, and across small, midsize, and large companies. The Multi-cap Funds are usually biased towards large companies, and take limited exposure to small and midsize companies depending on the market outlook. This frees up the investor from constantly trying to gauge the market movements and adjusting the mutual fund portfolio. However, if the investor is particularly risk averse, we occasionally do recommend Large-cap Funds, since they are mandated to invest at least 80% of their corpus in the shares of large and stable companies.
While recommending debt funds, the scheme category we choose depends upon the investment horizon. For the most part, debt funds are further categorised based on the weighted average time to maturity of the cash flows from the bonds they hold in their portfolio (macaulay duration). For instance, Ultra Short Duration Funds should have a macaulay duration of 3 to 6 months and are suitable for very short term goals, but Long Duration Funds need to maintain a macaulay duration of more than 7 years and are appropriate only if your goal is more than 7 years away.
Scheme Option: While creating goal-based investment portfolios, where wealth creation is the objective, we recommend that our customers opt for the growth option of the mutual fund schemes. Unlike the dividend option which distributes the returns to the investor on a periodic basis, the growth option reinvests the returns, so they could compound and grow the investment corpus faster.
Even when income generation is the primary objective, dividend plans have limited utility. While paying dividends, mutual funds incur a Dividend Distribution Tax (DDT), which is paid from your dividend income. For equity mutual funds the DDT is 10%; less than the short-term capital gains tax of 15%, but more than the effective long-term capital gains tax of 10%, since long-term capital gains of upto ₹1,00,000 are tax exempt. Therefore, for income generation using equity mutual funds, dividend option is useful only if the alternative is to withdraw investments made less than a year ago.
For debt mutual funds the DDT is 25%, and for the most part compares unfavourably with with both short term capital gains tax (which depends on the the tax slab applicable to the investor) and long term capital gains tax of 20% with the benefit of indexation. For income generation using debt mutual funds, dividend option is useful only if the alternative is withdrawing investments made less than three years ago and your taxable income falls in the highest tax bracket. If your investments have crossed the threshold of long term capital gains (one year for equity funds and three years for debt funds) the most tax efficient way of generating a regular income is to opt for a Systematic Withdrawal Plan.
Scheme Plan: Without exception, we recommend that our customers invest in direct plans of mutual fund schemes. The commission-free direct plans charge a significantly lower expense ratio as compared to the the alternative, regular plans, which include as much as 1% point in distributor commissions. In fact, now more than ever, it has become fairly easy to invest in direct plans with Mutual Funds Utility and a host of other services offering direct plans at minimal or no cost to the investor.
Step 2: Selecting the mutual funds most likely to perform well
Once we have clarity on the type of mutual funds that are suitable for the investment portfolio, we move on to identifying the specific schemes that are most likely to consistently deliver returns, without taking more risk than appropriate. This step of the process involves looking beyond just the past performance, and considering a number of additional qualitative and quantitative inputs.
Track record of the investment team: The performance of a mutual fund derives from a combination factors that include experience and skill of the fund manager, quality of the research team supporting the fund manager, and the risk management processes at the fund house.
First and foremost, we make sure that the fund manager has a long track record of successfully managing schemes from the same asset class and category as the scheme that we are evaluating, especially during periods of market correction. We also ensure that the investment team has been stable and the fund manager has been managing the scheme in question for at least 5 years, which makes the evaluation of past scheme performance a meaningful exercise.
One of the most important factors that dissuade us from recommending a mutual fund scheme is an adverse SEBI order against the mutual fund, or any other available information regarding violation of SEBI rules. On the other hand a big plus while evaluating a mutual fund scheme is a sizeable investment made in the scheme by the fund manager(s) and the directors of the asset management company.
Charges and fees: When you invest in a mutual fund, you pay a fee, aka 'expense ratio' to the asset management company. This is the money needed to run the mutual fund. All else being equal, you should invest in mutual funds with comparatively low expense ratios; after all, lower the expense ratio, lower the hurdle mutual fund returns have to beat for the money to start flowing into your pocket.
We make sure that our recommended schemes charge a low expense ratio consistent with the scheme category. The expense ratios of the schemes we recommend are lower (usually, much lower) than 1.5% for equity funds and 0.5% for debt funds. After all, just like returns, costs also compound over time, and can have a huge impact on the long-term growth of your investment corpus.
Past performance: Truth be told, past performance of mutual funds is of limited utility as a predictor of future performance. In fact, there is little empirical evidence to suggest that the top performing mutual funds from one year would replicate their performance in the subsequent year. Nevertheless, analysed correctly, historical scheme performance can still offer some useful insights.
We look at the long-term performance of a mutual fund to understand how it has performed, on average, relative to the benchmark index and to the other schemes in the category. We also look at how much risk it has taken to generate these returns, the rate at which the scheme portfolio has churned (turnover ratio), and how well the fund manager has adhered to the stated investment style of the scheme.
We consider trailing returns of the mutual fund scheme over one, three, and five years, as well as its performance from one year to the next to ensure there is some thread of consistency in the annual returns. As an example, we’d prefer a scheme that outperforms its category by 1% every year over a scheme that outperforms its category by 10% in one year but trails it for the rest of the evaluation period.
As of June 2018, the mutual fund industry in India completed a transition to the SEBI mandated mutual fund scheme classification and nomenclature. This is a significant change that resulted in the merger of some schemes, and a fundamental change in the attributes of some other schemes. This has had an impact on how the historical performance of these mutual funds is being reported, and has made past fund performance somewhat less relevant as a fund evaluation parameter in some cases.
Assets under management (AUM): The asset size, or the AUM, of a scheme by itself offers no insight into its performance; many large mutual fund schemes have accumulated assets on the back of a strong distributor push, rather than on the merit of their performance. However, for certain types of mutual fund schemes the AUM can have a bearing on the performance.
Among equity mutual funds, a large AUM can impede the performance of schemes that invest primarily in midsize and small companies. Such companies typically have a small volume of shares trading on the exchange, and the manager of a large fund would need to simultaneously find investment opportunities across multiple midsize and small companies in order to deploy a large chunk of cash. Midsize and small companies also pose a challenge for a large fund as it exits the investments; the exit by just one large mutual fund can create an ‘impact cost’ where the large-scale selling substantially hurts the stock price, and in turn, hurts the NAV of the mutual fund. Since we, at Clarified, mostly stick to multi-cap equity schemes, a large AUM has almost no impact on our investment recommendations.
AMU tends to matter more for debt mutual funds. Most of the investments in debt funds are held by large institutions; redemption pressure from just a few big investors can force a very small debt fund to prematurely liquidate a large part of its holdings. Moreover, very small debt mutual funds may often find it difficult to negotiate good rates with debt issuers. Conversely, if a very large fund is faced with high redemptions, the market may not have sufficient liquidity to accommodate the sale of securities to meet the redemption requests without an adverse price impact. Therefore, our preference is for debt mutual fund schemes that are neither to large, nor too small.
There is more to investment success than just the right mutual funds
As we have often emphasized, there is much more to investment success than just selecting the right mutual funds. We save and invest in order to be prepared for our financial goals, and not just to exceed the returns of some benchmark index. Accordingly, as you create a mutual fund portfolio, ensure that you have sufficient health and life insurance to adequately protect your family against risks like adverse health episodes, or the death of an earning member of the household.
Finally, you must also make sure that you have a reasonable understanding of your financial capacity to take risk as well as your emotional tolerance to withstand market volatility. Investment success is built on the power of compounding, which involves resisting the urge to frequently time the market, not acting on impulse when the market is volatile, and most importantly, staying the course and giving your investments enough time to generate the returns you expect.
Published on: September 5, 2018
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