MFs: Sifting through the paradox of plenty

Given the number of mutual fund schemes, choosing a suitable one is not an easy task. Often, one relies on the advice of friends or family members who have invested in mutual funds without really considering whether what is suitable for them is good for us too. While doing one’s own homework is ideal, where should one begin?

As SunTzu has famously said: “Every battle is won or lost, before it begins”. Hence, before taking the plunge, spare time to understand your needs as an investor. The key questions to ask are: “Why am I investing and what is my investment horizon?”

The amount of volatility you will be comfortable with, will depend on the answers to these two questions. No scheme is good or bad in itself but understanding your needs can help you determine whether a scheme is suitable or not.

For instance, if you are a conservative investor or your time horizon is short (say, under five years), you should steer clear of aggressively managed equity schemes, more so if they are the flavour of the season.

Also, ask yourself if you need income on a regular basis or not. Depending on that opt for the dividend paying option or the growth options of a scheme. As a general rule, it is not prudent to depend on equity schemes to earn annuity-like income.

Then, you also need to check out the fund house itself, such as their overarching philosophy, fund management team, and relevant track record. A few clues that are useful while evaluating:

Fund diversification: Choose schemes where the portfolio is not too concentrated as excessive concentration leads to greater portfolio volatility and consequently increases risk. However, at the same time also avoid schemes which are too diversified, as it may indicate lack of focus.

Risk and return: While measuring these keep the long-term in mind and ignore short-term statistics. Also, ideally, Standard Deviation of returns (measuring how much returns diverge from the average return) should be on the lower side.

For instance, if a fund’s average return is 10% and the standard deviation is 15%, it means that the fund’s return can fluctuate in either direction (up or down) by 15% from this average return.

Benchmark: A benchmark is a standard against which the performance of a fund is measured. Each scheme has its own benchmark.

For example, a mid-cap scheme may be benchmarked against the BSE Midcap index.
Portfolio characteristics: If you are conservative, you could prefer schemes with composite price-to-earnings (P/E) ratio as well as price-to-book (P/B) ratio are either at a discount to that for the broad indices or at a small premium.  Also, rather than dwelling too much on individual constituents, it is preferable to assess the portfolio as a whole.

Portfolio turnover: Conservative investors should prefer schemes which follow a buy-and-hold strategy. As a general rule, lower the turnover, the better it is. 

(The writer is the Chairman and CEO of PPFAS Mutual Fund)