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6 litmus tests before selecting your equity mutual fund
05 Jan 2023

Once you have finalized your goals and your financial plan, the next step is to actually identify the funds that you want to invest in. There will be a debt component and a liquidity component to your portfolio; but let us focus here purely on the equity component of your mutual fund portfolio. How to select equity mutual funds? Is there a method how to research mutual funds India? Above all, what should be the mutual fund selection process?


Of course, you will start with your screeners and then shortlist the funds you want to allocate money to. Then we have a bigger challenge. How to finally zero in on the specific funds? That is where your 6-point litmus test comes in handy.


1.  How has the fund performed vis-à-vis index and peers?

The first and basic approach is to compare returns of the fund vis-à-vis peers. There are two steps here. Firstly, ensure that the fund has outperformed an index fund, over a longer period of time; otherwise why should you pay a higher expense ratio? When you compare the performance of the fund with an index, always use the Total Return Index (TRI) as it includes the dividend effect and gives a better picture. What is the time period to consider for returns? One can argue about the length of the review but one good way is to look at 3 year rolling returns consistently for a period of 8 quarters. If the fund has underperformed in all the 8 quarters then it is best avoided.


2.  Has the fund been a consistent performer?
Total returns are one side of the story. The other aspect is consistency of returns. Let us look at the example of two funds who give the same return at the end of 3 years.

DateNAV of Fund AAnnual Returns (%)DateNAV of Fund BAnnual Returns (%)01-Jan-2015100.00
01- Jan -2015100.00
31-Dec-2015114.0014.00%31- Dec -201597.00-3.00%31- Dec -2016131.1015.00%31- Dec -2016115.5019.07%31- Dec -2017152.0716.00%31- Dec -2017152.0731.66%3-Year CAGR Returns15.00%3-Year CAGR Returns15.00%


In the above illustration, both the equity funds viz. Fund A and Fund B have given 3-year CAGR returns of 15% as their NAV is at the same level after 3 years. But there is a difference. Fund A is a lot more consistent while Fund B has been totally erratic in its performance. When selecting an equity fund, always prefer a fund which gives consistent performance as they are more predictable from the long term perspective. You never know when erratic funds may throw you into a spot.


3.  Is the fund generating return by taking higher risk?

Is your fund manager taking on higher risk to generate higher returns? A fund manager could be enhancing returns by buying lower quality stocks that are volatile. The fund manager may be adding more mid-cap and small-cap stocks in the portfolio. Alternatively, the fund manager may have given excess returns due to pure chance. How do you figure these out? There are measures like Sharpe and Treynor which gives returns per unit of risk and these are disclosed in the fund fact sheet itself. You can also measures like Fama Measures which separate the fund manager performance from chance returns. Ensure that you do not end up taking unnecessary risk in the quest for returns.


4.  Pedigree and AUM of the fund house

There are many fund houses in India which vanished without a trace. CRB Fund and Dundee Fund are cases in point. The Indian mutual fund industry is a complex business model and you need the backing of a large group and staying power to remain in the business. That is what the large funds with larger AUMs have perfected. While smaller funds may give you better returns, they remain vulnerable to a sudden run on their AUM. Always go for the more established schemes with AUM above a threshold of Rs.1000 crore.


5.  Stability of the fund management team

Why is the stability of the fund management team so important? Firstly, a stable fund management team is a sign that they see prospects in the fund and that is a good sign. Secondly, when the team of CEO, CIO and fund managers stick around for a longer time, they understand the working styles and that shows up in the performance. Lastly, a stable fund management team lends credibility and direction to the fund and that also shows up in the performance.


6.  Finally, does it gel with your long term financial plan?
This is the last and final test that you need to apply. As stated earlier, you start off with a financial plan and you have goals with specific milestones along the way. If at any time you realize that the fund is not in sync with your financial goals, then that will ultimately prevail and you need to look for a switch.

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