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Six Litmus tests before selecting a mutual fund..
07 Jul 2023

I am sure you are all aware of the litmus paper tests used to judge whether a solution is acidic or basic and how the litmus paper turns blue or red depending on the composition of the liquid. A litmus test is a simple test but is also largely fool-proof in its observations and results. For an investor who has chosen to allocate funds to mutual funds, the question whether there is the equivalent of a litmus test for mutual funds. Before you select a fund (equity or debt), you first need to be clear that the fund in question can combine returns, risk management and flexibility in the same breath. The good news is that are 6 such litmus tests which you can apply before selecting a mutual funds. Here is an interesting litmus list for you..

1.  Consistency is the key
This is the cardinal rule when you select a mutual fund. Would you prefer a fund where the annual returns have varied from 22% to 4% or another fund that has consistently earned around 15% per annum? Obviously, you will prefer the fund that gives you consistency. While the past cannot be the deciding factor for the future, you can safely assume that a fund that has been consistent for the last 5-10 years will continue to show consistency. In case of consistent performers, you are assured of gradual wealth creation over the long term. After all, that is what you are invested in mutual funds for and not for nasty surprises on the downside! There is another perspective to consistency. It is not just about returns but also about consistency of strategy. You must be wary of a fund that has seen a huge churn in fund managers as it is normally the fund manager who decides on the long term strategy of the fund.

2.  Is your fund manager working hard enough?
This is a very important litmus test to apply before you opt for a particular mutual fund. The most elementary measure is the out performance of the fund returns over the benchmark index. But that can tell you only one side of the story. What about the risk taken? If you fund manager has outperformed the benchmark by taking on too much risk then it means your fund manager is not working hard enough. There are measures like the Sharpe Ratio and the Treynor Ratio that calculate risk-adjusted returns. You can also apply the Fama measure that explains how much returns were generated by chance, and how much by your fund manager’s skill. The bottom-line is that your fund manager must be working hard to beat the market, be it in equity or in debt.

3.  Is there an expense ratio advantage?
If you think that expense ratios do not matter in debt fund or that expense ratios do not matter in equity-funds in the long term, then you are mistaken. The truth is that the expense ratio matters a lot. In the latest AGM of Berkshire Hathaway, Warren Buffett commended John Bogle of Vanguard for creating the index fund that had saved billions of dollars for US investors in the form of lower expense ratios. Irrespective of whether you are investing in an equity fund or a debt fund, compare with peers and select the fund that offers performance with the lowest expense ratio.

4.  Size of the scheme and the AMC matter a lot..
The mutual fund return rankings may show out performance by smaller funds, but you must ideally stick to larger funds that have been around for over 15-20 years in the business. Firstly, you can be assured that they have gone through cycles in business. Secondly, larger funds with bigger AUMs are most likely to stay on in the business for the longer term. That explains why many foreign AMCs have exited their India operations as they could not attain scale in the Indian markets. Smaller funds are more vulnerable to shocks as we saw in the case of JP Morgan Fund, Dundee Mutual Fund, Alliance Fund and CRB Mutual Fund in the past. So, size does matter!

5.  Diversification is the key
Is your fund manager diversifying your risk? You are in mutual funds because you want a diversified portfolio. You do not want the fund manager to come and substitute your concentration risk with more risk. Be it equity funds or debt funds, diversification is the key. The fund needs to be diversified in terms of sectors, equity quality, debt quality, debt tenor, market capitalization etc.

6.  Does it meet my long term financial goals?
This litmus test may have been posted in the end but it should actually come in the beginning. Your choice of any fund should not be judged by the question, “Is this fund good enough”? On the contrary, it should be judged by the question, “Is this fund good enough for me”? So look at every fund from the perspective of your own goals. What is your risk appetite and what are your return requirements? What is your tax status and what are your liquidity needs? All these personalized questions will ultimately determine the selection of the mutual fund.
These six litmus tests will form the cornerstone of your mutual fund selection. Broadly, it is performance and consistency of performance that matters at the end of the day. But above all, remember the golden rule. It is not just how good the fund is that matters. It is how good the fund is for you that really matters!

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