10 Things to be considered while choosing the best MF

Be it equity funds, tax saving funds or debt funds; there has to be a clear methodology to choosing the best mutual funds. Here is a 10-point checklist to decide upon the best mutual fund for you.

1. Choose the fund that best fits into your long term goals

   This litmus test of mutual funds is where you start. Your choice of fund should not be based on, “Is the fund good enough”? On the contrary, it should be judged by the question, “Is this fund good enough for me”? Look at every fund from the perspective of your own goals. Look at your return requirements, risk appetite, tax status and liquidity needs. These personalised questions will ultimately determine the selection of the mutual fund.

2. Key to mutual fund selection is consistency

   Would you prefer a fund where annual returns varied from 22% to 4% or another fund that consistently earned around 15% per annum? The answer is obvious because the latter fund is more consistent and hence more predictable. While the past need not always reflect the future, you can reliably believe that a fund which has been consistent for last 5-10 years will continue to show consistency in future too.

3. Are fund management skills contributing to returns?

   The most elementary measure is outperformance of the fund returns over the benchmark index. But that tells you just one side of the story. The bigger question is if the fund manager has worked hard for the returns? Beware of fund managers who outperform the benchmark by taking on inordinate risk. Outperformance must come from skill.

4. Costs matter, so look for the expense ratio advantage

   If you think expense ratios do not matter in debt funds or that expense ratios do not matter in equity-funds in the long term, you are mistaken. John Bogle of Vanguard is known for creating the index fund that 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 lowest expense ratio.

5. Size and pedigree of the AMC matter too

   Small funds can easily outperform but the test is when you become a large fund. That is when momentum works against the fund. Despite outperformance by smaller funds, ideally stick to larger funds that have been around for over 15-20 years in the business. Firstly, you can be assured they have gone through cycles in business. Also, larger funds with bigger AUMs are likely to remain in business for the long haul. Smaller funds are more vulnerable to shocks as we saw in the case of JP Morgan Fund, Dundee Mutual Fund and Alliance.

6. All mutual fund classes need diversification

   How effectively is the fund manager diversifying risk? The purpose of investing in mutual funds is to create a diversified portfolio. You do not need a professional fund manager to come and substitute your risk. Risk has to be mitigated and that is only possible through diversification. This applies to equity funds, debt funds and even money market funds.

7. Look at fund performance in risk-adjusted terms?

   Returns must be viewed in risk adjusted terms. Total return of 15% with low volatility is better than 17% returns with high volatility. You need funds that outperform the index funds over a longer period of time otherwise you are better off staying invested in passive funds like index funds and ETFs. That is where the Sharpe and Treynor ratio come in. You can also look to further refine your analysis with Fama analysis.

8. Longevity of fund management teamis a crucial factor

   Why does longevity of management matter? It brings about consistency in investment strategy and a better sync between the dealers, traders, researchers, the CIO and the CEO. Fund managers stay on in a fund if they are happy and if the fund is performing well. Funds that perform better have stable fund management teams ensuring continuity decision making.

9. Check for the exit loads and the tax implications

   If you sell equity funds before a period of 1 year they attract STCG tax at 15% while debt funds sold before 3 years will attract STCG tax of 30% (peak rate). Similarly, equity funds LTCG gains were tax-free but from April 01^st 2018 any gains in excess of Rs.1 lakh will be taxed at a flat rate of 10% without indexation. Exit loads range from 0.5% for larger funds to 1% for smaller funds and impact return on investment.

10. Has the fund been proactive in its approach?

    Has the equity fund manager managed to move into winners early and move out of losers early? Your fund manager may not catch every trend in the market but as long as he catches the key trends it is good. In case of a debt fund, has your fund manager been able to tweak the maturity of the portfolio based on interest rate expectations.

Your mutual fund may not meet all the criteria but if majority of the criteria are met, you are absolutely good to go.