Factors to consider before Investing in Mutual Funds

Factors to consider before Investing in Mutual Funds

07 Mar 2019

In the past few years, Mutual Funds have emerged as a popular investment product with virtually all ages and classes of investors. A Systematic Investment Plan (SIP) is the most preferred way of investing in mutual funds, which helps inculcate a sense of discipline and consistency in the investment process.

However, as with all other investment products available in the market, you must conduct your own due diligence before investing in mutual funds. This is needed in order to remain unperturbed with market downturns, fluctuations or volatility which is a part and parcel of mutual fund investing.

Elaborated below are a few important factors which need to be kept in mind before committing your hard-earned money into mutual funds:-

1. People – Check out the pedigree, expertise and stability of the fund management team. One of the most important aspects of investing in mutual funds is the management of the portfolio of the stocks and bonds and any other asset class. The fund is managed, either actively or passively by the fund manager. This has a huge impact on the performance of the fund and your overall portfolio over time. It will be fair to say that the role of a fund manager is pivotal in either making or breaking your investment. Your asset manager should be comfortable with managing a fund value and you should always search for an in-house investment research team.

2. Process – Understand the investment process; do not just take a leap of faith hoping that it will work. Be sure that your fund manager can define and skillfully execute an investment process. The primary process for mutual fund investments is more to facilitate the process and help you become an informed and diligent mutual fund investor. The second step is to apply more customized filters so that you are able to invest in the right fund. Ensure that the fund suits your risk appetite and risk tolerance level. The best way is to start off with a long term financial plan and then work backwards to see how much you need to allocate to each specific asset class. That is how your portfolio should be built. If there is neither rhyme nor reason when the fund does well and when it does not, it could be an indication of an idiosyncratic strategy.

3. Parent – The AMC should be a primary parameter for investing in mutual funds, alongwith the mutual funds offered by the AMC and how they are performing. Always research which mutual fund you want to invest your money in. Learn which equity / debt instruments the mutual fund invests in, who the fund manager is, how the fund has been performing, etc. The pedigree of the AMC definitely matters. The fund is able to retain talent and thereby consistency if there is a low turnover of the management team. The AMC should be able to focus on short term performance. An AMC which launches gimmicky or trendy funds is likely to be more focused on its bottom line.

4. Performance – The performance numbers must be comparable to the fund’s relevant benchmark and peers. The past performance of a mutual fund may not be a guarantee of future results but if you know how to analyze fund performance -- if you know what to look for and what to avoid -- you can make better investment decisions, which can increase the odds that future performance will meet or exceed your expectations. Do not compare a mid-cap fund to a large-cap one. Finally you should look at the investment process. A valuation-driven stock selection process is likely to be temporarily punished if the market is momentum driven.

  • a. Compare Funds to Appropriate Benchmarks - The fund's returns should be compared to an appropriate benchmark. For example, if you want to see how well your fund is performing, it's best to compare it to the average return for funds in the same category.
  • b. When Good Fund Performance is not necessarily an accurate indicator - Strong performance , under specific circumstances, can actually be anything but a positive indicator. There may be a few reasons for this: One reason is that an isolated year of unusually high returns is abnormal or at best could be an aberration, thereby implying that such high returns may not be sustainable going forward. Bear in mind that "Investing is a marathon, not a race; it should be boring, not exciting." Strong performance is not sustainable throughout. Another reason to remain cautious regarding any bout of unusually high short-term performance is that this attracts disproportionately more assets to the fund and if the same fund fails to deliver the same strong performance going ahead, this could be a major cause of disappointment for investors.
  • c. Market and Economic Cycles - Actively-managed funds require managers to take calculated risks to outperform their benchmarks. Therefore, one year of poor performance may just indicate that the manager's stock or bond selections have not had time to achieve expected results.
  • d. Periods for Mutual Fund Performance - Considering the fact that fund management styles come in and out of favor and the fact that market conditions are constantly changing, it is wise to judge a fund manager's skills, and hence a particular mutual fund's performance, by looking at time periods that span across differing economic environments. Most economic cycles (a full cycle consisting of both recessionary and growth periods) are 5 to 7 years in time duration.

5. Price – There is a famous saying - "There are no free lunches" - and this holds good for mutual funds also. Thus, the mutual fund company, which manages your money with the objective of delivering superior returns for you, will provide its services at a cost. An AMC charges you an annual fee called “Expense Ratio” for the same. A cheaper fund need not be necessarily better. Ensure that the fund is a viable proposition and this can be done by comparing the expense ratio with other funds from the same category. More than equity funds, this is all the more relevant in the case of debt funds. If the funds’ assets are small, the expense ratio can be quite high. This is because the fund has to meet its expenses from a restricted or a smaller asset base. Similarly, if the net assets of the fund are large, the expense percentage should ideally come down.

It is observed that many mutual fund investors start their investment journey with typing the `best mutual funds' in a search engine. Even if the search throws up some results, most investors don't proceed further. Apart from what we have covered in this blog, you should always choose mutual funds based on your financial goals, investment horizon and risk profile. It is extremely important for investors to keep their risk appetite and risk tolerance levels in mind while choosing a mutual fund scheme. Any mismatch could cause a lot of heartburn and disappointments later. If you do not have the appetite for the risk associated with your investments, you may find it extremely difficult to hold on to your investments during trying times.

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