Sunday, December 05, 2004

Mutual Funds - Selecting a Mutual Fund

Mutual funds are an excellent way to grow one’s money. Not only do they diversify risk by investing in a large number of stocks, they also provide small investors like me the reassurance of having an expert fund manager.

Welcome to the Jungle

For better or for worse, there are loads of fund choices open to retail investors looking for mutual funds and sorting through the lot is quite a chore. It’s a bit like hacking through the Amazon jungles with a machete - and, just like in the jungle, it’s very easy to get lost without a map!

In an earlier post, I’ve stressed the importance of having clearly-defined financial goals when investing for the future. Your goals are like your map of the jungle and a good, clear map (as opposed to an illegible scrawl about a site marked X) is essential for investments, including those in funds.

Before I started looking for a fund, I made sure I was clear about the following:

  • The returns I was looking for (15%)
  • My investment timeframe (over 10 years)
  • My degree of comfort with short-term volatility (very comfortable, as long as overall trend is upwards)
  • My ability to make regular, monthly payments to purchase units (I settled upon a relatively small monthly amount that I would not miss normally)

Having drawn up the map, I was all set to go hunting. The only issue was the bewildering number of options open to me:

  • Debt (funds that invest mostly in debt instruments like bonds), Balanced (roughly equal mix of debt and equity) or Equity (funds that invest primarily in shares) funds.
  • Within equity, there’s a choice of index funds (funds that invest in Sensex / Nifty stocks in exactly the same proportion as the indices themselves in order to exactly mirror their movements), sectoral funds (investing in specific sectors like Pharma) or diversified equity funds (investing across companies in a variety of industries)
  • Within diversified funds one needs to choose between about 12-15 fund houses – Franklin Templeton, Reliance, HDFC, HSBC…. you name it! My choice was limited to the 7 fund houses that my online brokerage allows. The decision to go with one of them was mainly based on history and prior track record
  • Each fund house has a few diversified equity schemes as well as index funds to track the Sensex as well as Nifty
  • Within each scheme, there is a choice between dividend and growth options – the dividend option pays out regular dividends from profits whereas the growth option retains the profit and grows the investment at a compounded annual rate

Confused? Well, you should be. I know I was completely stumped till I found an excellent mutual funds site that made comparison-shopping extremely simple. You could try it out too – The site gives all kinds of filters for you to short-list funds based on your goals and it also provided detailed information about each fund in the form of an information-packed page on the past performance, sector and company exposure, entry / exit loads and much more.

Choosing An Ideal Fund

I followed the following method to choose my funds:

Step 1
Look for diversified equity funds that have returned an average of over 25% annually. You may want to note that mutual funds gains seem to be reported in simple interest terms rather than as compound interest, so a gain of 25% for the past 5 years would actually only be a CAGR of 15%, which is my target. I realized this quite late and was initially taken in by the promises of 40-50% ‘annualized’ gains that some funds claim.

Step 2
Select the funds that have the longest track records and come from well-known fund houses that you trust. I believe a track record of at least 5 years is necessary to judge a fund’s performance.

Step 3
Narrow down the list to funds that your broker / online brokerage will support

Step 4
Look for 2-3 funds with the best combination of entry and exit loads and performance. ‘Loads’ are commissions charged on your investments with entry loads being charged on purchasing mutual fund units while exit loads are charged on redemption. The better performing funds usually charge higher loads, which are liable to be increased at any time.

Step 5
Finally, make your decision based on the management fee (ranges between 0.5 to 2.5%), which is the cost of running the fund and hence gets deducted from your returns. Again, the better funds tend to have higher management fees. Since the final shortlist would have similar performing funds, it makes sense to go for the cheapest.

A Couple of Suggestions

Once you have chosen your fund, I recommend Systematic Investment Plans (SIP) as the best fund investment method and an almost foolproof method to make good money in the long term. A SIP is essentially a standing instruction to invest a fixed amount in your chosen fund on a regular basis (usually monthly). It has the following advantages:

  • It is automatic and hassle-free. I’d suggest setting it up for 6 months to a year at a time and then forgetting about it
  • It removes the need to time the market because by making purchases at regular intervals, you essentially remain invested at all times, buying more units when the market is down and fewer when the market is up. This way, you broaden your base of units in lean times, enabling greater increases during bull runs. Your average cost of units also remains low.
  • It imparts discipline to your investing, which, along with goal setting, is a key ingredient in financial success

Having said that, an SIP is most effective over long periods of time so consider one only if your investment horizon is more than 3 years and you have the discipline and wherewithal to keep at it for the entire period.

Another recommendation is to seriously consider index funds, which are effectively diversified equity funds with very low loads and management fees (due to the fact that they only need to track the index and hence the stock choices are automatic and require little management). According to Warren Buffet, investors in index funds will likely outperform over 90% of ‘active’ investors over the long term!

My Choices

Being at a relatively early stage in my life and career, my primary goal is to grow my money as fast as possible and I’m quite prepared to live with short-term volatility. Hence, the choice was between diversified and sectoral equity funds.

I invest only in diversified equity funds / index funds with the growth option. Sectoral funds are extremely volatile and move up or down depending mainly on whether that particular industry is the ‘flavour of the month’. Hence there is a strong element of market timing involved, which is something I am not comfortable with – my targeted 15% returns do not warrant this much risk and effort anyway. Over a long period of 10 years or more, it seems better to take a wider basket of stocks, which could gain from upward movements in multiple sectors.

I have SIPs in a mid-cap fund, a large-cap fund and an index fund from the same fund house. After a few months of meddling with the amounts, I have managed to settle on investing in a ratio of 1:1:2 in these funds. Second-guessing and frequent changes to SIPs are not desirable, but its probably something that a rookie investor like me will have to live with for a while till I get a degree of comfort with the performance of my funds.

Over the course of nearly a year, my investments have yielded about 20% returns, this despite the fact that I made the mistake of committing large sums in purchasing over-priced units at the fag end of a bull run. My funds had to compensate for my poor initial judgment and weather a major market crash. That they have performed well despite these hurdles is testimony to the virtues of patience, discipline and the efficacy of SIPs.

Till next time, have fun(ds)! ;-)