• Liquidity
• Risk
• Fund Manager
• Cost of Fund
• Size of Fund
• Fund Portfolio

Everyone has seen the warning in mutual fund brochures – “Past performances is not indicative of future returns”. Along with returns of a mutual fund, various other factors need to be taken into consideration before investing in a mutual fund.

1. Liquidity

Investing is very subjective and people with same finances and same risk tolerances may invest very differently. Even their liquidity requirements will differ.

Mutual funds are either open-ended or close-ended.

Open-ended mutual funds are open for investors to enter and exit at any time, even after the New Fund Offering (NFO). The entry and exit of the investment is transacted directly with the mutual fund. Some schemes may have an exit load applicable if investment is redeemed before 6 or 12 months, differing from scheme to scheme. But the investment is very much liquid and can be redeemed at any time.

Close-ended mutual funds have a fixed maturity time. Investors can buy units of a close-ended scheme, from the fund, only during its NFO. Post-NFO, the scheme is listed on the stock exchange and the units can be traded on the exchange. The liquidity for such schemes is limited. If the investor is not able to find a buyer, they will receive the returns along with invested principal only upon maturity.

Thus, if an investor is seeking liquidity in their investment, they should preferably not invest in a close-ended fund.

2. Risk

Risk and return are directly proportional and an investor should balance their portfolio against the risk they are able to tolerate.

Risk can be measured in terms of Standard Deviation and Sharpe Ratio.

Standard Deviation (SD) measures the volatility the fund’s returns in relation to its own average. It tells you how much a funds returns can vary from its mean returns. For eg. If mean return of the MF scheme is 10%, and it has a standard deviation of 2%, the returns of the fund can vary from 8-12%.

Thus, higher the SD, higher is the volatility.

Standard Deviation = Square Root(Variance);

Where Variance is (Sum of squared difference between each monthly return and its mean / number of monthly return data – 1).

Sharpe Ratio measures how well the mutual fund performs vis-à-vis the risk undertaken by the fund. It is the excess return of the fund over the risk-free rate. Thus, higher the Sharpe Ratio of the mutual fund, the better the fund has performed.

Sharpe Ratio = (Total Return – Risk Free return)/ Standard Deviation of the Fund

Thus, higher the Sharpe Ratio, better would be the risk-adjusted performance of the fund. If the Sharpe Ratio was negative, a risk-less asset would be a better investment than that fund.

Sharpe ratio is used to compare funds with similar returns by analyzing the risk taken to get those returns. Higher the Sharpe ratio, the better are the risk adjusted returns.

3. Fund Manager

A fund manager is the fulcrum of the mutual fund. He picks the stocks and makes the investment decisions. The fund manager is responsible for executing the fund’s investment strategy.

A long-term fund performance record, of about 10 years, is a good indicator of the fund manager’s capabilities. It is important that the fund manager’s tenure and the fund performance match each other over a meaningful time span.

4. Cost of Fund

Low cost mutual funds usually outperform high cost mutual funds. All Asset Management Companies (AMCs), charge the investors investment management fees and other expenses as part of their operational cost. This cost is a certain percentage of the AUM of the fund. This is called the Expense Ratio.

According to SEBI guidelines, the expense ratio needs to be lower as the AUM increases.

Thus, cost of the fund is an important factor to be considered while investing in a mutual fund.

5. Size of Fund

Size of the mutual fund refers to the total assets under management (AUM)by the fund.

The size of the mutual fund increases either with the inflow of money coming into the fund or when the underlying asset value increases upon good performance of the fund.

As more and more inflows come into the fund, the manager has a significant amount of cash that needs to be deployed immediately. When the efficiency of the fund reduces and there is a drop in the returns of the fund, the size of the fund becomes harmful for the fund manager and he is no longer able to execute the investment strategy and produce the returns compared to the historical record.

6. Fund Portfolio

In addition to the fund manager’s record and investment strategy, one must be aware of the portfolio of a scheme being invested in. A detailed fund portfolio is released by the AMCs on a monthly basis. It is important to check for any red flags in the portfolio. A checklist for red flags can be the following:

• Investment in substandard companies
• Excess exposure to group companies i.e. allocating a big chunk of the portfolio across all Tata Group companies like Tata Motors, TCS, Tata Chemicals, TGBL, Indian Hotels, Voltas etc.
• Excessive Cash in the portfolio. A small percentage of every fund has cash reserves that are lying in liquid funds to allow for daily redemptions. But if there is a sizeable allocation to cash in the portfolio, it should be deployed soon otherwise it can be a red flag because it essentially means that an investor is paying fees and expenses to a fund for keeping their investment in cash.
• Invested in lower credit rated companies. The last few years have seen a high number of NPAs in the financial system in India which has forced them to go out of business. If the fund portfolio consists of NPAs, this is an immediate red flag.
• If the portfolio of a mutual fund has invested in ETFs or index funds, this can be a cause of concern because an investor is paying the mutual fund for its stock selection skills. Thus, if a fund manager of an active fund, invests in an index fund, it should be red flagged.

Conclusion

All the above characteristics of the mutual fund are necessary for the fund to deliver good returns. The performance of the fund is a combination of these factors and need to be taken into consideration during the process of selecting a mutual fund for investment. It would be advisable to consult your independent financial advisor to seek the best course of action.