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A lot of mutual fund advice/research out there is focussed on how investors must evaluate mutual funds. Unfortunately, that is often not enough, which explains why wrong mutual funds are still sold/bought and mis-selling continues to be the bane of the industry. As a result, a lot of investors who end up investing in the wrong investment are left very disillusioned with how their investments have performed. All this can be prevented if investors are armed with two rules -- guidelines on how to evaluate a mutual fund and just as importantly -- guidelines on how not to evaluate a mutual fund. This note deals with the latter.
1. Don't read too much into past performance
Read any mutual fund advertisement and there is likely to be a mention of the fund's incredible performance over the years. At times the focus on past performance is so overwhelming that it leaves investors with the impression that, it is all that matters while investing in a mutual fund. In our view, past performance is important, but it is just one of half a dozen factors that must be considered while investing in a mutual fund. Among other factors that rarely find a mention in advertisements are the fund house's investment philosophy and processes, level of ethics, performance across market phases especially the downturns.
Past performance is not everything
2. Don't read too much into mutual fund ratings
In our view, mutual fund ratings get more than their share of attention from investors, which is unfortunate. This is especially true since in the Indian context mutual fund ratings are often biased towards returns with little or no room for evaluating among other factors, the fund house's investment philosophy, processes, track record on transparency, compliance and ethics. Since the ratings are so heavily dependent on returns they are unviable, as investors cannot be expected to invest or redeem their investments every time there is a change in the ratings.
Mutual fund ratings aren't everything
Investors may want to consider what Morningstar, a leading stock and mutual fund research firm based in the US which in a way pioneered the concept of mutual fund ratings, has to say about its own ratings:
"As always the Morningstar Rating is intended for use as a first step in the fund evaluation process. A high rating alone is not sufficient basis for investment decisions."
3. Don't read too much into CAGR performance
One of the many selling points for mutual funds is their performance in terms of compounded annualised growth rate. Any student of mathematics can confirm this -- CAGR is just an indicator of growth between two points (or between two dates as in the case of a mutual fund investment). It tells you nothing about what transpired in the interval
4. Don't count on the star fund manager
You will notice this point is a little different from the previous points. Unlike other factors like past performance that merit some (positive) consideration, the presence of a star fund manager merits no such consideration. On the contrary a fund house must be given negative marks for attributing its success to a star fund manager. While over the short-term a star fund manager may bring about a dramatic change in the mutual fund's performance, over the long-term he can do more harm than good.
As a mutual fund's performance gets inextricably linked with the presence of the star fund manager, his existence in the fund house becomes a prerequisite for the fund's success. If the star fund manager quits the fund house, it could leave the fund and its investors in the lurch because the existing team is unlikely to be capacitated to deliver on the same lines as the star fund manager.
So what must investors do? Go for fund houses that institutionalise the fund management process by building teams that are guided by well-defined processes where individuals have a limited role to play.
5. Don't question every investment decision made by your fund manager
While it's good to be aware of what your fund manager is up to, it is only in the fitness of things that you let him do what he is good at doing, which is identifying the best investment opportunities ahead of the competition. As an investor you must do what you are supposed to do which is getting your financial planner involved in the process of keeping a tab on your investments. The financial planner (provided he is honest and competent) should be the one to tell you whether the fund manager is investing in line with his pre-determined investment mandate and philosophy. Once you understand the roles defined for all three parties over here fund manager, financial planner and you (i.e. the investor) you will not waste your time agonising over views like whether your fund manager is doing the right thing by investing in software stocks in the backdrop of a rising rupee.
Avoid 'backseat' fund management
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