6 Tests to Conduct Before Buying Mutual Funds – Religare Broking

Topics Covered

• 1. Beware of point-to-point returns
• 2. An SIP is more indicative than a lump-sum investment
• 3. When you benchmark; test the benchmark
• 4. Always target a fund for the long term
• 5. Be conscious of the risks in a mutual fund
• 6. Stick to the tried and tested Mutual Fund AMCs

1. Beware of point-to-point returns

This is the easiest way to get carried away by a mutual fund’s performance. For example, if you take the starting point as September 2013, then the returns over the next one year for most funds would have been phenomenal. That is because September 2013 marked the bottom of the Nifty around 5200 and the bull rally began from that point. The reality is that investors hardly get the opportunity to invest in mutual funds in a lump sum at the bottom of the market. While that may be technically correct, it is practically not possible!

2. An SIP is more indicative than a lump-sum investment

From a more practical standpoint, assuming that investors would invest in lump-sum at the bottom of the market does not really make sense. An SIP would be a more practical method since investing in a rule-based manner on a regular basis is a practical scenario. An SIP tends to be more agnostic about the crests and the troughs of the market. An SIP works more on the principle of rupee cost averaging, which is what every mutual fund investor would like to do and what every retail investor finds easier to do.

3. When you benchmark; test the benchmark

The common technique of measuring a fund’s performance is versus an index. If the index returns 11% and the fund returns 14% during the same period, that is a clear outperformance. But you need to be cautious about the benchmark that you are using in this case. For example, if you are evaluating a diversified mutual fund, then comparing it with the Nifty or Sensex adds little value. But if you are evaluating a sector fund, then comparing with the Nifty or Sensex can actually be misleading.

The common technique of measuring a fund’s performance is versus an index. If the index returns 11% and the fund returns 14% during the same period, that is a clear outperformance. But you need to be cautious about the benchmark that you are using in this case. For example, if you are evaluating a diversified mutual fund, then comparing it with the Nifty or Sensex adds little value. But if you are evaluating a sector fund, then comparing with the Nifty or Sensex can actually be misleading.

4. Always target a fund for the long term

You can argue that it is hard to predict the long term scenario in volatile market conditions. But the history of mutual funds is replete with proof that the full benefits of a mutual fund investment can be realized only over a longer time frame of 4-5 years. An AMC that talks about outperformance in 6 months, 1 year, or even 2 years is not giving the exact picture. A mutual fund gets to cover a full cycle of market vagaries only over a period of 4-5 years. That is the most appropriate time frame to evaluate the performance of a mutual fund.

5. Be conscious of the risks in a mutual fund

Mutual funds are not risk-free. In fact, they are anything but risk free. Equity mutual funds may be safer than direct equities because there are professional managers to manage the risk. But equity funds are still vulnerable to the vagaries of the market. Even G-Sec funds are not risk-free even though they invest in government securities. These funds are exposed to interest rate risk i.e. bond prices will come down if interest rates go up. And funds that invest in corporate bonds run a default risk, over and above the interest rate risk. For that matter, even liquid funds can become risky in extreme market conditions when there is an overall liquidity squeeze in the system.

6. Stick to the tried and tested Mutual Fund AMCs

In the Indian mutual fund industry, we have seen many funds either getting liquidated or sold out to bigger players. Among the older names, Centurion Fund, Alliance Mutual Fund, Kothari Pioneer, Zurich, Lotus, and Fidelity were the prominent names that merged out with larger names. Similarly, AMCs like Dundee, CRB, and Sahara had to wind up due to different reasons. If you look at the AUM of mutual funds, the top 6 names are dominated by big business houses or by very large financial institutions. HDFC, ICICI Pru, Reliance, Aditya Birla, SBI, UTI are all cases in point. As a mutual fund investor, a pedigree gives you that added advantage of safety and security. Secondly, an AUM in excess of $10 billion gives the requisite scale and flexibility to operate in uncertain market conditions.

Mutual funds offer an easy and transparent way to grow your wealth. The above 6 tests will help you make a more informed decision. It could be your starting point.

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