New Delhi: Equity is among the best asset classes to create long-term wealth. And equity mutual funds are among the best routes to invest in equity.
As per AMFI, more than Rs. 20 trillion has been invested in equity mutual funds in India. This is a testament to the belief Indians have in equity mutual funds for wealth creation.
However, most Indian investors are relatively new to equity mutual funds. Further, investing in mutual funds is super easy through digital apps and platforms – a boon for expert investors but a potential curse for amateur investors.
Hence, it is important to have a simple checklist to help you select/eliminate an equity mutual fund you are exploring. The checklist can also help you monitor your equity mutual funds and help you make exit calls.
Long and impressive track record
Most investors simply look at the last 1 year’s performance to select equity mutual funds for investment. However, this can backfire.
Different types of stocks, and hence mutual funds, can generate very different returns over shorter periods like 6 months and 1 year. So, 1 year performance tells very little about the mutual fund’s long-term performance.
It is essential to assess the performance over longer periods (more than 5 years) and see how the fund has performed.
Further, it is important not just to assess point-to-point returns. Make sure you check the rolling returns – average, minimum, and maximum.
Category ranking
If you look at the returns in isolation, you may sometimes be led to believe that the fund has done very well. Or very badly!
For example – As of Oct 2033, LIC Small Cap Fund has generated an annual return of 21.3% over the last 5 years. While 21.3% seems like a great return, LIC Small Cap Fund is the second worst performer over the last 5 years among 13 small cap mutual funds.
Similarly, in a year of a market crash, you will see many mutual funds generate very low or even negative returns. But, looking at the performance in isolation may not conclusively indicate how a fund performed with respect to its peers. Its category ranking will.
Just like performance, category ranking should be assessed on a rolling basis. It will help you evaluate if the fund has consistently performed better than its peers.
Low expense ratio
The expense ratio is what the mutual fund charges you for managing your money. Since the structure of a mutual fund is such that you don’t realise how much you are charged (in rupee terms), it is easy to forget about the expense ratio.
However, the expense ratio is deducted from your investment value. If the expense ratio is lower, your investment value can be higher and vice versa.
The expense ratio matters the most in the case of index funds. A higher expense ratio can result in returns significantly lower than the index the index fund is tracking.
However, a low expense ratio may not necessarily result in a higher return when it comes to actively managed equity funds. The expense ratio helps the mutual fund stay profitable, retain fund management talent, and operate smoothly. These factors contribute to the performance of the fund.
Some high-performing mutual funds may have an above-average expense ratio. It may make sense to invest/stay invested in such funds if the performance justifies the above-average expense ratio. However, if a below-average performer is charging above-average expense ratio, you should reconsider the fund.
Low tracking error (for index funds)
Index funds aim to mimic a benchmark index like NIFTY 50.
However, the returns the index funds generate are generally different from the benchmark index. This is because index funds charge an expense ratio, which lowers the returns. Further, underlying stocks are bought and sold at different times and prices across index funds.
The difference in return between the index fund and the index it aims to mimic is referred to as the tracking error.
You should invest in index funds that have a low tracking error. If an index fund you are invested in has a very large tracking error (compared to peers), you should reconsider the fund.
Fund manager stability
The fund manager is the most crucial person as far as the performance of your investment is concerned. The fund manager makes the decisions that directly influence the risk and return of your investment.
Suppose you invest in a top-performing equity mutual fund, but its manager changes after your investment. The fund’s performance can be significantly affected due to this change, and you may not be able to enjoy the potential good performance in the future.
Further, when assessing an equity fund’s performance, you are essentially assessing the fund manager’s investment decisions. If there have been too many fund manager changes during the period of fund assessment, it is difficult to make conclusive investment decisions based on the assessment.
Note: The above are mere guidelines, and there are many situations where one or more of them may not apply, and yet the equity mutual fund may deliver benchmark-beating returns. It is recommended that you consult a financial advisor before making important investment decisions.
Conclusion
Investing in equity mutual funds can be a very rewarding experience over the long term. However, it is essential to have solid checks and balances during mutual fund selection and regularly monitor the performance of equity mutual funds in your portfolio.
A 5-point checklist is available above but can be more personalised and comprehensive based on your risk profile and investment goals.
However, no checklist can ensure perfect investment decisions, but it can be powerful enough to help you avoid investment blunders.
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