Choosing a mutual fund is not an easy task with so many funds. We think that the correct first step towards deciding is to decide on a way of deciding. Rarely do investors-normal investors, who do something else for a living-have a systematic checklist of things that they should evaluate about a fund, which they are considering buying. Here's our blueprint for a structured approach to fund selection. There are four basic areas that you must evaluate in a fund to decide whether it's a good investment.
Performance: Performance comparisons must be used only to compare the same type of fund. They are meaningless otherwise. Only when used within the same category of funds do performance numbers tell you anything at all. By the time you come to the stage when you are comparing performance numbers of different funds, you should already have a good idea of how much you will invest in that category.
Risk: Almost all investing is risky, at least those investments that get you any meaningful returns. In general it is said that the riskier a fund, the more its potential for earning high returns, at least most of the time. However, this is a simplified view that implies that a given amount of risk always gets you the same returns. This is simply not true because not all funds are equally well-run.
The true measure of risk is whether a fund is able to give you the kind of returns that justify the kind of risk it is taking.
Evidently, this is not as easy to measure as returns. There are a wide variety of statistical techniques that can be used to measure this, and we distil a combination of performance and risk measurement into the Value Research Fund Rating. When we say that a fund has a five- or four-star rating, it means that the fund, compared to similar funds, performed better, given its risk level.
Portfolio: Unlike performance and risk, portfolio is one of the 'internals' of a fund. It is internal in the sense that the result of good, bad or ugly portfolios is already reflected in the first two measures and it's perfectly OK for you to choose funds on the basis of those two measures alone without actually bothering about what they own. Our basic analysis of portfolios measures whether a fund (we are talking about equity funds here) holds mostly large, medium or small companies. It also looks at whether a fund prefers companies that may be overpriced but which are growing fast or whether it prefers low-priced stocks belonging to companies that are growing at a more gentle pace. For fixed income funds, an analogous analysis tells one whether a fund prefers volatile but potentially high return long-duration securities or stable and low return short-duration securities. Also, one can analyse whether a fund prefers safer (lower returns) securities or riskier (higher returns) securities.
Management: Fund management is a fairly creative and personality-oriented activity. This may not be true of some types of funds like shorter-term fixed-income funds and, of course, index funds, but equity investment is more of an art than a science. When you are buying a fund because you like its track record (and unless you can foresee the future, that's the only way to buy a fund), what you are actually buying is a fund manager's (or sometimes a fund management team's) track record. What you need to make sure is that the fund manager who was responsible for the part of the fund's track record that you are buying into is still there. A high-performance equity fund with a new manager is a like a new fund.
Cost: While these are the four main points on which to evaluate a fund, there is one more factor that is becoming increasingly important and that is cost. Funds are not run for free and nor are they run at an identical cost. While the difference in different funds' cost is not large, these can compound to significant variations, especially for fixed income funds where the performance differential between funds is quite small to begin with. Even for equity funds, it may not be worth buying a higher cost fund that appears to be only slightly better than a lower cost one. Remember, there is no reason for one AMC to have much higher costs than others, apart from the fact that it wants to have a higher margin, or that it wants to spend more on things like marketing, which are of no relevance to you. If an AMC wants higher returns from its business, then it must justify it by giving you higher returns on your investments.
What are derivatives? Derivatives are financial instruments, which as the name suggests, derive their value from another asset — called the underlying. What are the typical underlying assets? Any asset, whose price is dynamic, probably has a derivative contract today. The most popular ones being stocks, indices, precious metals, commodities, agro products, currencies, etc. Why were they invented? In an increasingly dynamic world, prices of virtually all assets keep changing, thereby exposing participants to price risks. Hence, derivatives were invented to negate these price fluctuations. For example, a wheat farmer expects to sell his crop at the current price of Rs 10/kg and make profits of Rs 2/kg. But, by the time his crop is ready, the price of wheat may have gone down to Rs 5/kg, making him sell his crop at a loss of Rs 3/kg. In order to avoid this, he may enter into a forward contract, agreeing to sell wheat at Rs 10/ kg, right at the outset. So, even if the price of wheat falls ...
