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How to Choose Best Equity Fund to Invest

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If you believe that selecting debt funds is complicated as compared to equity funds, think again! It is easy to get carried away by an equity fund's blockbuster performance relative to its peers over the last one, three or five years. But how do you check whether this performance is the result of skills and not fluke? So, here are five checks to run while selecting your equity fund.


Know the Fund mandate
All fund factsheets will dutifully tell you that the fund is designed to 'invest in equity and equity-related instruments'. But to understand the risk and return phenomena of an equity fund, you need to dig deeper. You need to find answers to three basic questions to understand the true character of the fund you are investing in.


One, what is the universe of stocks the fund plans to invest in? Some funds clearly define this in terms of an index (for example, all stocks in the BSE 200 index) or market capitalisation range (for example, all stocks falling within the market-cap range of the BSE Mid-cap index), while others can provide hints through the benchmark they use. Knowing this is essential to know how you can measure the fund's returns.


Two, what is its investment style - value, growth or a combination of the two? The style decides what kind of stocks the fund will end up owning and what kind of markets it can navigate well. Value funds outperform in the initial stages of a bull market and contain downside in bear markets. Growth funds do well in trending bull markets.


Three, what are fund's risk control measures? Will it take cash calls or hold concentrated positions? This is essential to decide how the fund will behave in unfavourable market conditions.




Assess track record 
Picking up a fund simply based on its spectacular show over the last one, three or five year(s) can be quite difficult because these returns can be highly influenced by the fund's recent performance. In a runaway bull market, funds that top the trailing-return charts are also usually the ones that are heavily invested in the momentum and over-owned stocks in the market. If the tide turns, such funds may well end up at the bottom of the rankings. Trailing returns also depend to a large extent on the start date and the end date for those calculations.


While investing in a fund for the long term, what you need to know is how consistently it will perform and whether its good show can sustain both in bull and bear markets. Looking back at the fund's calendar-year returns over its life relative to its benchmark and category is an excellent way to gauge this. This information is readily available on the fund pages on the Value Research website. Check if the fund has beaten its benchmark in all or most of the last 10 years (since inception, if the 10-year record is unavailable) and whether it has contained losses better than the index/peers in bear markets. This can also tell you a lot about the risk profile of the scheme. A scheme which tops the chart in bull markets but slips up in a bear market will not leave you better off in the long run.




Fund Market-cap mix
In India, equity funds are arranged into different categories mainly based on the market capitalisation of the stocks they invest in. But funds can stray quite a lot from their labels. A multi-cap fund that owns a 50-50 mix of large- and mid-cap stocks is a very different product from one that owns a 70-30 mix. Similarly, a micro-cap fund with leeway to invest 20 per cent in large-cap stocks is very different from a pure-play micro-cap fund. Given loosely defined fund mandates, investors should also expect considerable drift in market-cap allocations. Funds that start out as large-cap funds can gradually turn multi cap in a favourable market.


This is why, when considering any new fund for your portfolio, it is important to check out its current market-cap composition. Small and mid caps have more volatile earnings, carry governance risks and are less liquid than large caps. They compensate for these by offering higher returns. A fund with higher mid- and small-cap allocations may earn a higher return in a favourable market, but that comes with greater volatility and possibly less liquidity. The 'Snapshot' section on the fund pages on the Value Research website offers a break-up of every equity scheme's weights across giant caps, large caps, mid caps and small caps stacked up against the category and the benchmark. This can be a useful input to understand its returns.


Fund Costs and Portfolio churn 
In the Indian context, because of the huge upside in equities, expense ratios matter less in the case of equity funds than debt funds. But as poor fund performance can often go hand in hand with high costs, it is best to check out a fund's expense ratio before adding it to your portfolio.




If the fund's expense ratio can bite into its effective NAV returns, high portfolio churn can add to transaction costs and hurt investors, too. Frequent changes in a fund's portfolio are also a sign that the fund manager's calls are probably not working as they should. One good number to understand whether the fund is over-churning its portfolio is the portfolio turnover ratio


Portfolio turnover is calculated as the lower of total stock purchases or sales during a period divided by the average assets of the scheme. A high portfolio turnover (say, 100 per cent) indicates high churn and means that the fund has done purchases or sales amounting to its entire assets over the year. A low portfolio turnover (less than 50 per cent) is an indication that it follows a buy-and-hold strategy. A fund which manages good returns with a low portfolio turnover is your best bet as it shows that the fund manager's stock selection works.


Fund manager tenure 
AMCs often insist that they have a foolproof 'process' in place to make their equity funds immune to a change in its fund manager. But a fund manager's experience with handling multiple market cycles, his personal character traits (cautious or aggressive) and his areas of expertise (large-cap/mid-cap, value/growth) often have a big bearing on the fund's performance and risk profile. This makes it extremely important for you to check on an equity fund's current fund manager and his tenure with the scheme. The longer this tenure, the more confident you can be about the continuity of the fund's investment style, market-cap mix, risk characteristics and return record. If a scheme has recently seen a change in fund manager, the disclaimer that 'past performance is no indicator of future returns' applies doubly to the fund. If you've unearthed two equity funds with similar mandates, track record, market cap mix and costs, go for the one with the more seasoned fund manager. The 'Analysis' section of the fund snapshot offers ready information on both the current fund manager and his/her tenure.





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