Information on anything, yes almost anything is available at our fingertips. We investors are blessed to witness this jet age of information technology. And interestingly, to add further icing to the cake, all this information is available absolutely free.
In the domain of providing financial services and advisory too, the situation is no different. There are host of website hogging to provide information.
While many of you may consider that as a valuable service, have you ever wondered whether that's helping you to add wisdom or it's just pure "information overload"?
In our opinion it is vital that you investors' recognise that wisdom stands at the pinnacle, whereas information is positioned much below (see chart above). And for you to make wise decisions what matters is wisdom.
While investing all of you have relevant questions to ask such as - Where to invest? How much to invest? What should be the investment horizon? etc.; but in order to take a wise investment decision it is vital to assess which resources you tap. This assessment is relevant because for you to take wise investment decisions, you need to tap that resource which provides wisdom rather than just pure information overload, which still keeps you hanging on what to do with your investments.
Today with several investment instruments available, the task of doing prudent investment planning is furthermore difficult, because you are surrounded with host of information around several investment instruments such as stocks, mutual funds, bank FDs, NCDs, corporate bonds, Public Provident Funds (PPF), National Savings Certificate (NSC), etc., but at the end of it you are still wondering whether you have made the right investment decision. Why? - Because there are several people who have been influencing your investment decision, right from your family members, friends, websites, mutual fund distributors, agents, brokers etc - and mind you everyone has their own view, which often adds to confusion.
In order for you to remove this anarchy caused by "information overload", what is required is capturing the pinnacle of wisdom through an investment advisor who provides independent and unbiased financial advice, keeping his vested interests (of commissions) at bay. Never mind if he charges you a separate advisory fee, as long as he can help you capture that pinnacle of wisdom which would assist you to do prudent investment planning.
We are sure that many of you investors in the past have had horrendous experiences with your investments. Let discuss of mutual funds in detail. In the year 2006 and 2007 when the equity markets were on an upswing, there were several New Fund Offers (NFOs) lined up by various mutual fund houses. Several cities were painted with attractive ad campaigns enticing you to invest. Mutual fund distributors / agents / relationship managers too tempted many of you investors to invest in equity mutual funds, giving a favourable picture. But suddenly all these schemes promoted in great gusto lost their charm during the downturn of the equity markets of 2008 and eroded wealth for you investors in a manner that you almost lost confidence of investing even in those mutual funds which have a consistent track record, and those which follow strong investment processes and systems.
Please recognise that with 4000 schemes floating around in the market the task of selecting winning mutual funds is rather complex not only for you, but even your mutual fund distributor / agent / relationship managers. And mind you the exercise of selecting winning mutual funds is much more than just assessing past performance. It is also only exhaustive research which can help you in selecting winning mutual funds -create wealth for you, and not the excitement created by some mutual fund distributors / agents / relationship managers or even the business channels.
While all the mutual fund distributors' / agents / relationship managers claim that they subscribe to research habits, you need to ensure that they consider the following research aspects, and provide independent and an unbiased advice.
- Performance:The past performance of a mutual fund scheme is important to broadly assess which mutual fund schemes should form a part of your portfolio. But mind you it is not "the most" important factor to select the right mutual fund schemes for your portfolio, because we believe that past performance is not everything, and it may or may not be sustained in the future.
While analysing past performance what's needed is assessment of "performance across market cycles" which can help you recognise how a fund has performed during times of equity market turbulence as well as a boom. Moreover, you need to consider the following points while selecting winning mutual funds:
Fund Management:The performance of fund largely depends on the fund manager and his team. Hence it is very important the fund management team has considerable experience in steering the fund in times of extreme market volatility. Also, you as investors' you should avoid funds that owe their performance to a "star fund manager". Simply because the fund manager present today, might quit tomorrow thus jeopardising your choice. Therefore, the focus should be on the fund houses that are strong in their investment systems and processes.
- Peer comparison: A fund analysed in isolation does not indicate anything. Hence, its performance must be compared to its benchmark index and peer group in order to construe its supremacy in the category. Again, one must be careful while selecting the peers for comparison. For instance, it doesn't make sense comparing the performance of a mid-cap fund to that of a large-cap.
Remember: Don't compare apples with oranges.
- Time period: The key to wealth creation is long term investing. Thus while selecting mutual funds (especially the equity oriented ones) for your portfolio; you need to judge the long-term performance. Besides, it is equally important to evaluate how a fund has performed over different market cycles (especially during the downturn). During a rally it is easy for a fund to deliver above-average returns; but the true measure of its performance is when it posts higher returns than its benchmark and peers during the downturn.
Remember: Choose a fund with consistent and robust track record across time frames.
- Returns: Returns are obviously an important parameter to evaluate a fund's performance. But wait a second; it is not the only parameter which needs to be looked upon as the deciding factor. Many investors invest in mutual funds just because the fund has delivered higher returns. But it is noteworthy that such a method of selecting mutual funds may be futile as it may erode wealth rather than create it in the long term. In addition to the returns, you need to look into the volatility, which explain how much risk the fund has taken to clock higher returns.
- Risk: The risk is normally measured by the Standard Deviation (SD) of the fund. SD signifies the degree of risk the fund has exposed its investors to. Studying this parameter helps in matching the risk profile of the fund with that of yours. For example, if two funds have delivered similar returns, then it would be prudent to invest in a fund which has taken less risk as denoted by its low SD.
- Risk-adjusted returns: This parameter is normally measured by the Sharpe Ratio (SR). It signifies how much return a fund has delivered vis-à-vis the risk taken. Higher the Sharpe Ratio better is the fund's performance. Thus, it makes sense in choosing a fund which has a higher SR over the one which has a lower SR. In fact, this ratio enables you in assessing whether the high returns of a fund are attributed to good investment decisions, or to higher risk.
- Portfolio Concentration: Funds which are skewed or concentrated towards certain sectors or stocks tend to be very risky or volatile. This is because if the stock bets or sectoral bets taken by the fund manager go wrong, it would harm the fund's overall performance. Hence, ideally while selecting mutual funds for your portfolio you should look at funds which have fairly a diversified portfolio, wherein top-10 stocks do not exceed more than 40% of its total assets. Also it is vital that you do not have a high exposure to particular fund house while selecting various types of mutual funds.
Remember: Make sure your fund does not put all its eggs in one basket .
- Portfolio Turnover: The portfolio turnover indicates how frequently stocks are bought and sold by the fund manager of a mutual fund. A fund manager who aggressively churns his portfolio in a move to deliver high returns simply engages in momentum playing rather than investing, which may off-course be risky, but may also balloon the expense ratio of the fund.
Remember: Prefer a fund with low portfolio turnover ratio as this reduces the risk for you, and also curtails the expense ratio of the fund, as the fund manager engages in Investing and not trading.
Remember: Fund houses should be process-driven and not 'star' fund-manager driven. Costs:
One also needs to assess the cost incurred by mutual fund scheme. If two funds are similar in most contexts, it might not be worth buying the one with a high cost if it is only marginally better than the other. The two main costs which are incurred during investments in mutual funds are:
- Expense Ratio: Annual expenses involved in running the mutual fund include administrative costs, management salary, overheads etc. Expense Ratio is the percentage of assets that go towards these expenses. Every time the fund manager churns his portfolio, he pays a brokerage fee, which is ultimately borne by you in the form of an Expense Ratio.
Remember: Higher churning not only leads to higher risk, but also higher cost to you investors.
- Exit load: After SEBI's ban on entry loads, you investors now have only exit loads to worry about. An exit load is charged to you investors only when you sell or switch units of a mutual fund within a particular tenure; most funds charge if the units are sold or switched out within a year from date of purchase. As exit load is a fraction of the NAV, it eats into your investment value.
Remember: Invest in a fund with a low expense ratio and stay invested in it for a longer duration.
Also apart from the above research aspects / parameters, you need to evaluate the following points while selecting a prudent, independent and unbiased mutual fund advisor:
- Attitudes/Rationalisation: Yes, the attitude and the rationalisations of the agent / distributor / relationship managers do play a very vital role, which in a way exhibits what investment products he advises. So, if he thinks of his objective of being richer, he may sell you inappropriate products not suiting your investment objectives or financial goals, and earn a handsome sum through the commissions. Hence it is important that you understand their attitude or philosophy, by having numerous meetings with them before signing a cheque for your investments.
- Advisors qualification: It is imperative to understand your mutual fund advisors qualifications. The Association of Mutual Funds in India (AMFI) makes it mandatory for individuals engaging into service of mutual fund advisory to have an advisors certification issued by the National Institute of Securities Management (NISM). But merely relying on the certification too isn't enough as one needs to delve a little deeper into the philosophy (attitude and rationalisation) and research process which he adopts while advising clients. Moreover, you need to ensure that the advisor is not an individual who peddles investments as "on the side" activity. Remember, acting on the advice offered by a mutual fund advisor who doesn't hold the requisite knowledge, could spell disaster for your mutual fund portfolio.
- Infrastructure and value add services: Apart from assessing his attitude and qualifications you also need to judge whether he has the right infrastructure set up, in order for you to receive a prudent advise on a continuous basis. Remember entering an investment is merely the starting point; your investments need to be monitored and tracked on a regular basis. Hence, as value addition your mutual fund advisor should ideally provide you various tools and calculators for online tracking of your investments. Moreover, he should persistently advise you on your portfolio in accordance to the change in markets conditions and financial goals.
- After sales support: As mentioned earlier that entering into an investment is just the starting point, you also need to judge whether prudent and reliable after sales support can be provided by your mutual fund advisor. Liquidity is often a driving factor for mutual fund for many of you investors, and hence the advisor should be able to service redemptions, transfers etc. An advisor who is easily accessible would generally make sense.
- Track record of the advice: Well, if he can offer you this you would be able to gauge quality of the advice. You can cross verify the data provided by him with some of his clients as reference check. This exercise may not only help you understand his performance track record, but also help you recognise whether does he (advisor) provide prompt and reliable after sales service, or is he merely a bluff master.
So if we recognise the facets to be looked into while selecting a prudent, independent and unbiased mutual fund advisor; you’ll understand that selecting a good mutual fund advisor is quite similar to selecting a good wife in many ways – who can stand by you through health and sickness.
This article was written exclusively for Equitymaster, India's leading Independent research initiative. Trusted by over a million members all over the world, Equitymaster is known for its well-researched, unbiased and honest opinions on the Indian Stock Market.