How not to select mutual funds?

Question: How many mutual fund schemes are there in existence?

Answer: Close to 1000 mutual fund schemes including diversified equity, debt, tax saving, balanced, MIPs, sectoral, thematic, etc. etc.

Question: How many schemes do you need to invest in?

Answer: About 5 to 7, depending upon needs. So, out of 1000 mutual fund schemes, you, as an investor, have to select about 5 to 7 schemes to invest in. That means only 0.5% to 0.7% schemes of the total.

Question: How do you find these 5 – 7 schemes out of a 1000?

Answer:  (Blank look. No answer. Head starts spinning.)

Let’s put it like this – finding good mutual fund schemes relevant to your needs is like finding a needle in a haystack.

And you start to apply various filters and shortcuts to find these needles in a haystack – to select mutual funds that you should invest in.

So, you pick and choose based on the most obvious factors such as:

1. Star Ratings – Typically 4 to 5 stars
2. Past Returns – 3 to 5 year returns should be better than the rest
3. Brand – Should be a popular, well known brand
4. Friends, Colleagues, Popular media – You feel you can trust them.

Let us take on them one by one.

#1 Star Ratings

Star Ratings is an idea that we use in almost every aspect of our lives for evaluating hotels, restaurants, business services, websites, advisors, etc. Everything has a star rating.

The star ratings just make it easier for us to decide. I mean how else do you find out whether to put your money for that product/service or not. It is convenient to rely on existing user experiences, which reflect in the ratings.

Now when it comes to mutual funds, you would prefer to invest in a 4 or 5 star rated fund. You believe it to be the best. Right?

Not really. There is a big problem with star ratings of mutual funds.

First, these star ratings do not reflect user experiences like they do for hotels or e-commerce sites. They are created based on a complex methodology using past returns and risk and is developed by the rating organisation.

Second, mutual funds are not able to maintain their ratings over time. If you track the ratings over 1 or 3 or 5 years of various mutual funds, you would see that the ratings change almost every year. This is because they reflect the underlying performance and the risk parameters of the mutual fund. As the parameters change, the ratings change too. It will not be surprising to see a 5 star rated fund being down rated to 3 stars and vice versa.

If you go to any of the rating portals, like Value Research or Morning Star, you can track the ratings and see how these ratings change for the funds that you are invested in or want to invest in.

You invest in a 5 star rated fund only to find that next year it has gone to 3 star. Now, how reliable is that?

Let’s see what it does to your investment. 

When you select mutual funds and invest on the basis of star ratings, you would have to keep selling and buying mutual funds as and when the ratings change. This means you have to incur transaction costs including any taxes related to buying and selling. It also means that you need to invest time and effort to keep track of ratings changes or pay up an advisor to do the same for you.

Investing on the basis of star ratings only is definitely NOT a good idea. And one of the biggest Mutual Fund rating company, Morning Star, says that too.

#2 Past Returns 

What is the standard disclaimer you will find on any mutual fund factsheet?

“Past performance is no guarantee of future returns. Please read the offer documents carefully before investing.”

This is not just a disclaimer. It is a fact. Yet, when we set out to buy mutual funds, the first thing that we want to look at is ‘returns‘. I would argue that you should NEVER look only at returns to select mutual funds.

In my humble opinion, an investment decision purely on the basis of returns is a big mistake.

The returns of a mutual fund reflect its past. What happened in the past may not be repeated in future. The fact is that most funds FAIL to retain their positions at the top in terms of rankings based on just returns.

You cannot control returns. At best, you can control the process you use to select the right mutual funds for your needs.

#3 Brand Name

Our wanting to associate with a BRAND is not just true for mutual funds but almost anything. Ask any fresh MBA today about where she would want to work and the pet answer is “with a big brand“.

Now, money is a very sensitive subject. You would not want to hand over your hard earned money in the custody of someone you cannot trust. A popular, well-known brand is an affirmation of the existence of a trust.

A good brand name, however, is no guarantee that it is good for your money too. Let me bring forth some facts.

A lot of existing fund houses in India have been working the legacy brands of their parent organisations and riding on the trust that the parent organisations enjoy. Take for example, an HDFC, Tata, Birla, etc.

Yet, the brands have committed big mistakes.

They have launched multiple schemes to amass large funds, all in the name of marketing. They have made it choosing a mutual fund difficult for a common investor by offering so many choices; too many schemes with similar profiles thus making the life of the investor difficult.

The bottomline is – a brand is great but take it with a pinch of salt.

#4 Friends & family

A simple example would do the job here. I remember a gentleman ran a poll on a popular Facebook forum, as to which top 2 or 3 equity mutual funds do the members invest in? In the replies, you could find almost every mutual fund out there.

As the popular hindi saying goes, jitney muh, utni baatein.  You get the rest of it. 🙂

A new investor out there to select mutual funds for his or her first investments has a high probability for falling for any of the above.

What is the result? I have had real cases, where investors have used the above filters and ended up with bulky portfolios consisting of 15 to 20 mutual funds schemes. This is a disaster. You spread your money too thin (over diversification) and create a tracking nightmare.

At best these factors can be used as a starting point for creating your first list, but they definitely are not the only factors that you should rely on to invest your hard earned money.

So, what should you focus on to select mutual funds?

There are other important factors that you should take into account as an investor to select mutual funds. These include expense ratio, turnover, the investment objective and portfolio style of the fund.

We will cover these factors in detail in subsequent posts.