Thursday 31 December 2009

How to Choose an Equity Mutual Fund?-VRK100-10Nov2006

 


AUTHOR: Rama Krishna Vadlamudi, MUMBAI, November 10th, 2006.

(Please see disclaimer below).

The Mutual Fund Industry has grown by manifold in the last three to four years. As per the latest available statistics, Assets Under Management of MFs in India is more than Rs 3,00,000 crore. The number of Fund Houses is about 30 and these Fund Houses have floated a number of schemes over the years. The number of fund schemes, at present, is about 700. 
 
The types of schemes range from well-diversified, debt, balanced, equity, large-cap oriented, mid-cap oriented, theme-based, index, MIP, G-Sec, sector-based ones to equity-linked savings schemes. This bewildering array of schemes often leads investors to opt for schemes which seldom meet their investment objectives. 
 
Many a time, there will be a huge disconnect between what the market sells aggressively and the kind of scheme that best serves the real interests of the investor concerned. 
  

HOW TO CHOOSE AN EQUITY MUTUAL FUND

Before investing in an equity mutual fund, it would be better if investors take a hard look at the following four parameters:

1. SUSTAINABLE PERFORMANCE: It is always safe and better to choose a fund which has a well-established track record of at least three to five year period. The comparison of over a longer period gives the investor a better perspective with regard to the ability of the fund to ride any bear phase in the stock markets. 
 
Several funds do well in certain time periods and fail miserably in other time periods.  For example, HDFC Capital Builder was doing well till 2005. But in the last six months, its performance had dropped and the fund is an underperformer of late. Its present rank, on a one-year scale, is 120 out of a total of 135 diversified equity funds (source: Mutual Fund Insight). 

     In contrast, HDFC Top 200 has given superior performance in bear phases as well as bull runs since its launch in 1996. In addition, one needs to compare the fund’s performance with the benchmark index. Every fund would have a yardstick, called benchmark index, against which it requires to be measured. 
 
BSE Sensex is the benchmark index for Tata Select Equity Fund, Templeton India Growth Fund, DSPML Opportunities Fund. Funds, like, Tata Index Fund, Sundaram Select Focus and Reliance Growth are benchmarked to S&P CNX Nifty. 

     One also needs to use the  performance comparison with funds of similar objective. For example, Birla Sun Life Equity fund is a large-cap oriented one and the major portion of total assets is in large-cap stocks. 
 
The fund’s performance is to be compared with other funds, that have large-cap orientation, like, Tata Pure Equity, Principal Growth, etc. Likewise, Birla Mid-cap, a Mid-cap oriented fund is required to be evaluated in relation to other Mid-cap funds, like, Franklin India Prima, Magnum Global, etc

2. SUITABILITY: Almost all investments have a certain degree of risk attached to them. Risk appetite differs from person to person. In general, the degree of return is in consonance with the amount of risk taken, provided the investment is well managed by the investment manager.
 
Some funds take higher risk than other funds. That is why it is important to know whether the fund is sticking to its objectives. 

    Investors need to be aware of their investment objectives before they select a particular type of scheme. For example, Sundram Rural India Fund invests in companies that are focusing on Rural India. HDFC Top 200 states its objective as generating capital appreciation from stocks in BSE 200 Index. 
 
Let us suppose, an investor who has a low risk appetite and who wants good long term returns, should avoid investing in mid-cap funds, like Sundaram Select Midcap or Birla Midcap, who predominantly invest in mid-cap stocks and churn their portfolios in an aggressive manner. Mid-cap stocks are considered more volatile than large-cap stocks. 

    In bull markets, mid-cap stocks outperform large-cap stocks, however, in bear markets, mid-cap stocks fall much more heavily than large-cap stocks. If one looks into the portfolio of the fund, one can have a better idea of stocks and sectors that the fund is invested in. The portfolio of stocks can be compared over different time periods.

3. FUND MANAGER’s TRACK RECORD: Equity Fund Managers, like, Prashant Jain, K N Siva Subramanian, Sukumar Rajah, Anoop Bhaskar, Sandip Sabharwal, etc., have rewarded investors with excellent returns through funds managed by them.
 
 It is the ability of the fund manager to foresee the trends much earlier than others that sets them apart in the crowd. Fund management requires real talent, creativity and sharp focus with a keen eye on market dynamics. 
 
Dhirendra Kumar, CEO, Value Research, says, “The continuity of fund managers is important. It is not a coincidence that in some of the great performing funds in the country over the past ten years, the common element is continuity of fund manager.” 

    Prashant Jain (HDFC Mutual Fund) looks for sustainability. His biggest success thus far has been his call on technology in 1999. Jain sensed the fall six months in advance and sold off tech stocks from his portfolio. Sanjay Dongre (UTI Mutual Fund) picks stocks which exhibit high growth visibility. He has consciously avoided metal stocks. 
 
K N Siva Subramanian (Franklin Templeton) looks for companies with quality management. He follows a blend of growth and value style of investing and holds to his stocks for long term. He says, “If the management and business are good, one can hold on to a stock even if the stock valuations run ahead of fundamentals for a while.” 

Contrastingly, Anoop Bhaskar (Sundaram Mutual Fund) makes money by selling stocks when they have reached their peak rather than holding on to them for long. He opines, “There is nothing called long-term investing. We identify stocks with a questionable management and low institutions holding. It may be futile to attach too much importance to corporate governance.”

4. DIVERSIFICATION: Mutual funds are supposed to have a well diversified portfolios. But, sometimes, it so happens, that the funds are heavily concentrated in a particular sector or a stock, exposing the investors to higher risk. 
 
Kotak MNC fund is having an exposure of 28 per cent (of total assets) in Basic/Engineering sector. Any adverse and swift market reaction to Engineering companies is likely to expose the fund to a steep fall in NAV. Taurus Starshare Fund holds 25 per cent in Jai Prakash Associates. This excessive concentration may jeopardize the interests of investors, when they look for a well diversified fund. 

      Another problem with some funds is client concentration. It is highly likely that only a few clients are available with funds having insignificant corpus. If a client with a higher share of the fund exits, the performance of the fund may suffer adversely. 
 
However, SEBI had, a few years back, taken certain measures to avoid such client concentration. Investors need to have a close watch on any large erosion in assets under management (AUM) of the fund. The history of mutual fund industry reveals that there are many instances of funds losing up to 70-90 per cent of their total assets. 
 
In such circumstances, investors who stay on in the fund lose heavily. Over diversification is also a problem with certain funds, like, Fidelity Equity Fund which holds more than 120 stocks in its portfolio.
 
   In addition to the above mentioned parameters, it is advisable to use certain statistical measures also. 

(i). Beta: Beta is a statistical tool, which gives one an idea of how a fund will move in relation to the market. Beta represents fluctuations in the NAV of the fund in relation to market returns. A fund with a greater value of one is more volatile than the benchmark.  
 
If a fund’s beta is one, it indicates that the fund is closely following the benchmark. A low-beta fund will rise les than the market on the way up and lose less on the way down. Similarly, a high-beta fund will rise more than the market and also fall more than the market. 

(ii). Sharpe Ratio: This ratio measures the amount of excess return for each unit of risk taken by the fund. Risk in this case is taken to be the fund’s standard deviation. Excess return is measured as the difference in return generated by the fund and the return generated by the risk free rate of interest. 
 
A negative excess return indicates that the fund is generating less return than the risk free rate. A Sharpe ratio is always used as a measure of comparison between similar funds.
   

MUTUAL FUND MYTHS


There are a lot of misconceptions about mutual funds. Investors need to stay clear of these myths. These mistaken beliefs often lead investors to choose funds that do not match their intended goals. Some of the common myths are discussed below:


One of the most popular myths is: A fund with an NAV of Rs 10 is cheaper than an existing fund with an NAV (net asset value) of Rs 50. The reality is completely opposite. The structure of a mutual fund is such that an MF does not have any intrinsic value; instead, the value of an MF is derived from the value of investments that a fund holds.

On an identical investment outlay, we would get more units when a mutual fund offering is priced at Rs 10 than when it is available in the market at Rs 50. But the number of units we get, which is a function of a scheme’s NAV, is not an indicator of how cheap a scheme is. 

Cheap is a function of the returns, which can be assessed only in hindsight, never at the time of investing. A scheme’s NAV is the market value of its portfolio at a given point of time–and its performance is what determines the returns. Say, fund A (a new scheme, with an NAV of Rs 10) and fund B (an old scheme, with an NAV of Rs 50) have invested only in scrip X, which is currently quoting at Rs 150. 

If the scrip appreciates 20 per cent to Rs 180, the NAV of the two schemes too would appreciate by 20 per cent, to Rs 12 and Rs 60, respectively. In both cases, the gain, too, would be 20 per cent. 


    So, as investment options, both funds are the same. However, since no two funds have the same portfolio, the returns given by them tend to differ. Theoretically, the share price of a stock can peak, but the NAV of a scheme cannot. That’s because the fund manager can sell the stock if he feels it has peaked, and buy another stock that offers appreciation potential. 
 
Thus, the key to the returns is not the number of units we get when we invest in a scheme, but the stocks the fund chooses to invest in. A higher NAV implies accumulated appreciation, which can be used to pay dividends to unit holders. 
 
So from whichever way we see it, the NAV makes no difference to returns. It is irrelevant how high or low the NAV of a fund is. Mutual Fund schemes have to be judged on their performance. The best way to do this is to compare returns over similar periods. 

    Let us examine the record of a few New Fund Offers (NFOs) against the old/existing funds. ABN Amro Future Leaders Fund was launched in April 2006 and its NAV, as on 9.11.06, is still well below Rs 10, that is, Rs 9.829. 
 
UTI Contra was launched in March 2006 and its NAV, as on 9.11.06, is Rs 9.68. It is quite possible that these funds may do well going forward, provided the fund manager manages the scheme in an improved manner. 
 
Let us examine the returns from some hypothetical investments made in the months of April and May 2006: As can be seen from the table given below, two old funds HDFC Top 200 & Tata Infrastructure Fund have given an annual yield of 34.68% and 33.87% respectively; whereas, the NFOs, Sundaram Rural India and Templeton India Equity Income have posted an annual yield of 25.44% and 21.47% respectively.




Another misconception is that a good fund manager will beat the market year after year. Mutual Fund performance is prone to market risk. The fund manager’s performance depends on the market fluctuations. If the fund manager is creative and talented, he/she will be able to select the right stocks and give good returns to investors. 
 
However, if the stock selection is wrong, the scheme will underperform the market. Indian Mutual Fund industry is awash with such underperforming funds. Some fund managers churn their portfolios excessively. 
 
This excessive churn may result in under performance of the fund, because, mutual funds involve some costs, like, brokerage, STT and operational costs. Besides, investors have to bear other expenses, like, entry load, exit load, recurring expenses and initial issue expenses. 

Six months ago, SEBI disallowed open-ended mutual funds from charging and amortizing the initial expenses. Rather, funds will have to meet the issue expenses from the load itself. Now, if we want to exit from an NFO, the funds are charging exit loads to the extent of about three per cent, which is very high in the short-term.  
 
Moreover, many fund houses are introducing exit loads even for investments of Rs 5 crore and above for several of their schemes. For example, Franking Templeton is introducing exit load for several of its schemes. Such exit loads help in deterring the funds and investors from excessively churning their investments.

One more popular belief, propagated in the halcyon days of US-64, was that the capital of and return from mutual fund are protected and assured respectively. 
 
After the debacle of US-64, it dawned on the unit holders that there is no guarantee of capital and returns in mutual funds. Mutual funds carry various risks, like, market risk, liquidity risk, excess diversification/over diversification risk, etc. For instance, unlike bank deposits, our investment in a mutual fund can fall in value.  
 
There are strict norms (by SEBI) for any fund that assures returns and mutual fund can not issue any guarantee for returns or capital. This is because most closed-end funds that assured returns in the early-nineties failed to stick to their assurances made at the time of launch, resulting in losses to the unit holders.

  
WHEN TO SELL AN EQUITY MUTUAL FUND

In equity investment, the decision to sell is more important and crirtical than a buy decision. The same can be applied to equity mutual funds. Before selling, it would be better if we take a considered view of individual stocks in the MF. 
 
All mutual funds are subjected to a little underperformance in certain periods. But such underperformance, if it is not very severe, is only natural. A close scrutiny of the performance, for the past six to seven years, of mutual funds suggests that some fund may show average performance for certain quarters, but they will bounce back and give good to excellent performance after the lean period. 
 
Several studies the world over indicate that buy-and-hold strategy is the easiest  and most effective strategy on a historical basis. 

    What buy-and-hold really means is staying the course through short-term dips. However, when individual funds fail to measure up to market or peer performance from time to time, one should consider selling. 
 
If investors weed out the such under performing funds on a constant basis, they will be awarded with much better returns on their overall portfolio. Some funds remain at the lowest rung for several quarters, such funds are to be discarded immediately. 
 
Evaluating fund performance on a regular basis is the first step for arriving at the critical sell-decisions. When evaluating performance, it is necessary to make sure that one compares a fund with the most appropriate peer group.

WELL-KNOWN DIVERSIFIED EQUITY FUNDS


There is a need to build a good Mutual Fund portfolio, subject to prudential norms, for future/long-term. Some investors are comfortable with short-term and some are happy with long-term investments. 
 
It is perilous to judge funds purely on short-term returns basis that they have generated in the kind of bull-run that is currently going on. Serious investors generally avoid sectoral funds. Usually, well diversified funds form the core of investors’ portfolio. Based on the comfort level, we can build a good portfolio in measured steps and monitor the portfolio performance on a regular basis. 
 
The following are some of the well diversified funds that have weathered several bear periods as well as bull phases:

1. HDFC Equity Fund: Steady returns for the long term investor. HDFC Equity Fund has got a large-cap tilt. It finds a place in the core portfolio of many smart investors. For more than a decade, the fund has weathered different phases in the market with aplomb and delivered attractive value to long term investors. 
 
The consistency in performance across quarters is a comfortable factor. Investors are also comfortable about its ability to sail through any sluggish market phase. HDFC Equity has not only outpaced the indices, but also a host of peer funds. The fund has got a well diversified portfolio. 
 
The fund is appropriate/suitable for investors looking for a long term option with a large cap tilt. The fund was launched in January 1995. In the last five years, it has given a CAGR of 55.20 per cent.  The fund manager is Prashant Jain. 

2. Franklin India Bluechip Fund: A trustworthy fund with a good fund manager. It is an open-ended diversified (large-cap oriented) fund launched in 1993. It aims to provide medium to long term capital appreciation. 
 
The fund has got a good track record. Total Assets under management are Rs 2,420 crore. The fund takes concentrated exposures to large-cap stocks. It is one of the most trustworthy funds. After lagging behind its peers in 2005, the fund has clawed its way back. 
 
The fund has sustained good performance during bull phases as well as bear markets. The fund’s hallmark is its consistency. Mr. K N Siva Subramanian is fund manager since the inception of the scheme. Its benchmark index is Sensex.  In the last five years, it has given a CAGR of 49.7 per cent. 

3. Tata Pure Equity fund: It is an open-ended diversified (large-cap oriented) fund launched in 1998. It aims to provide income distribution and/or medium long term capital gains while at all times emphasizing the importance of capital appreciation. The fund has got a good track record. Total Assets under management are Rs 307 crore as on 31.03.06. 
 
The fund has sustained good performance during bull phases as well as bear markets. Slowly but steadily, the fund is emerging as one of the better options for equity fund investors. Its investment canvas is wide as it can invest both in large as well as mid-cap stocks. 
 
This fund is in the habit of going against the crowd if it is convinced about an investment idea. Mr. M.Venugopal is fund manager of the scheme. Its benchmark index is Sensex.  In the last five years, it has given a CAGR of 47.2 per cent.

4. Reliance Vision Fund: It is an open-ended diversified fund launched in 1995. Its Top five holdings are Siemens, Grasim Industries, Divis’ Labs, Reliance Communications and Indian Hotels. The fund manager is Ashwani Kumar. Its total assets (AUM) are Rs 1,960 crore. 
 
By shuffling its portfolio between large and mid cap, this fund has earned handsome returns for its investors. Astute stock picking is the hallmark of this fund. It does not hesitate to try untested stocks. In the last five years, it has given a CAGR of 66.5 per cent.

5. HSBC Equity: It is an open-ended diversified fund launched in December 2002. The fund managers are Mihir Vora and Jitendra Sriram. 
 
The top five holdings are Infosys, Reliance Industries, Satyam Computer, ONGC and BHEL. It has got an excellent blend of large and mid cap stocks. It follows a top-down approach and takes sectoral calls. Within the sector, it carefully picks stocks with strong fundamentals. 
 
It has been able to negotiate the first market decline of its life quite well. The total assets are Rs 1,028 crore. In the last three years, it has given a CAGR of 51.3 per cent. 

6. DSPML Equity: It is an open-ended diversified fund launched in April 1997. 
 
The fund manager is Apoorva Shah. The total assets are Rs 635 crore. Its top five holdings are: Larsen and Toubro, Reliance Industries, Grasim Industries, SBI and Hindustan Lever. 
 
The top three sectors are Technology, Diversified and Consumer ND. In the last five years, it has given a CAGR of 48.9 per cent.

7. Franklin India Prima Plus: It is an open-ended fund launched in September 1994. Its total assets are Rs 705 crore. Its top five holdings are Grasim Industries, Infosys, MICO, Larsen and Toubro and Bharti Airtel. 
 
The top three sectors are Diversified, Financial Services and Technology. The fund has got no capitalization bias, meaning it moves from large cap stocks to mid cap stocks and vice versa, depending on the market conditions. 
 
It has got a fine blend of large cap and mid cap stocks. The fund managers, Sukumar Rajah and Satish Ramanathan are well experienced. In the last five years, it has given a CAGR of 49.2 per cent.

8. Birla Sun Life Equity: It is an open-ended fund launched in August 1998. Its assets under management are Rs 406 crore. Its top five holdings are Infosys, Crompton Greaves, Siemens, SBI and BHEL. 
 
Its top three sectors are Financial Services, Basic/Engineering and Technology. It is one of the better funds in this category, its investments span across large and mid-cap stocks. 
 
With stock bets ahead of the others, it has done quite well. After being acquired by Birla Sun Life in late 2005, the fund has stayed the course. In the last five years, it has given a CAGR of 53.4 per cent. 


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Sources: web sites, newspapers, magazines, etc.


Disclaimer: The author is an equity analyst with a bank. He has a vested interest in the financial markets and it is safe to assume he may have investments in the above mentioned stocks/mutual fund plans. This article is for information purposes only. This should not be construed as investment advice. Readers are advised to consult their own financial adviser before making any investments. All investments are subject to market risk. These views are personal and does not reflect on the organisation he is working for.

Note: The article was originally written on 10th of November, 2006; but got uploaded on this blog only on 12th of December, 2009.

Disclosure:  I've vested interested in Indian stocks and other investments. It's safe to assume I've interest in the financial instruments / products discussed, if any.


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