Buying mutual funds? Some great tips

A lot because when it comes to investments most of us tend to give a lot of weight to the winners of last year. We want the highest rated fund or best performing stock. The financial services industry along with its aggressive marketing entices people to chase performance by touting 5- star mutual funds or emerald stocks. Magazines and television channels are not far behind in getting experts to tell you how you should identify these gems. And for some people it's so easy -  just pick last years best performing funds or stocks.

Fidelity Magellan was one of the best performing funds in the US and Peter Lynch was regarded as one of the best fund managers in US history. Under Lynch's management, the fund had a stellar performance and guess what. It had billions of dollars pouring in and as its popularity grew, its performance diminished. But Mr. Lynch retired at his peak when he was doing well and got himself a coveted position of being one of the best fund managers.

Lets take the example of one of the best performing funds of 2003, which delivered around 177 per cent in a year. Any guesses. The name was Franklin India Prima Fund. In April 2003 the fund was managing approximately Rs 120 crore (Rs 1.2 billion) and was a small fund.

Slowly buoyed by the success of the fund and aggressive marketing of its returns saw the fund garner over Rs 2000 crore (Rs 20 billion) by the end of 2005. Was the fund the star performer in 2006? No it was not. The fund ended 2006 with a very dismal performance of around 23 per cent against the mid cap index return of 29 per cent.

At the same time the top funds in this category Sundaram BNP Paribas Select Midcap gave returns of 60 per cent and SBI Magnum Global of 57 per cent in the same period. The question is why did a star performer of 1-2 years falter in the next year and does this happen quite often? Let us try to examine a few reasons.

The Star Performing Scheme suddenly attracts a lot of money and is sitting on cash for sometime trying to figure out what to do with it.

Lack of opportunities in the mid cap (mad cap) space for funds collected either makes fund managers look out for large caps or buy more of the same stock.

When a core product does well, mutual fund houses often tout these returns and launch several other schemes, which tend to dilute the focus of the fund manager from the core product to several other offerings.

This fund still has a 5 star rating from one of the prominent mutual fund rating agencies of India. I am not trying to say that one should not look at this fund. Instead from a broader perspective, I would like to highlight that there are other important things that one should look out for when choosing funds for his/her portfolio.

Besides your financial goals, current situation, returns required and asset allocation, here are a couple of other filters you need to check out:

Look at the risk that a fund comes with and does that match with your risk capacity and risk tolerance
Mid cap funds were down an average 35 per cent in May 2006. Some of the Large Cap Funds were down 28 per cent. Can you take this kind of volatility? It's sexy to look at exotic numbers on the upside but when the same happens on the downside, you are either out of the stock market forever or you take a short-term equity holiday only to enter again when your friend is making money cocoon.

I have given options below in the ascending order of risk:

• Liquid Funds
• Floating rate funds, FMPs and arbitrage funds
• Monthly income plans of mutual funds
• Hybrid Funds with 30-40 per cent exposure to equity
• Balanced funds with 65 per cent exposure to equity
• Index funds /diversified equity funds
• Opportunity/thematic funds
• Sectoral Funds

Standard deviation tells us how much the return on the fund is deviating from the expected normal returns.

Beta tells us how the fund would respond to swings in the market. If the beta is more than 1, then the funds swings will be greater than the market swings and vice versa.

Sharpe Ratio tells us whether the returns of a portfolio are due to smart investment decisions or due to excess risk. This measurement is very useful because although one mutual fund can give higher returns than its peers, it is only a good investment if the higher returns do not come with too much additional risk. The greater a portfolio's Sharpe ratio, the better is its risk-adjusted performance.

Consistency of performance
How has the fund performed in rising and falling markets? The best funds are the ones that have the potential to rise fast and fall less. It is hard to identify such funds and there might be very few such funds.

Look at performance over the last 1, 3, 5 and 7 years to see how the funds have done and especially look closely at the fund's performance in falling markets.

The point that I am trying to make is there is no way to know in advance who the first or the best will be. So it's a futile exercise to identify the number 1 and anyone who has this midas touch is fooling both you and himself.

Mutual funds themselves know that selecting funds on the basis of past returns alone is a lousy concept and hence by law, they are required to give this caveat saying "Past Performance is no indicator of future performance" and yet all the funds tout returns like it's the only language, which people understand.

Well it's partly true and sad that it's the returns language that supersedes all discussions about risk and the decision is generally skewed in favor of returns.

Let's take a look at see one of last year's best performing fund - Sundaram BNP Paribas Select Midcap Fund. From a small size of Rs 140 crore (Rs 1.4 billion) in September 2004 it has significantly grown to a size of Rs 2000 crore (Rs 20 billion) now having cash levels between 20-28 per cent.

Excess cash can eat into the returns and like we mentioned above the focus of the fund manager could be diluted by the launch of several NFO's under his belt.

Well history repeats itself. We hope the crowd is right this time.