How ‘NOT’ to Select a Mutual Fund to Invest?

Ever since Mutual Funds were launched in India, there has been a steady increase in the number of funds. Post Covid, many such companies have emerged and as of now, around 45 AMCs are accounting for 1453 different Mutual Funds.

Though this has made investing easy for the new generation, it also leaves novice investors confused with so many options available before them.

While there are tons of information on the web on how to invest and how to choose Mutual Funds, there aren’t many which show how not to pick a fund.

In this article, we will take a deep dive into some counterintuitive pointers regarding Mutual Fund selection.

We will explore these unconventional approaches to shed light on the pitfalls to avoid, ultimately equipping you with the knowledge needed to make well-informed choices when selecting Mutual Funds.

Table of Contents:

1.)Look Beyond the Ratings

• i) Star Ratings – Not A Constant
• ii)A Star Rating is ‘NOT’ the End!

2.)Why Chasing Yesterday’s Returns is a Mistake

• i) Changing World-Changing Market – Changing Returns!
• ii) Law of Mean Reversion
• iii) Constant Switching = Uneven Compounding

3.)Consistency is the Key!
4.)Brand-Driven Investing – No

• i) Branded AMCs – Good Funds?
• ii) One Size Doesn’t Fit All

5.)Don’t Let Influencers or Friends Influence Your Investments.

• i) Impact of Influencers
• ii) Invest According To Your Personal Goals

6.)Lower NAV funds – Higher Returns?

• i) Stock NAV vs. Mutual Fund NAV
• ii) NAV – Not A Parameter
• iii) NAV is Just a Denomination
• iv) NAV is for Convenience!

7.)Thematic/Sectoral funds. Yay, or Nay?

• i) What are Thematic Funds and Sectoral Funds?
• ii) Risk > Returns
• iii) Market Cyclicity
• iv) Thematic/Sectoral Funds – Points To Remember

8.)So, How ‘NOT’ to select a Mutual Fund?

1. Look Beyond the Ratings

We rely on star ratings for almost everything in our lives, isn’t it?

Whether it’s choosing a hotel, a restaurant, a service, or a website star ratings are everywhere. They make our decisions easier, right?

We trust these ratings and accompanying reviews as they may hold significant trustworthiness and can offer genuine insights into the products or services’ actual quality and performance. This is true to a certain extent.

But the same analogy cannot be applied when we choose a Mutual Fund.

i) Star Ratings – Not A Constant

The dynamics of the Mutual Funds are fast changing. There are so many socioeconomic factors deciding the performance of these funds. So a mutual fund once rated 5 stars can go down the barrel and turn out to be a 2-star or a 3-star in no time.

Do you know how Star ratings are created?

These star ratings are created mostly based on past returns, drawdowns, alpha generated, and many more factors and the time ever since the inception of these funds. They do not represent the actual satisfaction of the investors nor does the CAGR reflect what the fund may have generated.

But what if you choose to invest based only on the star ratings?

Year 1: You choose to invest in funds of an AMC and it is doing well.

Year 2: The chosen funds outperform all the funds and turn out to be a great compounder.

Year 3: Suddenly everything takes a U-turn and the ratings are downgraded from 5 stars to 3 stars.

2 things can happen here.

A) You choose to stop investing in this Mutual Fund and continue to hold it in your portfolio.

B) You choose to dispose of this fund and exit it.

• In option A you invest your time and choose the next 5-star fund. In this process, you may end up in another fund. But this may also have a portfolio overlapping with your current fund which you stopped investing. So when you do this multiple times you’ll end up with a cluttered portfolio containing many different schemes.

• In option B you may incur LTCG and the real wealth building doesn’t take place. The beauty of Mutual Funds is the compounding effect which doesn’t happen in this case.

ii) A Star Rating is ‘NOT’ the End!

This technique also demands your time and effort to monitor these rating changes. This is okay if it is bearing fruits, but in this case, it isn’t and you tend to spend considerable effort.

In essence, while star ratings can provide a quick snapshot of a Mutual Fund’s performance, they don’t tell the whole story.

2) Why Chasing Yesterday’s Returns is a Mistake

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

You would have seen the above lines in all Mutual Fund factsheet isn’t under the disclaimer right?

Well, they aren’t disclaimers, they are fundamental truths!

Past returns are the major parameter on which an investor selects the Mutual Fund.

Why?.

They envision the same can happen to their fund when they invest. The main thing that we investors fail to understand is that the markets are always on the move and they would have moved on from what it was previously.

i) Changing World – Changing Market – Changing Returns!

The world is rapidly changing and so are the markets. There was once a time when the USA and China were considered to grow faster. But now there is a paradigm shift and all the investors are bullish on India.

When the world changes, how can a fund remain unchanged and deliver the same returns?

ii) Law of Mean Reversion

When investors like you see a fund that has been consistently delivering high returns, they tend to jump in, hoping to ride the wave of success. Unfortunately, by the time you make a move, the fund may have already reached its peak.

This means that we are entering the fund at a time when it’s more likely to experience a downturn or a period of lower performance. This is the law of mean reversion: What goes up must eventually come down.

iii) Constant Switching = Uneven Compounding

Just like we discussed in the earlier section, constant changes in the fund lead to lesser compounding and even higher taxes. So it is better to stop chasing behind for the funds generating higher returns and stay invested in your chosen fund.

Even Warren Buffett, known for his exceptional investment track record, has experienced years where his returns fell short of the market, approximately 33% of the time. Had he changed his investments he wouldn’t be as successful as he is now.

3. Consistency is the Key!

Okay, so now we are aware of how to not select the fund based on the previous returns. But what should be the ideal way to choose based on this parameter?

Consistency!

Yes. Choose a fund that is consistent and showing gradual improvement. It is better to have a fund that is growing rather than having a fund with returns like –8 %, -10 %,   +25 %, +30 %, -5 % CAGR.

4.  Brand-Driven Investing – No.

Do you love branded items? Don’t we all!

Right from our accessories to the appliances in our home, we always go for branded ones only. The reasons are trust, durability, and guaranteed performance over time.

But is it the same with investing as well?

The answer is both a Yes and a No.

i) Branded AMCs – Good Funds?

Seasoned and well-known AMC brands offer trust to investors as they have a very good history of managing the funds of people. Fund houses like HDFC, SBI, Aditya Birla, and others have proved this time and again.

But here’s the catch: A Good Brand Name doesn’t necessarily mean it’s the right choice for our money.

Not all of the fund house’s funds become superstars. Not all stars shine bright. There are some laggards.

ii) One Size Doesn’t Fit All

A big brand might have a solid reputation on one side of the spectrum but could stumble when it comes to new avenues. Just because they’re famous for something else doesn’t guarantee expertise in managing your money effectively.

While brand-driven investing has its merits, it’s not a one-size-fits-all approach. Trust in a brand is a valuable factor, but it should be just one of many considerations.

Look beyond the brand label and delve into the specifics of the funds themselves. Assess their performance, strategy, risk profile, and alignment with your financial goals.

5) Don’t Let Influencers or Friends Influence Your Investments.

This is the most common mistake amongst the novice investors. Seeking advice from Family, friends, and influencers from social media and act according to that.

i) Impact of Influencers

There was a recent discussion on Facebook where a user ran a poll to select the best Mutual Fund to invest in. To his surprise, he got nearly all of the major funds.

There is another set of people who go only by the advice of famous influencers on social media. Below are some of the reasons why we shouldn’t go only by their words

• We do not know who these influencers are as they are fairly unknown to commoners. Though their content may be promising, whatever they invest may not suit us.

• We as individual investors may be limited to a certain degree of risk, unlike the influencers who may have a higher risk appetite. They may have the capability to take on risks that may not apply to us.

ii) Invest According To Your Personal Goals

There are no concerns in checking with friends and family for your investment advice on which Mutual Fund to invest in. But the final decision to invest should be yours, after all, it’s your money that is at stake.

There is no one-size-fits-all approach to Mutual Funds, and what works well for one person may not work for another as the investment goals can be different and can be influenced by many personal factors.

In short, we cannot rely on friends and relatives or any other influencer’s investment advice as what is best suited for them may not be best suited for us. When you invest in any financial product for the matter, it is necessary to assess your needs, investment objective, risk profile, and the financial goals you are addressing and take wise action.

6) Lower NAV funds – Higher Returns?

In stock, the common methodology is to buy low and sell High. So can we apply the same to the Mutual Fund’s NAV?

Is a Mutual Fund with a NAV of 15 preferred over another fund with a NAV of 50 in the same category?

NO!

i) Stock Price vs. Mutual Fund NAV

The value or pricing structure for stocks is purely determined by market demand. A mutual fund’s worth, on the other hand, is decided by how much money is invested in it, as well as the costs of running it and the number of outstanding securities.

ii) NAV – Not A Parameter

Some investors believe that opting for a fund with a lower NAV is the ideal choice.

The consensus is that a lower NAV leaves greater potential for future growth. They associate it with the idea of buying cheap and expecting it to appreciate significantly, leading to higher returns.

What is a NAV?

“NAV is merely the per-unit market value of all the securities held by a Mutual Fund, minus its liabilities, divided by the total number of units outstanding”.

It’s essentially the price at which investors buy or sell Mutual Fund units.

iii) NAV is Just a Denomination

Your Purchase NAV is taken as the base for calculating the appreciation/return. The appreciation happens not because of low NAV or high NAV. Appreciation happens because of the underlying portfolio and the ability of the fund manager.

Which is better?

Buying 10 Nos of 1 gm Gold coin or buying 1 No of 10 gm gold coin…

The return is not based on whether you have bought 1 gm denomination or 10 gm denomination.

“The return is based on whether Gold rates are going up or down”.

iv) NAV is for Convenience!

Similarly, a Mutual Fund NAV is just a denomination through which you buy a Mutual Fund portfolio. Because you are buying a portfolio with 20 Re NAV/ denomination will not make it cheaper. Also, the 200 Re NAV -denomination is not costlier. Denomination is for our convenience and not to decide whether it is cheap or costly.

On the same lines, an NFO (New Fund Offering) despite their initial price of Rs 10, should not be automatically considered inexpensive.

So, Do we want to just decide based on the NAV?

Rather, we should check the other parameters like the fund’s composition fund’s performance history, asset allocation, and management strategy.

7) Thematic/Sectoral funds. Yay, or Nay?

i) What are Thematic Funds and Sectoral Funds?

These are the types of Mutual Funds dedicated to investing in a specific sector or theme known as Thematic Funds.

Sectoral Funds focus on companies within a particular industry, such as banking, technology, or healthcare.

ii) Risk > Returns

These funds offer very high returns but also offer a greater risk to the investors. The trade-off between risk and reward is slightly tilted towards the risk side as the chance of the fund to underperform is higher.

iii) Market Cyclicity

One of the most important factors to consider in this style of investing is to take into account the Market Cyclicity. Different themes have experienced periods of success at various times.

iv) Thematic/Sectoral Funds – Points To Remember

Sectors or themes that performed exceptionally well in recent years may not maintain their performance in the coming years, and the opposite can also hold.

• The market timing is also another important criterion and understanding this is critical to entering and exiting the market.

• A good-performing fund can underperform for a considerable period and may face extreme volatility.

• Choosing thematic funds demands diligent monitoring and thorough research.

The primary goal of investing is to grow your capital through well-performing funds while also protecting your investment.

Thematic and sectoral funds, as mentioned earlier, appear to be less suitable for the latter Investment Objective.

So, what should a Novice Investor do?

The best decision is to stay away from these funds till you gain expertise and are willing to bet your money.

So, How ‘NOT’ to select a Mutual Fund?

The idea of identifying the ‘Best’ Mutual Fund is a misconception because there are no absolute Best Mutual Funds!

This is primarily because a Mutual Fund’s current strong performance doesn’t assure it will maintain the same performance or deliver exceptional returns in the future. The same goes the other way as well. A worst-performing Mutual Fund may have a turnaround and may overperform the markets.

So, it is essential to keep a constant check on the fundamentals and not make the mistakes that we have discussed in the article.

Do not go by the words of the influencers and by the Mutual Fund-related posts on Quora, Facebook, Twitter, etc., as they may be biased and may not paint a true picture

Please refrain from following bad advice and wasting your hard-earned money. Consult a professional financial planner to avoid pitfalls in your investment journey!

Happy Investing!!