Selecting the right equity mutual fund scheme is not possible!

Published: April 4, 2016 at 8:23 am

Last Updated on

Mutual fund investing is not like investing in an insurance scheme or buying term life insurance or health insurance. You cannot choose a fund based on past performance and assume that all you need to do is to invest in it from time to time. As mentioned several times before, one should not get married to a SIP! Selecting a fund for SIP is not as important as understanding  how to review mutual Fund SIP performance.

Selecting the right equity mutual fund scheme is not possible! Simply because past performance is not an indicator of future performance – duh!

All we can do is to select a fund with a good track record (returns and downside protection is what I recommend), from a fund house you are comfortable with, and review performance from time to time.

Knowing how to review performance is far more important that choosing a fund based on past data. When you review performance, you are not reviewing the performance of the fund, but the performance of your investment, from the day you started investing.  This will make all the difference when it comes to equity mutual fund schemes.

I write this post because an amusing poll conducted by Moneylife foundation caught my eye on twitter.

Title: “Survey: Selecting the right equity
mutual fund scheme

Preamble:

Many invest in equity mutual fund schemes to generate wealth over the long term. However, there is a huge difference in the performance of the best and the worst equity schemes. This makes selecting the right mutual fund scheme crucial. Before investing in an equity scheme, you may consider multiple factors such as performance, costs, portfolio composition etc. Moneylife Foundation is conducting a short survey to understand which parameters do investors give the most weightage.

I am amused because of the claim, “However, there is a huge difference in the performance of the best and the worst equity schemes. This makes selecting the right mutual fund scheme crucial”.

It is a fact that there is a difference between the worst and best schemes – huge for short durations, and not so huge over longer periods.

Moneylife gives the reader the impression that it is crucial to select the ‘right fund’. Regardless of what their intention with the poll is, it is silly to project that kind of impression as there is no way of knowing future performance.

The difference in return between the best and worst fund can only be known in future and it is irrelevant to the investor!

In fact, this is a tactic employed by many ‘advisors’ to scare wannabe DIY investors – ‘how will you know what to select, since there are so many schemes?’

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New mutual fund investors must recognise that choosing a fund is a leap of faith. No amount of mathematcial sophistication employed in selecting a fund can make up for the fact that we are clueless about how markets will behave in future.

It is important to have a method while selecting a fund because it is important to have a method while reviewing it! The former aids the latter. I would even say, the former begets the latter.

However, while selecting a fund, many  head straight to – which fund to choose?! This is an incorrect approach.

The objective comes first – why am I investing?

Asset allocation comes second – what asset class am I going to use to diversify my portfolio and reduce risk. Read more: Deciding on asset allocation for a financial goal and Equity investing: How to define ‘long-term’ and ‘short-term’

Financial instruments in each asset class come third:  where am I going to invest – stocks, mutual funds, bonds, fixed deposits etc.

If mutual funds are preferred, what category to choose comes fourth – what kind of equity fund or debt fund am I going to choose from?

Once the above four steps are completed and only when they are completed, should we ask, ‘which fund to choose from?’ as the fifth step.

Regardless of the method used to select funds, it is important to monitor the performance periodically (for new investors, I recommend doing this after a few years only). But first, one should understand how to review fund performance. I have some example videos on this. It is crucial to evaluate the fund wrt its benchmark over the period in which you have invested.

There is no such thing as ‘selecting the right equity mutual fund scheme’ unless we get hold of a crystal ball or a Palantir (if you are a LOTR fan)!

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About the Author Pattabiraman editor freefincalM. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. since Aug 2006. Connect with him via Twitter or Linkedin Pattabiraman has co-authored two print-books, You can be rich too with goal-based investing (CNBC TV18) and Gamechanger and seven other free e-books on various topics of money management. He is a patron and co-founder of “Fee-only India” an organisation to promote unbiased, commission-free investment advice. He conducts free money management sessions for corporates and associations on the basis of money management. Previous engagements include World Bank, RBI, BHEL, Asian Paints, Cognizant, Madras Atomic Power Station, Honeywell, Tamil Nadu Investors Association. For speaking engagements write to pattu [at] freefincal [dot] com
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