Advanced Selection Strategies for Mutual Fund Schemes: NISM Series VA (Part 2)
This second part of the guide into Mutual Fund Scheme Selection focuses on identifying specific fund characteristics, evaluating internal management factors, and understanding the practical "Do's and Don'ts" for building a resilient portfolio based on the provided material.
1. Selecting Schemes Based on Investment Strategy
Beyond asset allocation, the specific strategy employed by a fund manager significantly impacts the risk-return profile of an investment.
Active vs. Passive Management
- Passive Funds: These are ideal for investors who want broad market exposure without the "manager risk" associated with stock picking. Index Funds are the primary example; they aim to mimic a specific market index in both security selection and weightage.
- Active Funds: Investors choose active funds when they seek returns higher than the benchmark (Alpha). This comes with a higher cost (Total Expense Ratio) and the risk that the fund manager’s strategy may underperform the market.
Structural Considerations: Open-ended vs. Close-ended
- Open-ended Funds: These offer the most significant benefit of liquidity, allowing investors to redeem units at the current NAV directly from the fund house.
- Close-ended Funds: These provide liquidity through listing on a stock exchange. However, they are often not actively traded, meaning an investor needs a counterparty on the exchange to exit their position.
2. Sectoral and Thematic Selection
The level of concentration in a portfolio determines its sensitivity to specific economic events.
- Diversified Funds: These invest across multiple sectors, making them less risky because poor performance in one industry can be offset by another.
- Sector and Thematic Funds: These are considered high-risk due to their concentration in a single industry or theme. If that specific sector underperforms, the scheme’s overall returns are likely to be poor.
3. Equity Style Selection: Growth vs. Value
Equity fund managers typically follow one of two major philosophies, or a blend of both:
- Growth Strategy: Focuses on identifying companies expected to grow at rates higher than the average economic growth rate.
- Value Strategy: Involves picking stocks that are "cheap" or priced lower relative to their intrinsic value. The goal is to wait for the market to eventually unlock and recognize that value.
4. Considerations for International Equity Funds
When an Indian investor selects an international fund, they are essentially taking two distinct exposures:
- Market Exposure: Performance of the specific international equity market (e.g., the US market).
- Currency Exposure: The exchange rate of the Rupee against the foreign currency (e.g., the US Dollar).
Key Insight: If the Rupee strengthens against the Dollar, the portfolio's returns in Rupee terms will be lower, even if the international stocks performed well.
5. How to Select a Fund Within a Category
Once a category (like "Large Cap" or "Liquid Fund") is chosen, investors must evaluate specific schemes using these eight metrics:
- Portfolio Matching: Ensure the portfolio actually aligns with the stated investment objective.
- Fund Manager: Evaluate the experience and track record of the person managing the money.
- Fund Performance: Look at historical returns, but prioritize consistency over short-term spikes.
- Fund Portfolio: Review the underlying holdings for quality and diversification.
- Fund Age: Older funds often have more data to prove their performance across different market cycles.
- Fund Size (AUM): Extreme sizes (too small or too large) can sometimes impact a manager's ability to execute a strategy.
- Portfolio Turnover: Indicates how frequently the manager buys and sells stocks; high turnover can lead to higher transaction costs.
- Scheme Expenses: Lower expenses (TER) generally lead to better net returns for the investor.
6. Do’s and Don’ts of Scheme Selection
To maintain a disciplined investment approach, the sources recommend following these guidelines:
| Do's | Don'ts |
|---|---|
| Ensure Suitability: Only pick schemes that match your specific goals. | Chase Past Performance: Don't pick a fund just because it was the top performer last year. |
| Stick to Asset Allocation: Maintain the decided ratio between equity, debt, and other assets. | Ignore Taxes and Loads: Always account for the impact of Exit Loads and Capital Gains Tax. |
| Understand Strategy: Know exactly how the manager intends to generate returns. | Invest Without a Method: Avoid impulsive decisions; use a consistent selection process. |
Key Takeaways for Part 2
- Liquidity Advantage: Open-ended funds are generally superior for investors who prioritize easy access to their capital.
- Concentration Risk: Sector funds require higher risk tolerance and should be used sparingly compared to diversified funds.
- The Currency Factor: International investing is as much a play on currency movements as it is on stock performance.
- Holistic Evaluation: Selection within a category should involve checking the fund manager, age, size, and expenses, not just the return percentage.
Important Terms
- Alpha: The return generated by a fund manager over and above the benchmark return.
- Intrinsic Value: The actual "true" value of a company based on fundamentals, regardless of its current market price.
- Portfolio Turnover: A measure of how frequently assets within a fund are bought and sold by the managers.
- Currency Risk: The potential for loss due to fluctuations in foreign exchange rates.