It’s an investing tenet that cannot be stressed enough. While going for a mutual fund, first check whether it fits your investment plan and then look at its performance record and expense ratio. Most investors hunt for high returns and some stop right there, inviting disaster. Others look at risk, then cursorily check the expenses and, finally, think about how it gels with the rest of their investment plans. By reversing this order, you can vastly improve the odds of finding the right fund. So, first check the funds that suit your overall investment plan and the next step should be to find out the expenses; returns fluctuate but expenses stay forever.
A mutual fund’s returns should not be the only criterion for selecting a scheme for investing. Investors also need to evaluate how these returns are generated. A fund manager’s strategy gives a good idea of the risk associated with the returns.
A diversified portfolio means the fund holds small quantities of a large number of stocks across various sectors. Small holdings translate into lower risk as the fund’s performance is not affected too strongly by the bad performance of a particular stock or sector. On the flipside, a large number of holdings need to do well for the fund to give good returns. A concentrated portfolio, on the other hand, has larger holdings in fewer scrips, so good performance by a few stocks can result in positive returns. By the same logic, poor performance by just a few stocks can have a significant impact.
The extent to which a fund’s assets are invested in the top five stocks in a portfolio gives a fair idea of whether it follows a diversified or a concentrated strategy. The number of sectors that a fund invests in and its asset allocation in the top five sectors also indicate the portfolio’s risk. The funds that focus on a few sectors and have a substantial portion of their assets in these are susceptible to a downturn in these sectors’ fortunes. Just as you churn your mutual fund portfolio, the fund itself churns its investments.
The purchase and sale of securities is termed as turnover or churning. Some funds aggressively buy and sell securities to take advantage of short-term market movements. A portfolio turnover ratio of 100 per cent means the fund has overhauled the portfolio completely once during the period under review. High churning also increases the fund’s expenses in the form of brokerages and commissions, which can be detrimental to long-term returns. So, higher returns usually also imply higher risks and expenses.
In times of uncertainty, funds move to cash, which defines the risk of the portfolio. Some funds shift to the safety of cash in volatile markets to either protect the downside or take advantage of opportunities. The danger here is that the fund manager may exit from a stock too early or miss out on a rally by entering too late. So, investors need to evaluate their risk appetite—hold cash for the possibility of higher returns or safely remain invested through the market volatility. A careful evaluation of the portfolio characteristics is essential to estimate the risks as it will help the investor choose the right fund.
