Beyond asset allocation, how to choose the right mutual funds

While asset allocation and goal mapping form the foundation of investing, the real challenge lies in selecting the right instruments to execute the plan. In the case of mutual funds, chasing top performers or following popular trends often exposes investors to unintended risks.

A more effective approach begins with aligning fund categories to one’s risk profile and time horizon, followed by evaluating consistency of performance against benchmarks rather than short-term returns

While many investment lessons and ideas ponder on asset allocation, goal-mapping, and risk appetite, they only addresses the most basic. While it certainly serves us the initial action plan or to derive an investment policy statement/philosophy, it won’t get us to the nuts-and-bolts of executing the plan. That’s only the beginning of the investment journey, and the actual dirty work remains elsewhere.

Once the investment plan is in place, for instance, the asset allocation mix is in place, and now we get down to shortlisting the instruments. The classic, transparent, and convenient way is to build through mutual funds. So, how to pick the right funds from the plethora of offerings that fit to your requirements. This is a work in itself, similar to the initial exhaustive exercise of the investment planning.

The crude and most common way is to mimic a friend or a known person. The most frequent question I’ve ventured is what’s the flavor of the season, or which fund to invest. There’s no background of the need description or goal timelines, but just to invest in a fund. The other frequent way is to pull out the top performers list as on a date, comparing over periods of 1-yr, 3-yr, 5-yr, and more.

True, the very reason for any investment is to make money, i.e., higher returns, but its like comparing a car based on the fastest to reach 0 to 100kmph. Would that allow you to make up your mind? How then do we arrive at zeroing down on a fund to invest?

Chasing returns wouldn’t end us with better returns but could expose us to higher risks than we might desire or tolerate. So, one should first begin with their risk profile. Based on the risk tolerance, one should distil to the category that better aligns with their risk. That’ll be a wise way to reduce the distractions of performance-based comparisons.

If the risk is conservative with shorter timeline requirements, then debt or debt-oriented funds would address the need. That way, we’re aligning the risk, goal, and time periods. If the risk is moderate with a relatively lengthier period, a hybrid fund could suffice the need and an equity fund for longer time and moderate to aggressive risk profiles.

And how many times do we see the same fund(s) at the top, across multiple timelines? There’s a seasonality of fund returns, like many of the sportsmen. It’s only a few who perform over longer periods that become great and remain etched in our memory. Similarly, we need to check for not just performance but consistent ones to consider in our portfolio within the suitable category.

If one were to check the performance comparisons, one could find suddenly a new fund top of the list with spectacular returns suddenly and then fade away after a few months or quarters. It might never again feature in the top-quartile, even. This is because at times the market might align with the fund’s composition that provides for a quick fillip in the performance and when the tide goes low, the constituents of the fund mayn’t feature in the market outperformers.

This is particularly true with thematic or sectoral funds. For example, during COVID and right around the restrictive mobility, the information technology sector did extremely well, logging huge returns for about a year, and then fell out of flavor as the conditions eased and valuations peaked. When perfectly timed, i.e., entry and exit, an investor could’ve made decent money, but had they approached in a staggered way or ill-timed, they were burdened up with underperformance for the next two-three years.

The better way to compare the fund's performance over long periods is with its benchmark. So, if a particular fund has managed to beat the benchmark, say 6 out of the last 10 years and been above the category average (apple-to-apple comparison) about 7/8 of the times, then it would be a consistent performer, even if it had never topped the charts ever in the category.

And probably a crucial factor is the risk management of the fund, i.e., how it protects the investor on the downside. While most funds ride with the momentum, few tend to withstand an onslaught. Particularly during a broad-based market correction, if the fund could withstand compared to its peers within the category, then that could be a better fund. So, measures like Sortino Ratio show the risk adjusted return considering only the downside deviations. Another important ratio one could consider is the Treynor’s ratio, which shows the excess return the fund generated for each unit of risk taken.

Once the funds are shortlisted over the above parameters, one could then compare these on their expense ratio. Each fund incurs expenses for administering and managing the fund, with the upper limit capped for each category by the regulator. However, within each of these selected funds, one is better off with the least expense ratio. It would be prudent to opt for a fund that generates better risk-adjusted returns at a lower expense, as these eat into your returns.

Unfortunately, most DIY (Do-It-Yourself) investors don’t do this due diligence and hence end up switching between funds and/or discontinuing their systematic investment setups. By following these steps, one could technically arrive at a decent allocation to their portfolios. Nevertheless, providing enough time for the money to work for you remains the top exercise.

(The author is a partner at ‘Wealocity Analytics’, a SEBI-registered Research Analyst and could be reached at [email protected])