5 Tips for Investing in Equity Mutual Funds

In almost every other financial blog post, the emphasis on equity mutual funds has been immense. It is without doubt the most sought after investment these days, with real estate and deposits/debt taking a back seat. It is therefore important to understand certain realities about these funds which can guide us to make better investment decisions.

What Goes Up, Comes Down

Newton discovered this law centuries ago but investors have not paid enough attention. An equity mutual fund that performs extraordinarily well in the past year or so need not continue to do well. In fact, there is a high possibility of the fund correcting or consolidating, in which case you may end up making a loss.

One of the reasons that this happens is that the fund may have invested in a sector that could have done really well. Some sectors are cyclical in which case a good period is followed by a bad or an ordinary period. At the moment mid and small cap companies have been doing really well for the past 3 years, and hence could see some near term consolidation. Therefore small and mid-cap funds may not replicate past performance in the coming years.

Fund Manager’s Track Record

We cannot stress this enough. The fees you pay for the mutual fund is not half as important as the track record of the fund manager. A good fund manager can generate above average returns for an extended period of time (>10 years). The fees that you pay for a good fund manager with a credible track record may well be worth it compared to a cheaper fund.

Weigh your options considering qualitative aspects as well. But how does one assess the manager’s track record? You can ask yourself the following:

1. How did the fund manager perform during the 2008 financial crisis or for that matter any bear market. Did their fund correct lesser than the average market. If it corrected much more, that would mean the fund manager was simply chasing trendy stocks which eventually collapsed.
2. How long have they been a fund manager and how many bull-bear cycles have been witnessed? This is very important. The stock market is a great leveler. A fund manager learns a new lesson during every bull and bear market. More experience, the better the manager handles the investment.
3. Go-Go stocks: Go-Go stocks are stocks that the market fancies a lot at a given time. Good fund managers do not go after these stocks as they are generally over priced and when there is a crash these are the ones to get punished the most. This happened to Infra stocks in the last Indian bull market.

Spend time knowing your fund manager as it may be a partnership for life.

The Truth about NAV

NAV or Net Asset Value is the sum of the underlying assets of the mutual fund. It is NOT the measure of the value of the fund. You cannot measure if the fund is cheap or expensive with the NAV. Often we are misled to think a fund with a lower NAV is cheaper which is far away from the truth.

Probably the rate of change of NAV is a better indicator of fund performance. So next time an agent talks about NAV, ask him/her about the fund portfolio to assess.

How Many Funds?

“The definition of genius is taking the complex and making it simple”, a famous quote by Albert Einstein.

We need to take this seriously. Often agents and advisers suggest buying a number of mutual funds in the name of diversification. We need to understand that diversification is already present in any individual fund and there should be no need to buy funds from different companies. What could be considered, is diversification in terms of small, mid and large cap funds or just go for a diversified fund. But buying funds from different banks and institutions is not diversification.

Constant Review

Investment process is a journey, rather than just sitting idle after investing. Constant review of the performance of your fund, the market sentiment and knowing your fund manager are some key elements of the journey.

Keep reading and learning. It’s your money after all.

Let us know about your experience with equity mutual funds in the comments section.

Arjun Balakrishnan is an investment fanatic who loves writing about investment topics. He regularly writes at Investment Gyaan.