How to select a mutual fund

MUMBAI:  Not everyone believes in retail investors investing in stocks directly to make more money.

As John C. Bogle writes in the book, Bogle on Mutual Funds - New Perspectives for the Intelligent Investor, “In my view, attempting to build a life time investment programme around the selection of a handful of individual securities is, for all but the most exception investors, a fool’s errand. To be sure, by owning individual equities, some active investors will enjoy spectacular results. But others perforce will lose much of their capital. Earning extraordinary returns from the ownership of individual stocks is a high-risk, long-shot bet for most investors. Specific stock bets should be made, if at all, in small portions, and more for the excitement of the game than for the profit. Serious money belongs elsewhere; it belongs in a widely diversified investment programme.”

Coming from Bogle, the man who set up Vanguard group of investment companies and is a pioneer of index funds, it needs some attention. So if not stocks, what is the way out?     “For nearly all investors, mutual funds are the most efficient method of achieving this diversification,” writes Bogle.

Having advocated the need of investing in mutual funds, Bogle feels that investors need to be careful, when investing. “In my view, too many fund complexes have put the business need for asset gathering, the better to enhance the profits earned by fund managers, ahead of the fiduciary duty to provide efficient asset management at the lowest reasonable price,” writes Bogle.

Given this and the fact that there are so many mutual funds available in the market, how does one get around to identifying the right kind of mutual fund to invest in?

The first thing an investor can easily take a look at is the immediate past performance of the mutual fund. Data relating to this is easily available these days either on websites or business magazines and newspapers. But this may not be always the best way to go about it.

As Bogle writes “Reports by the financial press typically lionise the portfolio managers who had the “best” records (i.e., achieved the largest gains) during the previous quarter or year or even longer. This myopic focus on past performance is not helpful. It is a flawed and a counterproductive way to select a mutual fund”.

Having said that it always makes sense to look at the performance of the fund over a longer period of time. As Bogle writes “In most cases, a fund should prove its merit over a period of at least five to ten years.”

Chances are that a fund which has performed well for this period of time has seen various phases of the market and performed well across these various periods. In an Indian context, there wouldn’t be many schemes which have proved their performance over a period of ten years. But there certainly are enough schemes which have proved their performance over a period of three to five years.

The next thing to take a look at is the fund manager who is managing the scheme. As Bogle writes “Find out whether the portfolio manager has run the fund for a few months, a few years, or a few decades, and give this information whatever weight you deem appropriate.”

Having said that this should not be the only reason while deciding whether or not to invest in a scheme. As Bogle writes “Even when funds have individual fund managers, performance in a particular period can be due to much more- or less - than the manager’s skill. For instance, a manager may be less important than the research and the analytical support he receives. Or a manager may grow or shrink, in capability. It is not unknown for a new manager to do better than a successful predecessor.

A market environment in which a manager has been able to shine brightly may be replaced by a very different environment that does not favour the manager’s investment style. Finally, good luck (always a factor in shaping fund returns) may turn to bad and vice versa. And if the fund manager has changed recently for that Bogle’s advice is “when managers change, a wait-and-see policy is usually appropriate.”

The next thing to look at is portfolio concentration. “It is not enough to know how many stocks a fund owns, because many of them may represent a small percentage of the net assets and have little impact on the fund’s overall performance. The better test is the proportion of total assets the fund holds in its largest positions. One good measure is to check the fund’s ten largest holdings. In the more concentrated funds, the ten largest holdings may comprise up to 50% of the portfolio; in the less concentrated funds, they may comprise as little as 15%. As a general rule, the greater the portfolio concentration, the greater is the opportunity for the fund to provide differentiated performance,” writes Bogle.

What this means is that a greater amount of scheme’s investment is in fewer stocks, the better is its chance to perform better than others or worse than others.

Another thing to look at is the size of the mutual fund. Investing in schemes with very small assets under management (AUM) is not advisable, as Bogle writes “simply because of the relatively higher expenses associated with small funds.”

But what if you are a lazy investor and neither have the time nor the inclination to go looking for all the above information, while deciding to invest in a mutual fund. For these investors, the best way of investing is to invest in index funds.

Index fund is a mutual fund which collects money from investors and invests money in stocks that make up a stock market index in the same proportion as their proportion in the index.

As Bogle points out in Eric J Weiner’s book “What goes up - The Uncensored History of Wall Street - As told by the Bankers, Brokers, CEOs, and Scoundrels who made it happen”,  “The germ of the idea for index funds was in my thesis at Princeton, which was about mutual funds. In 1951, in that ancient thesis, I wrote, “Mutual funds can make no claims of superiority over the market averages.”

I didn’t do any exhaustive statistical test, just looked at a dozen or so funds, but it was quite clear that beating the market wasn’t something this industry was about to do”.  The Vanguard group started Vanguard 500, the first index fund in the world.