Don't just consider past year's returns while choosing mutual fund scheme

The spiral in equity markets has lured many investors. Having burnt their fingers earlier, this time around investors are opting for the mutual fund (MF) route to benefit from stock markets that are on a roll. This is evident from the growth in MF folios, which are nothing but number of fresh investments sought into various MF schemes.

The number of folios registered between January and March 2015 are nearly twice of those added during September and December 2014. As per Association of Mutual Funds in India, 17.85 lakh retail folios have been added during the six month period of September 2014 to March 2015 to equity-oriented mutual fund schemes.

But with 50 new schemes pending for approval to be launched during the year and 400-odd existing equity schemes how does one pick the right fund? Your overall portfolio returns would be impacted based on the scheme you opt for. For instance, if you have been investing Rs 1,000 in a scheme for the past 10 years, the best fund would have helped you build a corpus of Rs 5.24 lakh, while a wrong decision of picking up a scheme that has delivered the lowest return of 7% would result in final saving of just Rs 1.69 lakh, which is much lower than the Rs 2.83 lakh that you would have gained on an average.

The difference between the best and the worst schemes has been the widest during the past one year, where cherry-picking stocks has been the key, even as renowned bluechips failed to move above the levels seen in 2008. Take for instance, the tax-saving funds where the best performing scheme IDBI Equity Advantage has delivered 61.79% over the past year and HDFC Tax Saver has generated 20.79% returns.

In spite of the premier returns, not all financial advisors would recommend the one-year old IDBI Equity Advantage Fund. The simple reason is that one-year returns aren't an indicator of long-term performance. Experts always prefer a long-term consistent performance record to peg their mutual fund recommendations on. So, one should stop falling for schemes which have recently gained the limelight, but have a history of underperformance.

"One needs to question why the fund has outperformed. If the fund has a concentrated portfolio and the performance has been the result of just a couple of stocks, then you might be entering a risky fund. Investor needs to be careful. It should not be like a one batsman team, which performs against all teams even as it dreads the Australian team," says Paul D'Souza, proprietor of Cuzinns Investment Services.

The past record helps one weed out the chances of ups and downs due to movement of fund managers. A longer track record also helps one assess how the scheme has performed during various phases of the stock markets. Apart from years when the markets have been roaring, one should assess the scheme's returns during dull phases such as after the fall in 2008 up to 2012. One should examine whether the fall in the returns was more than what the benchmark indices gave up or the fund managers were able to restrict the slide.

The size of the fund too is a deciding factor, especially in case of mid- and small-cap funds. Last year a couple of funds restricted fresh investments as finding good stocks to invest in gets limited after a point, and then too much money chases the same stocks resulting in inflated prices. The asset size of the fund shouldn't be too small or too big.

Another indicator is the frequency of churning the scheme's portfolio and the expense ratio. The higher the churning, higher are the expenses of a scheme. These expenses eat into the returns of your fund. Charged in the range of 1.5% to 3% (6% for closed-ended schemes) these small differences in the expense ratios go a long way in building wealth over years.

Now there is even an option available to further reduce the expense charged by opting for a direct plan over the regular plan. Here one needs to do the initial running around to set up the systematic investment plan (SIP) or make the first investments sans a mutual fund distributor. The direct investments route, which surpasses the commission paid to distributors, results in a higher saving considering the returns of direct plans are 0.75-1.5% higher than the regular plan. The direct plan of Sundaram S.M.I.L.E. Fund has generated 79.57% over the past two years, while the regular plan has offered investors 78.31%.

When you have a lumpsum amount to invest and are unsure whether you should enter the markets at that particular instance, you need not keep the money idle in a savings bank account, where it would earn 4% interest. A better way would be to park it in a liquid fund with a mutual fund and enter into a systematic transfer plan (STP) where the money would be invested in your choice of scheme at select intervals thus erasing the fear of investment at very high market levels as the purchase cost is averaged out.

D'Souza recommends, "Returns that are 10% lower than the best performing scheme doesn't mean a scheme generating 20% per annum hasn't been performing. If you are expecting a 15% returns to meet your goal and have got 20%, be content. Everyone wants to invest in the top fund for the period, but past performance is not a guarantee for the future."