When investing in mutual funds, here's what you should know

Volatility and uncertainty are part and parcel of equity investing. Equity mutual fund (EMF) investors too cannot remain unscathed when the movement of indices becomes range-bound. In times like these the performance of indices as well as mutual funds (MF) takes a beating. The Sensex's 1-3-5 year returns have been negative 6.55 percent, 9.88 percent and 5.82 percent, respectively.

Investors can use this as an opportunity to review and build a robust EMF portfolio. After all, if an investor has invested in an equity fund with a specific long-term goal in mind, returns from the equity asset class in the short-to-medium term need to be ignored.

The MF scheme's performance, however, should be monitored on a regular basis. Reviewing of an EMF portfolio could entail scanning the schemes in the portfolio, including various diversified schemes, thematic or sector funds and even the large, mid, and small cap funds. Here's how and what it takes to review a fund's performance.

Measuring performance
While looking at a fund's performance, do not be led by the fund's return in isolation. A scheme may have generated 8 per cent annualised return in the last 24 months, but then, even the market indices would be strolling around that figure. Under-performance in a falling market, i.e. when the NAV of the fund falls more than its benchmark (or the market), could still be a reason to review your investment.

Therefore, compare the scheme's return as against its benchmark return. A scheme not being able to beat its benchmark on a consistent basis need not be in one's portfolio. If there are consistent under-performers, replace them with front runners after carefully evaluating the new buys. Importantly, identifying under- and over-performers need a longer time horizon.

In addition, one may also consider evaluating the 'category average returns'. Even if the scheme has outperformed the benchmark by a decent margin, there could be better performers in the peer group. A look at the category average returns will tell you how good or bad is your investment against its peers. There could be reasons for that and you need to explore before switching.

Considering category average returns in case of mid-cap and multi-cap funds could be more effective than large-cap funds as the universe of stocks is large in the former.

How often to review
Avoid the temptation to review the fund's performance every time the market falls or moves up 500 points. For an actively-managed equity MF, one needs to give some time to the fund manager to generate returns in the portfolio. There is no tried and tested time-frame but reviewing the performance of the fund anywhere between 18 and 24 months could be effective. Sanjiv Singhal, Founder & Head of Product Strategy, Scripbox, says, "If you have taken care to analyse the last 4-5 years' performance of the fund while selecting it for your portfolio, you don't need to start reviewing it before one year."

The review may become more pronounced in case of thematic or sector MF schemes as they are more prone to the changing economic environment. The same may hold water for a new-fund offering (NF0). Srikanth Meenakshi, Co-founder and COO, FundsIndia.com, says, "Unless it is an NFO, if an investor has invested in funds with a good track record, an annual review comparing the fund with the benchmark and then with category peers will do. For an NFO, a quarterly watch may be needed, especially in the initial years."

Factors to look at
Although it will be not be an easy task for a lay investor to get to the reason of under-performance, one of the primary reasons could be a change in portfolio holdings. Such a move by the fund manger may have a negative impact on the fund's NAV in the short term but may bear fruit over the long term. Anil Rego, CEO & Founder, Right Horizons, says, "One needs to even check the reason for the under-performance, which may be expressed in the fund manager's commentary. This could be a realignment of the portfolio and be expected to provide out performance in future."

Therefore, taking a call merely on under-performance might also not help. Bring the laggards under the radar and keep a close watch. Meenakshi suggests, "An investor has to make a separate watch list of funds that he or she finds underperforming their benchmark or their comparable peers. From this list, over the subsequent 2-3 quarters, one should look for any improvement in performance. A sustained under-performance over 3-4 quarters may warrant a switch to another scheme." Do not take hasty decisions in showing the door to the under-performers while reviewing the MF portfolio.

The underlying stocks in the portfolio of an MF scheme keep changing and along with it change the associated risks. Rego says, "An important factor would be risk metrics. If the risk profile of the fund has skewed further towards "High" risk with the returns being the same or being lower, then it would be advisable to exit the fund."

Therefore, a look at the fund's risk-adjusted return, i.e. a measure to find how much return an investment will generate given the level of risk associated with it, could be more helpful. As an investor, high return at low risk is always preferred. So MF schemes with high risk-adjusted returns are most sought-after. Risk-adjusted returns are well captured by several rating agencies. Check here for rated schemes.

The downside
The winners of today may not continue with the winning streak year after year. Therefore, decisions based on reviewing may not be fruitful always. Also, tracking and reviewing of a scheme's portfolio is a different ball-game compared to reviewing one's own portfolio. Meenakshi says, "As far as fund portfolio is concerned, unless an investor is active in the markets and understands sector prospects, taking a call on whether the fund manager is invested in the best sectors may be tough. It is best left to the experts."

So, while reviewing, what factors specific to the fund portfolio should the investor be looking at? "None! A mutual fund investor should not concern themselves with the portfolio of a fund. That's the fund manager's job and they get paid to do it," says Singhal. To know what a mutual fund manager earns, click here.

Watch out
Exiting from equity-based MF schemes may disrupt the overall portfolio allocation. Try to maintain the original levels unless allocation needs a change. The proceeds may have to be deployed in another MF scheme which will require re-visiting the process of choosing the right scheme to invest in. Rego informs, "The fund you are choosing to reinvest must be from a similar category. For instance, it may not be a good idea to exit a large-cap fund and enter a midcap fund instead; unless of course you were under invested in midcaps. As far as possible, make like-to-like category switches to avoid mis-timing in different categories."

Here's a piece of advice from Meenakshi, "Constant review and tracking of fund returns may push you into taking impulsive decisions. Keep a calendar of review to be done and stick to it. When there are market falls, at best, see if you can plough more, and do so. Do not let a single month or quarterly fall in NAV push you into stopping SIPs or exiting a fund."

Conclusion
Reviewing of the EMF portfolio doesn't merely help you rejig schemes in terms of performance but may also throw up surprises. You may be holding a too little or too much-diversified portfolio. Even the expense ratio of some of the schemes that you could be holding may be high compared to others within the same category. Most importantly, the review helps you validate if the investments are aligned to your goals. So, get a review process in place and reap its benefits before the next big market wave.