3 ways how not to choose an equity mutual fundWith as little as Rs 500 a month, you can start investing in a mutual fund and make great returns over the long-term. However, the main problem faced by do-it-yourself retail investors is not in the understanding about a mutual fund, but the selection of the fund.

With the Sensex hitting new highs almost on a daily basis, new investors want to buy an equity mutual fund which will have the potential to grow. The process of selection of a fund is not as complicated as it sounds, once you know the pitfalls. So, to choose a good equity mutual fund one must know how not to choose one.

Mistake 1: Choosing the best fund of last one year.

The first error that most people make when selecting a good equity MF is that they choose the best fund of last one year. In fact, this is exactly how you should NOT choose an MF.

Different studies have conclusively proven that the best-performing equity fund in one time-period is seldom the best performing again in another time-period. You can check it yourself. The best fund in the calendar year 2017 was the SBI Small Cap Fund with a 79% return. In the 2018 year to date, that fund is down 29%. In 2016, the best equity scheme was HSBC Brazil Fund with over 60% gain. Come 2017, the same fund was among the 20 worst performers. There are many such examples.

Why does the best fund in the last one year often come a cropper in the next year? Just because a fund manager’s portfolio experienced success in one time-period, it does not mean that they have a greater chance of further success in additional attempts. When you look at short periods of time like six months or 12 months to judge whether a fund is good or bad, you make the same mistake. Always remember, past performance may or may not be sustained in future. One year is too short a time to judge the good from the bad.

When choosing a good equity fund, it is vital that you look at truly long-term performance, i.e. 10 years or more. It is also important to see how the fund has performed over market-cycles such as a bear market and a bull market. Some funds, just like some cricket batsmen, do very well in bull markets (or flat pitches), but cannot defend well in a bear market (when the ball spins or swings)!

Mistake 2: My friend said this is a great fund.

One of the major mistakes that many do-it-yourself investors commit while selecting a fund is taking advice from unqualified sources. While our friends and family are extremely important in our social lives, financial advice is a different cup of tea! Your friend may be working in a bank or maybe an honest government official; that does not necessarily mean you have to take their mutual fund advice at face-value.

The bandwagon effect is one of the biggest biases we have. The tendency to do and believe things because many other people do or believe) the same often leads us to bad decisions. Every investor i.e. you, your friend and me, are different. Our needs are unique and so is our perception of things. Instead of blindly following the fund selected by your friend, it is a good idea to understand what made your friend choose the fund.

An investor comfortable with high amounts of risk will always choose a riskier product. In case your risk appetite is not the same, choosing the same riskier product may compel you to go through an unpleasant experience. So, talk to your friend why she/he chose a particular fund. As soon as you ask the question ‘why’ instead of ‘what’, we promise you the answers may surprise you.

If you are a new investor, it is best to take advice from professional advisors who charge a fee. It is probably not the best idea to become a do-it-yourself investor right from the word go. All of us need a coach or a mentor when we are learning the ropes. There are digital platforms and advisor professionals who provide good advice. Once you learn MF investing, you can then turn DIY and choose funds on your own.

Mistake 3: This is the biggest fund and so it is the best.

We love big things: a big house, a big car, a big physique etc. The love for ‘big’ and ‘large’ often compels us to overlook smaller things. When you are unsure about a decision, that is when we look for confirmation in large numbers. Naturally, a fund with tens of thousand crores of assets appeals much more than a fund with a few thousand or hundred crores.

Choosing an equity MF just based on its large size is a mistake. There is no conclusive proof that shows the performance numbers of the top 5-10 funds across all equity categories have a one-to-one correlation between fund size and performance. For the fund-house, a large fund means higher profits. The same, however, cannot be said about investors.

A fund’s size has little bearing on its ability to beat its benchmark or peers. A big fund is only an indication of a large number of investors putting in their money. That’s it. In fact, a giant fund has its own unique share of problems even though the fund manager would not admit. Large funds, like others, can sometimes slip up on performance. Generating returns for investors is not a wrestling bout or a one-on-one mixed martial arts fight!

A large fund size doesn’t automatically translate into good or bad performance. A better indicator of performance is the regular growth in a fund’s size. A steadily increasing fund size is a sign of good performance and investors’ assets flowing in. In the same vein, a steadily decreasing fund size is often a tell-tale sign of a sub-par performance record, which is driving out investors.

Staff Writer

This article is written by RupeeIQ editorial staff.