‘Looking only at past returns and expense ratio, you could miss the other vital aspects’

Investing in the best mutual funds across categories and subcategories is not an easy task. There are various facets to look at. One cannot simply zero in on the best mutual fund schemes based on historical returns as they do not necessarily indicate how the scheme will likely fare in the future. A host of quantitative and qualitative parameters of the mutual fund scheme under consideration need to be deeply studied to make a prudent decision. Among the quantitative parameters is the Expense Ratio charged by the scheme. This is nothing but the costs that are levied on the mutual fund scheme (by the fund house) as a percentage of its daily net assets. Usually, the costs incurred by the fund house on their schemes are investment management fees, brokerage on buying and selling securities, registrar & transfer fees, custodian fees, legal fees, audit fees, sales & marketing/advertising expenses, administrative expenses, statutory levies and so on. These costs are levied on the mutual fund scheme as a percentage of its daily net assets and are referred to as the Total Expense Ratio (TER). The capital market regulator makes it mandatory for mutual fund houses to disclose the TER of all schemes on a daily basis on their websites as well as the Association of Mutual Funds in India’s (AMFI’s) website. There are guidelines on the maximum TER a fund house can levy on its actively managed mutual fund schemes (equity-oriented and debt-oriented) and the passively managed mutual fund schemes.

The regulator is working in the interest of investors and planning to overhaul the Expense Ratio structure of mutual funds. In May 2023, by releasing a Consultation Paper on Expense Ratio, the regulator proposed a variety of changes in how Expense Ratio could be levied. And based on certain feedback and concerns of the Indian mutual fund industry, it is currently under review.

Usually, the lower the Expense Ratio, the better it is said to be for the investors because the Expense Ratio has a bearing on the mutual fund scheme’s Net Asset Value (NAV). However, it is not always right to make a judgement about a mutual fund scheme going by the Expense Ratio.

To an extent, the Expense Ratio is important as it could weigh on the returns if the scheme is not performing. But it does not mean that a fund with a lower Expense Ratio is always better. Each scheme follows its own investment strategy and style, which you, the investor, need to recognise. If the mutual fund scheme is compensating well, i.e. generating respectable returns against the risk exposure (by holding a robust portfolio by following sound investment processes and systems), then the Expense Ratio is well justified. For this reason, SEBI, in its Consultation Paper, has proposed the idea of a performance-linked Expense Ratio (for actively managed open-ended equity mutual fund schemes) if the scheme performance is more than an indicative return above the ‘tracking difference adjusted benchmark’. The ‘Tracking difference adjusted benchmark’ means benchmark returns adjusted for the permissible operational cost of managing the fund. A performance-linked Expense Ratio aligns the interest of the fund house with that of the investors, but its monitoring and computation is slightly complex.

Keep in mind, only by looking at past returns and Expense Ratio charged, you could miss the other vital aspects that need to be evaluated to pick the best mutual fund schemes.

To select the best mutual fund scheme you need to evaluate a host of other quantitative and qualitative parameters, such as…

• Returns over various time frames (6-months, 1-year, 2-year, 3-year, 5-year, 10-year, since inception)
• Performance across market phases (i.e. bull and bear phases)
• Performance across interest rate cycle (in the case of debt mutual funds)
• The current interest rate cycle (in the case of debt mutual funds)
• Risk ratios (Standard Deviation, Sharpe, Sortino, etc.)
• Portfolio characteristics (the top-10 holdings, top-5 sector exposure, how concentrated/diversified is the portfolio, the market capitalisation bias, the style of investing followed – value, growth, or blend, the portfolio turnover, and in the case of debt mutual funds the quality of debt papers held, the average maturity, and modified duration)
• The overall efficiency of the mutual fund house in managing investors’ hard-earned money (i.e. the proportion of AUM actually performing. This shall reveal whether the fund house is an asset gatherer or a prudent asset manager.)
• The quality of the fund management team (the experience of the fund manager, the number of schemes he/she manages, the track record of the mutual fund schemes under his/her watch, and the experience of the research team)
• Portfolio Churn, i.e., to see if the fund is holding its portfolio with conviction or indulging in momentum play to generate returns.

In addition, understanding the investment ideologies, plus the processes and systems followed at the fund house, could prove useful.

Analysing a mutual fund scheme in the above holistic manner shall help you gauge the risk-return potential of a fund, i.e. how it would perform in the future, and choose among the consistent performers.

Furthermore, choose not just among the best but even the most suitable ones, in congruence with your age, risk profile, broader investment objective, financial goals, and investment time horizon.

To keep the cost of investing low, Direct Plans offered by fund houses for their respective scheme make sense. The Expense Ratio of the Direct Plan is lower than that of the Regular Plan (since mutual fund houses do not have to pay commissions to distributors).

As regards whether one should invest a lumpsum or choose SIP (Systematic Investment Plan) shall depend on the market condition, investible surplus, and liquidity needs. But usually, at the market high or when there is high volatility, it is sensible to take the SIP route as the inherent rupee-cost average feature shall help mitigate the risk involved while you endeavour to compound your hard money. SIPs are a useful medium for financial goal planning.

As good things take time, ensure you give enough time for your mutual fund portfolio to perform and avoid making any decisions based on short-term returns.

Jimmy Patel is MD & CEO of Quantum Mutual Fund.