There are more than 5,000 Mutual Funds available for investment. If you are looking for making investments. If you call your bank manager for advice, he would tell you a few funds. All of them are best according to him. If you go on Google or Quora and search “what is the best Mutual Fund to invest in”, you will probably get 10–15 different threads, all from the reputed sources. If you are like most of the people, you would call on to your friends who you know understands this industry to suggest a good mutual fund. They may give you another list of funds.

As a result, you would have a shortlist of say 15–20 good funds for your investments. But the key question is how do you choose the final list of 3 or 4 Mutual Funds. To help you, here is a 5-minute guide to review a mutual fund and see whether the fund advised to you is indeed a good fund.

00:00: Mutual Fund Category Test

First thing is to look at the category of the Mutual Funds. There are broadly three categories

In equity, there is another category called ELSS( Equity Linked Savings Scheme) where the investments are exempted from income tax under section 80C, with a limit of 1.5 lac. They have a lock-in of 3 years.

At a glance, you can see what category of Fund is the Mutual Fund that you are reviewing. It if matches your investment needs, it passes. If it doesn’t, it fails. For e.g. DSP Blackrock Tax Saver and Birla Sun Life 96 Tax Relief are very good funds for tax saving investments. But if you have exhausted your limit of 1.5 lac under section 80C or you don’t have taxable income above 2.5 lac, then you should not be investing in these funds.

Sub Category Test

If the scheme passes, you need to do the next level category test. The Debt Fund and Equity Fund have few subcategories that further narrows the purpose of the fund. It’s important to understand the potential returns and risk associated with each of these categories. While it may sound too much of work, it is actually fairly simple. I have listed the subcategories from a low risk-low returns to a high risk-high return manner.

Category analysis for reviewing the mutual fund

The sub-category represents the investment strategy of the Mutual Fund (and of the Fund manager) to a great extent. Kotak Select Focus, a multi-cap equity fund invests in companies across market capitalization (market size of the company). The risk associated with such fund is higher than that of a large-cap fund such as Birla Sun Life Frontline Equity. On the other hand, Franklin India Smaller Companies, a micro-cap fund, invests in very small size companies. Therefore this fund is expected to be more volatile (risky) than the large-cap or multi-cap. At the same time, the returns potential is also higher for micro-cap fund as compared to a large-cap fund. Bottom line is that the investment strategy of the Mutual Fund and your investment needs should be aligned.

01:00: Past Performance Test

If the Mutual Fund category suits your investment needs, the next step to review the Mutual Fund is to look at the returns. Returns are the sole reason why you or I invest, right? Unfortunately, there is no sure shot way of knowing the future returns from any Mutual fund. Therefore we need to be confident that the fund has performed well in the past, in all sort of markets. Past performance is not a measure of future. Agreed. But a good fund manager with a strong strategy can repeat the performance. You can consider two different data points to gauge the past performance of the fund.

Annualized returns 

Most of the investment products talk about the annualized returns. To give you the context, a 7% Fixed deposit has an annualized returns of 7%. But when it comes to an investment with market-linked returns, the annualized returns give the cumulative annual returns (fixed) that would have resulted in the final value over the investment period. Past returns give an idea of what best or worst you can expect in future. The better perspective would come when you see it against the benchmark returns. The returns of the Mutual Fund should have outperformed the benchmark consistently.

Birla SL Equity — review mutual fund annualized returns

You can observe in the above chart that Birla Sun Life Equity (Multi-Cap Equity Fund) has consistently outperformed the benchmark — Nifty 500.

Age-AUM Test

Age of the Mutual Fund – The fund should not be a very recently launched fund. The problem with such a fund is that it might not have seen the ups and downs of the market. You would not have enough data to validate its performance in all sorts of situation. Also, it’s not possible to compare the performance of similar funds if you don’t have enough data. For eg., if you are reviewing a 3-year-old mutual fund, you may find the returns over last 1 and 3 years to be really good, but you cannot be confident that its performance would be so consistent in the hard times. Therefore, unless you perform a deeper analysis on the portfolio (we will briefly cover in the next minute), follow the fund manager’s investment style and know about overall AMC’s philosophy, don’t go for a very young fund.

Asset Under Management (AUM) – The AUM is the total money that is invested in the mutual fund. A very small AUM (less than 100 crores) is a sign of suspicion. The size represents a level of confidence of people and corporates in the fund. On the flip side, even a very large AUM (higher than 10,000 crores) is not good. See how ICICI Value Discovery, Axis Long Term Equity have started underperforming once their AUM crossed 10,000 crores. Fund managers find difficulty in identifying good opportunities for such a large AUM. They end up investing in most of the large cap and therefore the fund becomes a replica of the market. Here is a good read on how high AUM affect the growth opportunity of the Mutual Fund. Check more on AUM

02:30: Mutual Funds Holding Test

The performance is based on the historical data. The portfolio test is based on the future expectations. The actual returns on your investment do not depend upon the past returns but on the holdings (portfolio) of the Mutual Funds. Of course, the holdings do not remain same, but it doesn’t change too drastically. As long the fund manager is same, you can expect similar kind of portfolio. Here are the key things to look for in the portfolio

Debt Funds

The debt funds need to be analyzed in a different manner than the equity funds. It’s important to understand the quality of the holdings and the extent of risk Mutual Fund has taken. Consider the following fund as an example:

Axis Short Term Fund — This Fund endeavors to generate stable returns with a low risk strategy while maintaining liquidity through a portfolio comprising of debt and money market instruments.

Axis Short Term Mutual Fund Review

Yield To Maturity (YTM)

This is the weighted average interest rate at which the debt Fund has bought the entire portfolio — bonds (given loan) of various entities. To calculate the expected returns from the Mutual Fund, you need to add ~ 2–3% that a good fund manager can get you by trading these bonds. But the YTM can’t be considered in the silo. You also need to look at the average maturity. YTM of Axis Short Term Fund is 7.26%.

Risks in Debt Funds

Interest Risk- The long term or the dynamic term debt Funds have 6–9 years of maturity. The longer the average maturity is, the riskier the fund becomes and has higher sensitivity towards the interest rate movement. Average Maturity of Axis Short Term Fund is 2.30 years.

Credit Risk- The Ratings given by Credit Ratings should be checked so as to get an idea about the reviews of the funds. If any security has low credit rating then it might have high chances of default. Although, these type of securities pays high interest and you have to strike a balance between them.

Read more on about the hidden risk in debt funds here.

Equity Funds

In case you are reviewing an Equity Fund or a Balanced Fund, you need to look at the portfolio for the following data pointers:

True to its Category – The Fund should be true to its category which means that the category in which it is should be reflected through its holdings. For example- If the fund is in Large Cap, it should have significant holdings in large Cap stocks.

Focus

Has the Mutual Fund put 70% of the money in top 10 companies or its 40% in the top 10 companies? It matters how focused the fund is. An overly focussed fund runs a risk of being too dependent on the very few companies. On the other hand, a highly diversified fund basically suggests that the fund manager has no confidence in his/her calls.

Sector distribution

It’s very important to also consider the dominant sectors in the Mutual Fund. Most of the Mutual Funds have financial, technology, healthcare etc. sectors as their top 3 or 4 sectors. Unless you have a personal liking to any sector or disliking to one, just make sure that the Mutual Fund is not concentrated over very few sectors. For Example- ICICI Prudential Long Term Equity Fund (Tax Saving) has around 25% exposure to IT and Pharma. A change in the Macroeconomic conditions pertaining to these sectors will impact the returns.

4:00: Last Minute Test

After checking the performance and holdings of the Mutual Fund you would have already made up your mind about the fund. But before you transaction here are a few things you should just confirm for your satisfaction.

Exit loads

A lot of Mutual Funds have an exit load. Exit load is a penalty for withdrawing the money before a certain time. For eg., some funds have 2% load for withdrawing within 6 months, 1% for withdrawing between 6 and 12 months and 0% for withdrawing post 12 months. This is not really a deal maker factor, but you should be aware of it.

Red flags

A quick look at the portfolio will tell you whether there are any red flags or not. The red flags are such that there should be a sink between the Fund Manager, Fund Scheme, and Asset Management Companies strategies.

For Example, Birla SunLife Advantage Fund has significant positions in Yes Bank, hence a recent dip in Yes Bank was reflected in the NAV of the fund.

5:00: Conclude

Time is over. If the scheme has survived these five minutes, you should make an investment in it. Your only fear now has to be the macroeconomic elements — is the market overpriced, is some political event about to occur and so on. If you don’t have in-depth knowledge of these factors, go for a SIP.

Start Investing