3 questions that make you a smart fund investor

By Morningstar |  06-12-16 | 
 
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If you are under the impression that selecting a mutual fund is easy, it is probably because you are focusing only on the latest chart topper. And that can be very misleading.

Take a look at this: The year-to-date, or YTD returns of Sundaram S.M.I.L.E. and DSP BR Micro Cap are -0.68% and 12.66%, respectively. A vast difference.

However, if you dig deeper, you will see that Micro Cap has a larger number of stocks, higher cash allocation, and lower allocation to micro caps than S.M.I.L.E. And in 2008, S.M.I.L.E. fell by a lesser percentage while it delivered more in 2009. Not for one moment are we favouring one against the other here. All we are saying is that investors need to dig much deeper when making such a call.

Here are three questions, if answered, should keep you on the right track.

1) How have returns been under the current fund manager?

Most investors are looking for high returns, so it's natural to want to know how it has performed in the past relative to similar funds. The Morningstar Rating for funds (the star rating) is a quick and popular way to measure a fund's relative performance, but it has its limitations. Examining a fund's percentile ranking within its category over a long-term period, such as 5 or 10 years, is a good start, but a fund's past history doesn't always reflect its current situation.

Besides looking at the standard 3- and 5-year measures of performance, always consider performance over more meaningful time periods.

For one, look at the current manager's tenure on the fund. If a fund has a great 10-year record but the manager responsible for that record has recently left, err on the side of caution. Conversely, a fund with poor or mediocre long-term returns may look more promising if a new manager with a good track record has recently come on board.

Then look at extreme swings in market returns to throw clarity on the fund’s downside risks during stretches of market stress.

Also, look at returns over a full market cycle to see if the fund is consistent. If a fund is a bull market bellwether and tumbles steeply during market downturns, ask yourself if you can live with such volatility. Remember, funds that are prone to large, extended losses have to gain that much more to get back to even.

Strong trailing returns, even over the past 3 or 5 years, could stem from a short stretch of hot performance. More consistent performance tends to lead to better long-term results that are easier for investors to handle.

The point we are making is that it’s not just performance, but the drivers of long-term performance that put a fund's record in context.

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2) Why has the fund performed the way it has?

It is imperative to look at a fund’s portfolio, including where that portfolio is most concentrated relative to the fund's peers.

Does the fund harbor sector-specific or market-cap biases that can cause it to perform differently from peers at times?

If a fund is significantly heavy in certain sectors, it can give you some idea of how the fund is likely to perform in certain kinds of markets. For instance, a fund that holds a lot of consumer stocks will tend to do poorly in bull markets and relatively well in bear markets.

Look at its top holdings. If the top holdings are mostly big, easily recognisable stocks, then you are probably looking at a large-cap fund that's similar to the broad market and would be appropriate as a core holding. If they're mostly smaller names and/or stocks you don't recognise, that fund might be more useful in a supporting role in a portfolio.

Also look at the concentration of the top holdings. A concentrated portfolio can be prone to short-term underperformance if something goes wrong with a top holding.

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3)  What is the fund’s strategy and how well is it executed?

There's a big difference between having an investment strategy that could add value and one that actually does. Always consider a fund's strategy and if the manager uses it to deliver peer-beating returns over the long term. Fund managers should stick with their approach and have conviction in their research, rather than those who abandon their strategy when the market disagrees.

An understanding of the strategy also helps put performance into context and set investors' expectations regarding the risks associated with it. Is it a value fund or an aggressive-growth fund? Does it specialise in a small market niche or cover a broad swath of the universe? Does the fund focus more on relative returns versus a benchmark, or does it value absolute returns and capital preservation? The answers to those questions help us gauge how a fund might fare in different environments and how it might be used in a portfolio.

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