Ten ways to Evaluate a Mutual Fund

Every Mutual Fund agent and financial Web site has different theories on how to evaluate Mutual Funds. Many of these theories focus on simply analyzing the fund's recent performance and the reputation of the fund house, which is rarely enough to differentiate a good investment from a bad one.

In reality, Mutual Fund analysis is a sophisticated problem studied by global investment professionals, and while no list can do complete justice to the problem, there are ten nuanced factors that professionals look at:

1. Performance track record

Everyone scrutinizes returns but the key word is track record or the complete history of returns. Funds in India often sell on recent track record (a week, month, or year), which says little about the fund's long-term performance. Fund houses will also cherry pick the period of returns they show to make the fund house look good.

Since inception performance or performance over the fund's life is a critical factor, equally critical is what the starting point for the fund was. An equity fund that started in October 2008, a market low, will have great since-inception performance today, because it happened to catch a big bull market.

Everyone can succeed in a bull market; analyze how funds have performed in a bear market. Be sure to use a correct benchmark when analyzing a fund's relative performance. A small-cap fund should be bench marked to an index like the BSE 200 or BSE 500, while a large cap fund to the Nifty or Sensex.

Fund houses will commonly show small-cap funds in comparison to the Sensex, which is an unfair benchmark because there is a premium on small-cap stocks as they always do better in a broad based bull rally.

2. Fund manager profile

The fund manager (not the fund) is often ignored in the Mutual Fund decision-making process, and is more directly related to how your money is managed than the fund house. In reality, the fund manager is the one making the actual investment decisions and driving the trades.

A strong fund manager will have a professional qualification in finance and many years of experience in investment management, where investment management is specifically the management of funds, and not investment banking, chartered accountancy, and brokerage.

Understand what funds the manager has worked at in the past and what her/his own investment track record is. It's also important to look at the management of the firm and their involvement in the fund: Who makes the final decision, the fund manager or the fund house management?

3. Investment style and process

A good fund manager will have a distinct investment style, whether it is fundamental, quantitative or macroeconomic. No one style is better than the other; the important thing is whether the manager sticks to her/his investment style and if this style is reflected in the portfolio holdings. A small-cap fund manager should not start doing arbitrage strategies just because they get good returns.

A fundamental manager who focuses on the deep understanding of companies and sectors should not manage an IT fund, a pharma fund, and an infra fund. A fund manager's style should not be determined by what is selling in the market.

4. Risk

Returns are important, but risk is just as important, if not more.

Risk can be quantified in various ways from as simple as standard deviation and beta to more complicated risk models. What is important to check is a fund doesn't just show good returns, but good risk adjusted returns. Sharpe or information ratio is a good measure of risk-adjusted returns.

In addition to total returns, the risk a fund takes relative to its benchmark should be studied. If you are looking for equity returns similar to the benchmark and a fund is taking a lot of risk to the benchmark, you may not be paying for what you want.

Also, good funds should have an independent risk management team that oversees the portfolio manager and keeps the risk the manager takes in check.

5. Portfolio turnover

Portfolio turnover is a measure of the amount of trading the fund is doing and a measure of how aggressively the portfolio is churning the portfolio. Higher amounts of turnover means the fund is holding their investments for a much shorter period, which may be undesirable if you think of your equity investments as a long term investment.

In addition, higher amounts of turnover lead to higher expenses whether it is brokerage, custody, statutory taxes or other expenses. This is a hidden yet important cost because it directly reduces your returns.

6. Fund size

Fund houses and Mutual Fund agents often pitch larger funds as better, because raising more assets is a sign of fund performance and investor confidence.

This is only partly true. While a fund should have some size, larger funds are not nimble and their trading activity can move the markets. If a large institutional investor redeems his units from the fund, the fund will have to sell its holdings to meet the redemption request. The sell orders of the fund are likely to move prices and the brunt of this is borne by smaller retail investors.

In addition larger funds struggle with liquidity -- it is hard to exit out of holdings in a cost-efficient and timely way because the trade size is so large.

Also, larger funds are likely to skip smaller potential multi-bagger investments because at the starting point, the investments are too small to make a meaningful difference to the corpus.

7. Cost of funds

Mutual Fund investment costs are not insignificant and are often deceptive. Funds will often show only entry and exit loads, leaving out the expense ratio, which is a very significant cost. In addition, the entry load is now a moot point since SEBI has regulated that entry loads are out -- a fund is not doing you a favor with zero entry-load.

Exit loads, which are perceived negatively, are not always bad -- they prevent you from recklessly moving from one fund to another, and keep your focus on the long term. It is just important to make sure the exit load is in line with your investment horizon.

8. Fund house approach

The fund house's approach of managing their portfolio of funds says a lot about their commitment to providing clients good investment returns.

Fund houses that are focused on managing a few funds well are better than fund houses that launch one fund after another, just because there is a new flavor of the season. Fund houses that have the courage to launch innovative products and concepts are also better than those creating me-too products.

Also beware of fund houses that launch and shut down the same concept again and again -- just for the benefit of getting a fresh track record.

9. Investment objective

Ask your Mutual Fund agent to tell you the investment objective of the fund: What is the fund trying to provide to you?

Long-term capital appreciation is not an investment objective -- every fund tries to provide that and every investor wants that. Examples of investment objectives are tracking the Nifty, providing roughly 5 per cent over the Nifty, or providing 10 per cent a year in all market environments (bull or bear).

An investment objective should be concrete and realistic -- 50 per cent returns every year is not realistic.

Once you know the fund's objective you can correctly evaluate its performance -- a fund whose goal is to track the benchmark cannot be criticized for not outperforming it.

10. Aggressive cash management

It is important to understand what percentage of the assets a fund holds in cash and what its cash management strategy is, as well as what the historical cash holdings are.

Funds that move into cash aggressively may be able to protect you in crash. However, keep in mind, as the market rallies, they will lag the market as they move back from cash to equities. On the other hand, funds that are always fully invested will do well in a rally, but give you severely negative returns in a crash.

Selecting a Mutual Fund is both art and science and should be done very thoughtfully. Study the fund house carefully or work with a qualified investment adviser who understands Mutual Fund selection. More than 40 fund houses and thousands of funds make us spoilt for choice. So, choose wisely.

SEBI Declares System Audits of Mutual Funds to be Conducted by CISA/CISM-certified Auditors

The Securities Exchange Board of India (SEBI) stated recently that system audits of mutual funds in India must be conducted by CISA/CISM-certified (or equivalent) auditors. ISACA, a global association of 86,000 IT and business professionals and a provider of IT knowledge and certifications, believes that this is a crucial step undertaken by SEBI, considering the importance of systems audit in the technology-driven asset management activity. ISACA administers the globally respected Certified Information Systems Auditor (CISA) and Certified Information Security Manager (CISM) designations, as well as the newer Certified in the Governance of Enterprise IT (CGEIT) credential.

Avinash Kadam, past international vice president of ISACA, commented, “This is a welcome step taken by SEBI to protect the interests of the investors in mutual funds. There is very high dependency on information technology in the financial sector. Mandatory audits of systems and processes will bring transparency in the complex workings of mutual funds, prove integrity of the transactions and build confidence among the stakeholders.”

According to ISACA, the step will be beneficial as it requires a comprehensive audit of systems and processes related to examinations of the integration of the front office system with the back office system. The audit will also involve the examination of fund accounting systems for calculation of net asset values, financial accounting and reporting system for the AMC, unit-holder administration and servicing systems for customer service, funds flow process, system processes for meeting regulatory requirements, prudential investment limits and access rights to systems interface.

Accordingly, these systems audits will be conducted once every two years. A systems audit report and compliance status will be presented before the trustees of the mutual fund. The systems audit report/findings, along with trustee comments, are to be communicated to SEBI.

More than 70,000 professionals have earned the CISA designation since inception in 1978, and its retention each year consistently remains at 92-94 percent. More than 10,000 professionals have earned the CISM certification since it was established in 2002, and its retention each year consistently remains at 93-94 percent.

Sebi may allow MF units to be traded on exchanges

The move includes new fund offers.

After a series of bad news such as entry load ban, mutual funds may finally get some good news from the market regulator.

The Securities and Exchange Board of India (Sebi) is now planning to enable investors to buy and sell mutual fund units through stock exchanges. Fund houses will also be allowed to sell new fund offers (NFOs) through exchanges, helping them to save on distribution costs.

Sources privy to the discussions told Business Standard that a committee under a Sebi executive director has been constituted to look at amendments to the regulations governing stock exchanges, depositories and brokers to push through the move. Another source said to start with, it would be optional for fund houses to use the platform. Trading on stock exchanges would be in addition to the proposed platform being developed by Association of Mutual Fund of India (Amfi).

The sources added that Sebi was keen on stock exchange-based mutual fund purchases and sales or redemption because the Amfi platform could take a while to be ready.

The move comes at a time when the market regulator has terminated the system of entry load and put curbs on the levy of exit load on mutual funds.

At present, investors have to approach fund houses to buy or redeem units. On their part, fund houses declare net assets value (NAV) on a daily basis and trading takes place on the basis of the previous day’s NAVs.

Under the new mechanism, fund houses have to offer two-way quotes based on the previous day’s NAV for trading.

Last year, Sebi had mandated the listing of all new fixed maturity plans on the stock exchanges, which had lowered listing fees to push through the move. At present, 83 FMP schemes are listed on stock exchanges but volumes are low.

Apart from the sale and purchase of units, new fund offerings could also be made through the stock exchange channel in addition to those through distributors.

A Sebi official said that stock exchanges would have to make minor modifications to their software to allow for trading through terminals. The move would also require dematerialising mutual fund units.

On the trading platform being developed by Amfi, a committee headed by UTI Asset Management Company Chief Market Officer Jaideep Bhattacharya had suggested the introduction of a unique identification number for each investor that would help them track their portfolio, including their value, once they log on to a website.

“Sebi’s initiative should work well for the industry,” said the CEO of one of the largest asset management companies in the country. He said cost advantages would accrue for investors and fund houses and brokers would also benefit. “The commission may be low for financial advisors but it will be good for brokers who will also be able to make more use of their terminals,” the CEO added.

Asit C Mehta Investment Intermediaries Managing Director Deena Mehta said, “Fund houses can sell new schemes and even units of the schemes floated earlier. Distributors can act as sub-brokers. This will cut costs for fund houses also.”

There were over 500,000 trading terminals across 600 Indian towns and cities and Mehta pointed out mutual funds had a presence in 150 of these locations.

She added that trading through the stock exchanges would also mean that the settlement process could take place through the clearing houses of these exchanges.

What investors can do to take cover

With higher inflation likely to erode a good portion of one’s returns, investors must consciously inflation-proof their portfolios. Here are a few pointers.
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It is a bit of a paradox that inflation data should point downward even as commodity prices are headed in the opposite direction. This is exactly what is happening in India today.

Not only are consumer prices well ahead of the official price indices, even the official inflation number is expected to climb over the next year. But why is inflation important, what does it mean to investors and how should they factor inflation into their financials plans? An analysis.

The two commonly used indicators to gauge inflation — Consumer Price Index (CPI) and Wholesale Price Index (WPI) — have historically moved in tandem. But not any longer. Growth in the WPI, after being in the negative zone for 13 weeks, has now barely turned positive, with a reading of 0.3 per cent for the week ended September 12, 2009.

But growth in the CPI-Industrial Workers is a whopping 11.8 per cent for the latest month (July 2009). (In this analysis, we refer to the CPI-Industrial Workers index as CPI, as that may be most representative for the urban consumer).

If as an investor, you took note of the official inflation numbers (the WPI) to conclude that inflation was at a low ebb, you would be mistaken, as it is the CPI that is more representative of the prices you pay.

Higher inflation in consumer prices

In fact, such a divergence between the CPI and the WPI is of fairly recent origin. Between 1998 and 2008, inflation measured by the two indices moved in much the same way, with the correlation between them at a near perfect 0.99. However, that completely changed in the last year, with the correlation slipping to a negative (-0.14), suggesting that the CPI has moved up even as the WPI corrected sharply.

The reason for the divergence is explained, to a large extent, by the higher weight assigned to food articles and a lower one to fuel prices in the CPI. Food and food products form 46-67 per cent of the CPI, against 25.4 per cent in the WPI indices. On the other hand, fuel and other energy products have weights of 14.2 per cent in the WPI against 6.43 per cent in the CPI.

A rising CPI may also indicate that the services you consume are getting more expensive, as it takes into account expenses on housing (15 per cent weight) and services such as health, education, telecommunications and transportation, which are ignored by the WPI.

In the first half of 2008-09, WPI inflation ruled higher than CPI due to higher prices of oil, manufacturing products and metals putting upward pressure on the index. As oil prices and prices of other commodities (metals and minerals) cooled off, WPI began to fall; simultaneously, supply constraints started showing up and the CPI began to tread higher ground, outpacing the WPI.
What it means for investors

Having noted the divergence between CPI inflation and the official inflation numbers, what are the implications for investors?

Lower real returns: CPI inflation at 11.8 per cent, implies that investors who ploughed their savings into an 8.5 per cent one-year deposit offered by a public sector bank in July last year, would have ended up with a negative 3.4 per cent real return. The annual rate of CPI inflation in the last five years was 7.3 per cent.

This implies that any fixed income option that delivered less than 7.3 per cent has been fetching the investor a negative return in real terms. Note that inflation erodes your real returns from fixed-income investments. In a savings-focussed country such as India, where much of the savings are ploughed into bank deposits, higher inflation may effectively erode a good portion of the investors’ returns and, at times, the principal as well.

Therefore, investors who put their money mainly into fixed income investments have to make a conscious attempt to seek out those that offer high double-digit returns. Or they should add riskier investments to beat inflation.

Factoring inflation into your long-t erm plans: Financial planners usually assume a 5 per cent inflation rate (based on the WPI) to compute targets for long-term financial goals in Indian context. But the recent CPI-WPI divergence suggests that they should actually be assuming a much higher number.

As mentioned above, CPI in India over the last five years has grown by nearly 7 per cent annually. An investor may also need to have some margin of safety against factors that may drive inflation up by one or two percentage points in a particular year.

Rejig your investments: In high inflation scenario, a reasonable and real rate of return can be expected from investments in assets such as equity, commodities and real estate. Equity investments, which registered negative real returns the last year following the global meltdown, have recorded stellar returns during the bull market (2004-08), even adjusting for inflation.

The Sensex return during 2004-08 grew by 30 per cent, compounded annually, while CPI inflation grew at 6 per cent. This implies equity investments can conserve capital and may offer real returns.

Investors also have a hedging option against inflation in the form of commodity-oriented mutual funds, which take exposures to stocks of commodity producers or miners.

These are bound to be directly linked to the commodity basket tracking inflation. However, unlike equity, the options among commodity linked funds are few.

Some of the commodity funds offered in India are Magnum Comma Fund, DSP BlackRock Natural Resources and New Energy Funds and Mirae Asset Global Commodity Stocks Fund.

Purchasing property also acts as a good hedge against inflation, especially for people renting it out. Data suggest that rents grew at a decent pace in the last few years, apart from providing capital appreciation on the property. NHB housing index indicates that property prices went up 17.8 per cent CAGR in 2001-07 in five major cities.

Data suggest significant capital appreciation for property investments historically, notwithstanding the recent correction. Not only is the choice of investments important but also the marco-economic outlook, especially keeping tabs on the monetary response to inflation by the central bank.

Interest rate moves: One facet of your investments directly linked to inflation is interest rates. The Reserve Bank of India has traditionally used its policy rates to quell inflation.

As WPI inflation shot up from 7.8 per cent to 12.8 per cent between September 2004 and August 2008, the RBI increased repo and reverse repo rates by 300 and 150 basis points respectively and the cash reserve ratio (CRR) for banks was raised by 450 basis points to normalise inflation.

However, current divergence in the indices may put the central bank in a Catch-22 situation as CPI growth continues to stay high, even as WPI remains low. The benign interest rate regime may not be reversed until there are signs of revival, notwithstanding the spike in food prices and fiscal expansion.

With inflation expected to go back to high single digits by this financial year-end, the market expects moderate and gradual hikes in policy rates from January next year. Lending rates are sure to trend up if that happens. And bank deposit rates may catch up only later.

Debt funds boost mutual fund assets: CRISIL

The mutual fund industry’s assets under management (AUM) reached a new peak at the end of August touching Rs.7.57 trillion, growing by 5 per cent over the previous month. Only the debt category, driven by ultra short term debt funds, registered net inflows during the month. All other categories saw net outflows.

As for returns, equity funds outperformed due to strong performance from mid-cap and small-cap funds while long-term debt funds saw negative returns due to rising yields. “Ultra short term debt funds saw strong inflows in August, with banks parking their surplus funds in these schemes. The new no entry load rule seems to have initially dulled the inflows into equity funds even though fund performances were good during the month,” said Krishnan Sitaraman, director, CRISIL Fund Services.

Poor monsoon to affect auto sector after festival season

Edelweiss Research has said in a recent report that in North, West and South India, the impact of a weak monsoon does not seem to be substantial so far on the passenger car and two-wheeler segment. Nearly 90 per cent of the dealers (barring some in UP and Haryana) that their researchers met expected the festival season beginning October to be strong. The exception is the tractor segment where inventory build up is visible.

Based on their interactions with dealers, the researchers have concluded that around 50 per cent of two-wheeler and 30 per cent of car volumes in the rural sector are accounted for by farmers, around 30 per cent by the salaried class, and the balance by businessmen (primarily small traders, dependent on farmers for their income). Hence, around 70 per cent of vehicle buyers are directly or indirectly dependent on agriculture. Hence, most dealers (over 90 per cent) expect the impact of poor rains on volumes to be felt December onwards. However, late rains (that augur well for the post monsoon Rabi crop) and various measures by state governments may buffer the blow.

WPI inflation turns positive

For the week ending September 5, 2009, headline inflation (the wholesale price index, WPI) stood at 0.12 per cent. Inflation for the week ending 11 July 2009 was revised to (-) 0.63 per cent from (-) 1.17 per cent. “Looking forward, we expect food prices to move up due to the start of the festive season in October. WPI inflation could cross 7 per cent by end March 2010,” says a research note from Anand Rathi Financial Services.

L&T Finance buhttp://www.blogger.com/img/blank.gifys Asset Management Arms Of Chola DBS for Rs 45cr

The transaction indicates how valuations have dropped in the Indian mutual fund space.

L&T Finance, the subsidiary of engineering and construction major Larsen & Toubro, has acquired 100% stake in the asset management business of Cholamandalam DBS Finance Ltd for a consideration of Rs 45 crore.

With this deal, L&T Finance gets to deepen its offerings in the financial services segment while Cholamandam DBS’ exit from asset management business will allow it to focus on its core areas. L&T recently raised $200 million from an issue of non-convertible debentures (NCDs).

The transaction indicates how valuations have dropped in the Indian mutual fund space. Valuations have come under greater pressure after capital markets regulator Securities and Exchange Board of India announced a move to abolish front-end or entry fees charged by mutual funds from August.

Cholamandam DBS is a joint venture between Murugappa Group and Singapore’s DBS Bank. The acquisition includes 100% stake purchase by L&T Finance of DBS Cholamandalam Asset Management Ltd (DCAM), DBS Cholamandalam Trustees Ltd. (DCTL) as well as involves the transfer of DBS Chola Mutual Fund (DCMF) and the schemes under the fund. DCAM has average assets under management of Rs 2,893 crore as of August 31, 2009. The transaction has happened at little more than 1.5% of the assets of the fund.

Earlier reports indicated that DBS, the largest bank in Singapore, will buy the partner’s stake in the whole venture. Equirius Capital advised L&T Finance while Edelweiss was sole advisor to Cholamandalam DBS.

Recent transactions in the industry like Nomura's stake buy in LIC Mutual Fund and Religare Enterprises' buyout of Lotus India Fund also happened at low valuations. LIC-Nomura deal happened at 2.5% of the funds assets while Lotus-Religare deal happened at 1-2% of the funds assets. Lotus India was owned by Singapore's sovereign wealth fund Temasek and private equity firm Sabre Capital Worldwide.

Compare this to peak valuations of 2007-08. In March 2008, Standard Chartered sold its Indian asset management business to Infrastructure Development Finance Co for $205 million, valuing the firm at about 6% of its assets under management. In December 2007, Reliance Capital sold about 5% of its fund unit for Rs 500 crore, valuing India’s largest fund firm at 13% of total assets.