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  • How should an investor choose a good Mutual Fund?

    April 17, 2014

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    The idea of a mutual fund is very simple. Investors pool in their resources and the professional managers manage that money to give reasonable returns to the investors. The managers are the stewards of the monies entrusted to them. For the professional services rendered they are adequately compensated. However the managers rewards being linked to the amount of assets under management has created a big distortion.

    There is a race for assets under management. The basic idea of stewardship has been sidelined and asset management companies have become marketing organisations. The rewards of the managers are not dependant on the returns they create for their unit holders. A disproportionate returns to the managers without taking any risk, as against measly returns to investors who take all the risk.

    When AMC’s turn in to marketing organisations they try to cater to any fancy in the market. They are not looking at investment opportunities that the market will offer and the fund managers ability to capitalise on them. They are looking at what will sell in the market. Say for instance there is a real estate boom, you will find real estate funds hitting the market.

    Then different variations are used like, large cap fund, mid cap and small cap. Then we have top 200, top 500 and so on. Now if you were a fund manger of a real estate fund you can invest only in the real estate sector.

    So you have to forgo all other opportunities in the market. Similarly if you are managing a small cap fund and there is a great arbitrage opportunity in a large cap fund you miss out.(Hindustan Lever had come out with a buy back offer. The shares were available in the market at Rs.590 and the company was buying it back at Rs.605.

    A straight arbitrage of Rs.15 per share. Attractive opportunity? But if you are a real estate fund, a mid cap fund or an infrastructure fund you have to miss the opportunity.

    When the marketing people decide on which scheme to get in the market, they are only thinking short term and are trying to capitalise on the euphoria prevailing in the market. Multiple schemes depending upon the current fancies have led to confusion amongst the investors and has led to the dismal performance of such short sighted funds.

    Other irrationality prevalent in the markets is the practice followed by the mutual fund tracking organisations. They only track mutual funds who have a track record of three years. Now all mutual funds come with a disclaimer “ Past performance is no guarantee for future performance”.

    Then I really do not understand the logic of these professional bodies only tracking mutual fund with a three year record. Qualitative factors like the credibility of the sponsors, their track record in capital markets, the design of the scheme, their commitment to the investment process, their investment strategy and principles, skin in the game etc. have no bearing.

    Such absurdity I would say is due to the lack of ability to judge these qualitative factors. Investors made more money by investing in companies like Amazon, Google, Reliance, Infosys, to name a few by investing in the early stages when track record was not available. That is how Silicon Valley has sprung up. Investors make decisions on people and business models. When that works it rewards the early entrants handsomely, and those who wanted to play safe and entered after the track record get the crumbs. This is what capitalism is all about.

    For a mutual fund, the scheme structure is essentially the business model and the people who run it. It is important for the investors to understand as to how to choose a mutual fund. I would say that a fund which gives maximum flexibility to the fund manager to reap investment opportunities in the capital market is important.

    The job of the fund manager is to capitalise on any investment opportunity that exists in the market. A scheme so designed forms the pillar for efficient management of monies entrusted. Such a scheme can be designed by the top management who have expertise in the financial markets and believe that they are in a stewardship capacity.

    Such managers will also invest their own money in the fund. They would have skin in the game. It not only shows commitment but also a strong belief in their investment principles and processes.


    Now, who would have a fund like this? Only those who have seen the ups and downs of the market and have been a part of the capital market for a long period of time. It is immaterial if the fund is new and does not have a track record. What is important is the people and the scheme structure. This reflects upon the management’s experience and maturity. But unfortunately investors will not know of such funds as they will not be tracked for three years.

    One such fund is Parag Parikh Flexi Cap Fund. The sponsors have a track record of over 30 years in the market although the fund was recently launched in May 2013. The scheme is designed by the management who have such rich experience in the capital markets. 65% of the AUM at all times will be invested in the Indian Equities.

    That allows it to get tax exemption status of an equity mutual fund. 35% in to International equities or debt. This is for geographical diversification or parking opportunity money. The scheme can invest in all asset classes, do arbitrage, invest in special situations like buy backs. no bar on caps etc. The fund manager has to look out at opportunities in the domestic as well as international markets and grow investors’ wealth. The sponsors, directors, fund managers and employees have all invested a substantial portion in the fund.

    They have their skin in the game and their interests are aligned with those of the investors. They have only one scheme and do not intend having any other, as the structure of this scheme allows them to capitalise on all investment opportunities that arise in the capital markets. They are not in the race for assets under management and do not have a sales team.

    On the contrary they dissuade investors with a short term focus by having a printed message in red on their form which reads “This fund is not meant for investors having an investment horizon of less than five years”. Unfortunately the fund is not tracked by anyone as it does not have a track record of three years.

    So next time you are looking to invest in a fund look at the qualitative factors like management, skin in the game and the scheme design.

    The original article could be seen here.
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    Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
    © PPFAS Asset Management Private Limited. All rights reserved.
    Sponsor: Parag Parikh Financial Advisory Services Limited. [CIN: U67190MH1992PLC068970], Trustee: PPFAS Trustee Company Private Limited. [CIN: U65100MH2011PTC221203], Investment Manager (AMC): PPFAS Asset Management Private Limited. [CIN: U65100MH2011PTC220623]