Mutual Funds 101: How to avoid choosing a bad fund

I was planning to write this for quite some time now. I will draw on my (short) experience of 3 years with mutual funds for this article, still with the aim of getting more people to invest in the Indian stock market and the Indian economy. I am writing this article for Investors, not for traders/speculators. It will be a bit of a long article, and I will describe the steps I take before I put money in a mutual fund.

What is a Mutual Fund?
A Mutual Fund is a group of people that takes your money and puts it into stocks/bonds etc. of companies which they think will do well and hence generate returns for you. Since this group manages your money, they charge a commission annually which is a percentage (Expense Ratio) of the total amount being managed. And they will charge this commission even if they incur losses on your money. The only thing that you can surely predict about mutual funds is that in any eventuality, even if they lose all your money, they will still charge you expenses!
So you provide the money, you assume all the risk, you will lose money, and they will still get their expenses. Can you guess that I don't like fund expenses? :). These expenses assume crazy proportions over the long term.

On predicting the future.
The most important thing that I can tell you before you get started is: You cannot predict which mutual fund will do well (better than average) in the future, and you cannot also predict the stock market. That said, what you can do is avoid choosing a bad mutual fund which gives you bad returns and hence loses money for you. 4-5 well chosen mutual funds are enough for any investor.

On the goals of a 'know-nothing' mutual fund investor.

According to me, all mutual fund investors should aim to do the following:

• To invest in a well-diversified basket of 4-5 mutual funds, not more
• To invest so that he has exposure to Large, Mid and Small Market Capitalizations [1] (which is implied by diversification)
• To stay invested in a good mutual fund for at least 10 years
  

All Indian investors should know that there is no tax on profits if you stay invested for at least a year i.e., there is no long-term capital gains tax. So if you buy a mutual fund and hold it for 1 year or more, you will not pay any tax on the profits and they will be completely yours. Mr. P. Chidambaram (India's finance minister) has done a good job with this policy to get more people to invest for the long term.

Choosing a mutual fund Step 1: Expenses

The first step should always be to know the expenses of the mutual fund which is indicated by the Expense Ratio [2]. In India, the usual expense ratio is around 1.9-2.4% and is very high. Average expense ratio in the US is 1.5%. You can find out the expense ratios of mutual funds on www.personalfn.com. Besides the expense ratio, all mutual funds have to pay the broker who tricked you into investing in their mutual fund. This is called the 'entry load' and is about 2.25%. So whenever you invest in a mutual fund, you lose about 2.25% at the start and 2% annually.

What I do is to try and choose a good fund with the lowest expenses i.e. minimize expenses. And this is where Index funds have an advantage, they have the lowest expenses and generally no entry load. The expense ratios of all other actively managed mutual funds in India are more or less the same and therefore the expenses have not played that big a role till now. They will when the expenses start going even more crazy. In the US, mutual funds with high expenses are known to give below average returns.

Choosing a mutual fund Step 2: Portfolio Turnover

All investors should be looking to invest for the long term and not trade. But if the mutual fund they invested in plays trading games, then the whole idea of being an investor is lost. The Turnover Ratio [3] is a measure of how frequently the mutual fund trades stocks. To explain it simply, a turnover ratio of 50% means that this mutual fund changed half the stocks in its portfolio during the previous year implying it holds a stock for 2 years on average. Mutual funds who sell stocks without holding them for at least 1 year pay taxes on the profits, and these are passed on to you.

Since I am a long-term investor, what I try to do is choose a fund with the lowest turnover ratio i.e. try to minimize turnover ratio. Index funds are not supposed to trade and so have TRs of less than 10%, i.e. they hold a stock for 10 years on average. I could also find a regular fund that had a TR of 20%. Now that is a good fund. This also implies that this fund researches its stocks before buying.

Finding the turnover ratio is an arduous task in India, and it takes a lot of phone calls to find out. If you're lucky, the MF will publish its turnover ratio in its fact sheet.

Choosing a mutual fund Step 3: Asset Size

One of the things I observed with my investments was that funds whose asset size is huge, tend to perform below average [4]. This is explained in many books as: when the mutual fund has a lot of cash to invest, it has trouble finding sufficient number of good investments to put money in. Hence I try also to minimize asset size. I try to choose funds which are not huge and don't need to find that many good investments.

Choosing a mutual fund Step 4: Past Performance

I repeat, you cannot predict whether a mutual fund will do well or not, you can only avoid choosing a bad mutual fund. Past performance does not mean that this mutual fund will do well in the coming years also. In fact, it is more likely to do badly [5].
Hence after I decide on my mutual fund based on the above 3 criteria, only then do I look at the past performance and the mutual fund rating just to make sure that this fund indeed can deliver an average performance. You can find that on www.valueresearchonline.com and also www.personalfn.com.

My mantra is: ETA - minimize Expenses, minimize Turnover and minimize Asset size.

P.S.
For the past 2 years, Index funds have outperformed almost every other type of fund by a wide margin as shown in the picture below:


Appendix.
[1] Market Capitalization
[2] Expense Ratio
[3] Turnover Ratio
[4] Asset Size
[5] Past Performance