It goes without saying that choosing a mutual fund is the most critical aspect of fund investing. How well your investments perform is directly dependant on how you pick them. It is safe to say that picking the right fund is almost as good as ensuring good returns on your investments. But, despite the fact that choosing funds is such an important factor, most people often seem to falter at this very step.
There are a lot of different approaches used to choose a mutual fund. When it comes to equity funds, the approach that is most ineffective is the one based on the fund’s portfolio. Under this approach, an investor – and quite often even an analyst or expert – looks at the fund’s recent portfolio statement and decides for or against the fund on the basis of the stocks it holds. I can’t stress enough on why this method is a futile way of choosing a fund to invest in.
Firstly, this approach is wrong because it takes away the basic advantage of investing in a fund. You invest in a fund because you don’t have either the time or the knowledge, or sometimes both, required to dabble in stocks. So you let the fund manager do it for you. But when you start decoding a fund’s portfolio, you are doing nothing but dabbling in stocks and worse, also assuming that you are a better judge of stocks than the fund manager. In general, stock investors who feel the need to venture into funds as well use this approach. Apart from them, this method is used by broking firms who have started selling funds. In such firms, the stock analyst analyses the funds as well. And hence, he looks at the fund’s portfolio. If he doesn’t like the stocks in it, he renders the fund unfit for investment.
This approach has been appearing in the media a lot too. Recently, a financial publication published a misdirected article that picked individual stocks in isolation from funds, followed the fund managers’ actions on those stocks through a couple of years and then declared those actions to be illogical. What amazed, and amused, me was that they didn’t realise that the funds that they had picked out were funds that had mostly outperformed their benchmarks and peers over the last few years.
This is just another example which shows why a fund shouldn’t be analysed on the basis of its portfolio. A fund buys or sells a stock for myriad reasons, many times for reasons that have nothing to do with the stock’s performance. At times, another stock from the industry could be more attractive. At times, there could be an internal limit on an industry, or to the company. And likewise.
Hence, a fund shouldn’t be analysed on the basis of its portfolio. For most funds, a look at its past returns-based performance is more than enough. A comparison of a fund’s returns, vis-à-vis its benchmark’s or peers’ returns, will give you a fair idea of whether the fund is worth investing in or not. The fund’s portfolio should be looked at after it has answered other basic questions. The portfolio should only be seen to know if the fund is concentrated, is it churned a lot, does it have exposure to emerging sectors, etc. The portfolio should be used to decide between two otherwise similar funds, not as a primary deciding factor....
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