How not to choose mutual funds

Do you have a check-list of what to avoid? For, when you want roaring returns, you can’t have them merely purring

November 10, 2019 10:30 pm | Updated November 11, 2019 11:53 am IST

Red cat with lion shadow

Red cat with lion shadow

If you’re wondering why I didn’t address the straight question of ‘how to choose mutual funds,’ here’s the straight answer: there’s no cookie-cutter approach to it.

Many factors such as your life situation, requirement and risk capability play a role in choosing mutual funds, besides the fund performance. But if I can list some of the things you can avoid while choosing funds, you’ll have a higher probability of doing it right. So here goes:

Dividend declaration

You don’t choose funds because they declare high dividends, for several reasons: one, there is no mandate for the fund house to declare such dividends regularly nor are they required to declare at a fixed rate. For example, when the market is down, a fund may simply stop declaring dividends.

Two, in equity funds, you invest to build wealth for the long term. Regularly stripping profit is also not a good idea since you do not allow your wealth to grow.

Three, there is now a dividend distribution tax of 10% on equity funds, which make it at par with tax on long-term capital gains for equity. So, when you need some returns, you can simply sell your units and not wait for dividend to be declared.

Additionally, in debt funds, the concept of dividend makes little sense what with systematic withdrawal plan (SWP) giving you a far more tax-efficient way to generate regular income. With dividends, you will suffer a 29.12% dividend distribution tax (in your NAV), irrespective of which tax bracket you are in.

With SWP, you will be taxed in your slab rate in the short term. More importantly, only a portion of your withdrawal (capital gain) will be taxed, thus effectively reducing the tax, even in the highest bracket. In the long term, further tax benefits through indexation make SWP the best option.

Low NAVs

Some investors who come into mutual funds with a stock investing background cannot help studying the 52-week high and low patterns of funds. A fund that is near its 52-week low does not automatically signal a buy opportunity. A scheme’s stock picks may have gone terribly wrong leading to its NAV slide.

That is not a buy signal. Besides, when markets slide, fund managers look for mispriced opportunities. There is little need for you to sit on top of that to discover low NAV funds. At best, you can focus on averaging your own investment by adding any surplus to existing investments.

Fund house familiarity

Many of you are familiar with the names of your bank and their pedigree and therefore prefer or think that the funds from such bank-backed AMCs are the best ones.

This is not necessarily true. Many of the bank-backed funds did take a hit in the recent debt fund crisis and many other bank-backed funds have had a poor track record in equity. When it comes to mutual funds, the track record of the fund, its consistency in performance and the fund manager’s track record matter more than your own familiarity with the name of the fund house.

Fund size

While you may take comfort from size (like a large bank is better than a small bank), the same may not be entirely applicable when it comes to the scheme’s asset size. In debt funds, size will matter to ensure the fund can support liquidity. In equity, size can sometimes be a deterrent. For example, large asset size for a small-cap fund can be a curse more than a blessing.

Also, when you focus on size, you lose out on emerging, nimble-footed funds that do a great job of managing portfolio adeptly. Hence, look at the fund’s record of performance and consistency in performance rather than the asset size.


With increased awareness of expense ratio, some of you may use this as a primary criterion to choose funds. Mutual funds, unlike insurance schemes, declare their NAV after deducting applicable expenses. Hence, the returns you see is post expenses.

If a fund, especially an equity fund, convincingly beats its benchmark or peers, there is little need to be overtly sensitive to expense ratio in equity funds. In debt, given that returns are not as high, expense ratio can impact returns. However, the quality of the fund, and the risk-reward ratio is more important than expense ratio.

One-year returns

One-year point-to-point returns, especially in equity funds, is deceptive data. Top funds in one-year charts seldom make a repeat appearance in the same rank slot next year.

For example, Aditya Birla Sun Life Equity, which was the top performer in the 2016 calendar was in the third quartile in performance rank in 2017. Why is this so? A fund needs to repeat its super-profit feat again to do that and that is hard. Any point-to-point returns (even 3 or 5 years) can be deceptive. The way to look at performace is to dissect the periods into at least calendar years and see consistency in performance.

That is, a fund should hold its ground; not jump from the top quartile to bottom quartile next year. It should contain declines in down markets.

(The author is Founding Partner —

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