Monday, February 19, 2007

Systematically narrow your choices

Work your Way up with your Wealth building Winners! (Contd.)

Performance Evaluation of Mutual Funds (contd.)

Systematically narrow your choices.

Having researched for consistent performers with sound credentials, you must have got a long list of such Funds. You can quickly whittle down the Fund list by using a few criteria like costs (already dealt with in detail in the articles dated 8, 15 and 22 October, 2006), size, investor concentration, customer service and tax implications.

Size of the Fund

When it comes to assessing the impact of a scheme’s size on its performance, the dynamics vary for Debt Funds and for Equity Funds.

Scheme size is an important consideration for income funds (debt funds that invest primarily in corporate debt), but not as much for their two cousins, gilt funds and money market funds. Corporates tend to peg the minimum subscription amount in debt at Rs 5 crore. A portfolio of 10 top-rated holdings is adequately diversified, and diversification beyond that does not reduce the risk proportionately. Assuming 10 holdings and a minimum lot of Rs 5 crore, Rs 50 crore is the bare minimum you should look for in an income fund. Since there is not an abundance of top-rated paper around, large-sized income funds are compelled to look at paper that does not have the highest rating or government securities which offer lower yields compared to corporate paper of identical maturity. Given that just Rs 300 crore worth of corporate paper is traded in a day, it is easier for a smaller fund than a large-sized fund to meet redemptions. In practice, though, it boils down to how well a fund manager manages its redemptions. An important advantage of a big corpus is that it helps in negotiating better terms in private placement deals. In fact, a performance analysis of income funds shows that schemes with a corpus of over Rs 500 crore delivered healthy, consistent returns. On the other hand, schemes with a corpus of Rs 50 crore and below under-performed and failed to deliver consistently.

In the context of the present asset sizes of the Indian Equity Funds, a huge asset size is more of a concern for schemes, investing predominantly in mid and small-cap stocks. The main reason is that such stocks happen to be relatively less liquid. The increasing corpus of a mid-cap fund can translate into disproportionately high amounts of money being invested into less liquid mid-cap stocks. This could be detrimental to your interest, if markets experience a sudden decline. A huge size can become a drag on performance. This is because even a large amount of money invested in a small but promising stock would constitute only a miniscule portion of the fund's portfolio. And should the stock perform very well subsequently, its impact on the fund returns would be meagre. Unlike mid-cap stocks, large-cap stocks are much more liquid and have the potential to absorb much higher volumes of transactions without impacting the stock price too much.

Investor concentration in the Fund

According to a study, almost 20% of India’s equity schemes are dominated by a handful of investors. Hard numbers show that a single investor holds 25-94% of the corpus of 23 equity schemes. The dominance by a handful of investors indicates the presence of corporate money, which is mostly short term in nature. Retail investors are vulnerable to investment decisions of such big investors. If they decide to redeem their holdings at short notice, the scheme might have to press panic sales, to the detriment of residual unitholders. If the single investor exits the scheme, the rest will be left in the lurch. Such schemes should be avoided.

Customer Service

Performance alone does not make a Fund a winner. Equally important is the service standards, speedy solutions to grievances of investors and transparency in actions. The reputation of the fund house among its investors and public at large indicates how well the fund scores on this front. Check with friends about easy accessibility, time taken for disbursing payments, regular portfolio updates and investor newsletters.

Tax implications of investment in Mutual Funds will be dealt with in detail in the forthcoming blogs.

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