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For the equity part of their portfolio, individual investors have the choice of either directly buying stocks or following the equity mutual fund route. Many individual investors, including myself earlier on in my investing life, make the mistake of evaluating mutual funds similar to stocks. The way to evaluate funds is quite different from evaluating stocks for investment.
Why is that? While direct stock investment involves researching and valuing businesses, and buying/selling them at the right price, mutual funds are pools of stocks where the fund manager takes those calls. Hence, what is important to evaluate is the ability and track record of the fund manager to take those calls, and whether that results in performance that is worth paying a fee for. The markets already do stock selection for you in the form of an Index for free. So what the fund investor needs to evaluate is whether the fund manager is worth paying the fees to – so as to get returns that are better than the Index on a consistent basis.
What to base your decision on:
Mandate: As mutual funds are a vehicle and have a role to play in the portfolio, it is important to ensure that the mandate of the fund is in line with your objective, and that the fund has a record of sticking to the mandate, despite changes in ownership or fund managers.
Costs: The disadvantages of high costs of research and fund management can tend to surpass the advantages of better performance of actively managed funds, specially over long periods of time. So choosing funds with low costs is important. Index funds typically have the lowest costs, and guarantee returns in line with the Index. So an actively managed fund’s higher costs need to be compensated by its better long-term performance.
Performance versus Index: This is often exaggerated as a standalone metric, specially over short periods of time. An investor should resign himself to the possibility of even his best fund choices not being the top performer at least some of the time. Even the best performing funds over long periods of time will have periods of under-performance. It is also difficult to predict which fund will deliver better performance in the future, even though it may have done so in the past. So rather than constantly shifting to the best performing fund, it may be better to choose one that has a record of beating the Index or being in the top 10% most of the time, and sticking to it over long periods.
What not to base your decision for:
Price: The price or NAV of the unit is completely irrelevant, and depends largely on the starting point of the fund. This feels counter-intuitive to most individual investors, and takes a while to understand. An investor should not even look at the NAV of the fund or compare it to others before purchasing it.
Dividends: Dividends paid by the stocks held by the fund are reflected in the NAV. Dividends paid by the equity mutual fund are simply a reflection of profits booked by the fund for you and paid back to you. Again this is counter-intuitive for most investors to understand, and lot of fund companies perpetuate this fallacy by marketing their funds based on historical dividends paid. An investor has no reason to feel anything positive about a fund because it pays dividends regularly. If at all, it may even be a negative specially if the fund is booking profits prematurely and not in line with the mandate of compounding capital appreciation.
So broadly, while choosing individual equity mutual funds to fit into his portfolio, the individual investor should neglect price and dividends, and evaluate funds based on adherence to mandate, low costs, and consistent performance versus index; and based on the same, construct a diversified mutual fund portfolio to meet goals.