Judge Before You Jump

Investing in equity funds is considered to be as simple as picking up a few top performing funds and then waiting for the results to be declared. No wonder, many investors often get carried away by the ‘flavour of the month’ funds. The truth, however, is very different. Though past performance is an important factor in the selection process, it can be suicidal to go by the short-term performance alone. The right way to shortlist a fund for investment is by comparing its performance to funds with similar objectives over a period of at least 3-5 years. Of course, the risk taken by the fund to deliver those returns has to be carefully assessed too.

Simply put, knowing what to expect in terms of returns and how to measure the performance is very important. All of us hope that the funds that we are invested in should continue to do well consistently. In reality, the performance of some of the funds may slip. While there is no need to panic each time the market turns volatile, it helps if one is prepared to deal with such a situation. For a long term and disciplined investor, fluctuations provide opportunities that casual or ‘one time’ investors miss out on. If the fund loses ground in a falling market, it should not cause concern. However, if the fund goes down when others are going up, it can be a warning signal. The consistency in the fund’s performance is the key for long-term success.

The core portfolio should consist of funds that are managed well and have the potential to provide consistent returns. While analysing funds over 3-5 years one should ignore funds that show very high past returns over a certain time period but are inconsistent performers over the remaining time periods. If one has sector funds in the portfolio, the results might be different from broadly diversified funds due to their narrow focus. That’s why one must have a mix of funds in the portfolio. A haphazard approach can result in over-exposure to a particular market cap or a sector/industry and thus jeopardize the chances of success.

Then there is the issue of choosing between a diversified and a concentrated portfolio. A well diversified portfolio enables an investor to spread his/her investments across different sectors and segments of the market. The idea is that if one or more stocks do badly, the portfolio won’t be affected as much. On the other hand, if a few stocks do very well, the portfolio won’t reap all the benefits. A diversified fund, therefore, is an ideal choice for someone who is looking for steady returns over a longer term.[PAGE BREAK]

A concentrated portfolio works exactly in the opposite manner. While a fund with a concentrated portfolio has a better chance of providing higher returns, it also increases one’s chances of underperforming or losing a significant portion of portfolio in a market downturn. Thus, a concentrated portfolio is ideally suited for those investors who have the capacity to shoulder higher risk in order to improve the chances of getting better returns.

Another important area that needs to be closely monitored is the size of the fund.  It is a proven fact that a fund can become a victim of its own success. In other words, it can become too unwieldy to manage efficiently. However, it is important to look at the fund size in the context of its nature and investment style. A fund’s performance can suffer in case it outgrows its investment style. Once the non-performers are identified on the basis of a comparative performance with the peer group over a reasonable time period, one should not hesitate to get rid of them. Many investors often get emotional about non-performing investments and wait endlessly in the hope of better results. More often than not, it can be a fruitless exercise.