Spotting red flags as mutual fund investors

The advent of digital personal finance tools has ushered in a new chapter in the realm of financial inclusion. From women, senior citizens, early career professionals to those belonging to economically underprivileged backgrounds – the plethora of apps and personal finance portals has simplified money management for a lot of people. Be it drafting a budget, investing in a fixed deposit scheme or mutual funds – these apps have empowered people to learn the tenets of money management and try their hands at it from the comfort of their homes without having to engage any third parties.

The omnipresent universe of apps, finance portals and the availability of a treasure trove of information on different aspects of saving and investing has its downsides too. The high decibel level poses challenges for novice investors in terms of picking the right investment product or service and there are tendencies to give in to peer pressure. In the world of mutual fund investments, this can manifest in the form of investors being oblivious to potential red flags in any mutual fund scheme. Here are a few red flags that you should be privy to when you go mutual fund shopping:

• Many people tend to make decisions based on recent past performances such as returns generated in the last one year however past performances cannot be a guarantee for future returns and taking calls based on such indicators without taking into account facts about the fund’s historical performance should be avoided. It is important to note here that good funds exhibit consistency when it comes to returns, which means that funds with drastic crests and troughs in their annual return graphs can be problematic. Wild inconsistency in returns in the last 5 years or so can be a major red flag.
• If looking at returns is one side of the coin, the second side is analyzing the risk levels entailed in the fund. It is crucial to look at risk adjusted returns when choosing a mutual fund. Also, a fund with high returns and a high volatility may not be a great choice as compared to a fund with moderate returns and lower volatility. While volatility is part and parcel of the game, funds with low volatility are more stable and these funds would usually have investments in stocks of companies that are well-established and thus can bring more stability.
• Deepak Chhabria, CEO of Axiom Financial Services advises that if a mutual fund schemes display a consistently high portfolio turnover, it should ring alarm bells for investors. “Schemes with consistently high portfolio turnover lead to higher cost that eventually is borne by the investor, there may be a period of high turnover due to certain reasons, but if the same persists, investor should raise the matter with the fund management team for an answer.” Portfolio turnover refers to how quickly securities in a fund are either bought or sold by the fund's managers, over a given period of time.
• The processes entailed in the management of the fund and those who have the reins of fund management should also be factored in by investors. For instance, a clear laying down of the processes and framework that are governing the fund’s running is to be taken as a good sign by investors whereas funds that are entirely at the discretion of the fund manager should be viewed with a pinch of cynicism. This is because in such cases the room for error is more and as an investor you would be leaving too much at the behest of the fund manager.
• When it comes to the management team of the fund running the show, investors should look for consistency there as well. Chhabria explains, “Frequent changes in the management team are something I abhor. Every fund manager has unique style and investment philosophy. Frequent changes can lead to period of underperformance or even complete departure from previous manager style. This may not suit investors and may require changes in the investment horizon.”
• A high level of churn at the top level could hint at distress at the fund management company but this should not be perceived as the only warning sign. Chhabria advises, “Something that is totally not negotiable is issues around the integrity of the fund management team. This is a fiduciary responsibility and any let up or whiff of compromise on this principle should be taken very seriously. There may be individual transgressions, but systematic failure at an organizational level is unforgivable and should not overlooked.”

The first step towards picking any mutual fund scheme is to gauge whether a fund fits in to your long term financial plan. And this involves checking whether fund sits well with you in terms of risks, returns, liquidity and tax efficiency. The selection process has to be individualistic. Chhabria says, “Thankfully with SEBI categorization and scheme labeling, deviation from mandate and offer document is difficult for mutual fund schemes. However, this does not eliminate the need for investors to be watchful when they invest or have a reliable intermediary who can keep an eye on the funds and ensure the safety of the money and the performance of the investment.”

Action points

• Trust data over a financial adviser or a broker who urges you to trust them blindly. A little bit of research on your part can go a long way in safeguarding your hard earned money.
• Advisors who overly demonise certain asset classes and overly glorify others should be avoided at all costs. The investment game is one that involves balance and a fair amount of patience for results to favourable.

This article is part of the HT Friday Finance series published in association with Aditya Birla Sun Life Mutual Fund.