Secrets & Tips about investing in Equity Funds

Show me the royal route to geometry

In the famous story, perhaps apocryphal, the celebrated mathematician, Euclid, is asked by the King Ptolemy of Egypt about a simple way to understand the nuances of geometry. Euclid’s response is now a part of mathematics folklore, “Excellency, there is no royal road to geometry.” What Euclid meant was that there are no simple answers in geometry and one has to go through the grind when it comes to the nuances of geometry. That is the principle in the stock markets too; there is no real royal road. All that exists is the hard road of process and discipline. However, when it comes to selecting a more specific product like equity funds, there are some simple secrets that can be of help.

If you are invested in equity funds, you are obviously in it for the long term. Here we look at some basic rules pertaining to equity funds, which can go a long way in helping you with the nuances

Basis for selecting equity funds

That is normally a tough task but the basic rule is that the proof of the pudding lies in the eating. In the realm of equity funds, it is all about long term returns do not obsess yourself with short term returns. Ideally, look at fund returns over a 3-year rolling period each quarter. This will not only get rid of the underperformers quite convincingly, but also largely rules out NFOs. Now you may wonder whether in the process you would lose out on some good NFOs. That is a risk you got to take. In avoiding NFOs altogether, you may miss out on the odd star performer that was launched last year. But 5 year pedigree and 3-year performance should be the key. Also, when you evaluate the performance of your fund focus on the Total Returns Index (TRI) as the benchmark. After all, the fund gets dividends from companies so the index must also measure index returns inclusive of dividends. 

Fund size and expense ratio

Both these things may appear to be small issues, but they do matter a good deal. It is better to invest in a fund with AUM of Rs2000 crore than a fund with an AUM of Rs300 crore. The pressure of redemptions likely to be is lower in larger funds so the forced churn to create liquidity will also be absent in such funds. Also, the costs are lower in the case of larger fund. That gets us to the point of the total expense ratio (TER). Now, TER is the sum total of costs that the fund incurs on marketing, transacting, custody, legal charges etc. This TER wipes away anywhere between 2.50% to 2.75% in the case of equity funds on an all-inclusive basis. Make it a point to select the fund with the lowest TER.

Never lose focus on consistency and risk

More than the absolute returns, it is the consistency of returns that really matters. What exactly do we understand by consistency? Take two funds that deliver 15% CAGR over 3 years. But one fund has generated annual returns in the range of 14-18% while the other fund has generated returns in the range of 2% and 33%. The first fund is obviously more consistent and hence more predictable. This ensures that you can earn these kind of returns irrespective of the time of entry. The second issue is of risk. In equity funds, you basically look at risk-adjusted returns. Let us get this point better. If Fund A earns 18% returns with 20% standard deviation (risk) it is a good performance. However, if Fund B earns 22% returns with a standard deviation of 50%; that is not too impressive. The fund manager is obviously taking more risk than he should be taking.

Be systematic and be disciplined

Your fund choices have to be consistent and disciplined in a number of ways. When it comes to equity funds, we know that SIPs give us the advantage of rupee cost averaging. However, there is a lot more to the discipline story. You need a consistent management in the first place. The question you need to ask is whether the CEO, CIO and fund managers keep changing; or whether the team has been stable for a long time. When fund teams stick around longer, they build consistency around a common style and that helps them in enhancing performance. In the final analysis, having a stable fund management team does matter a lot to performance and strategy.

Even at the risk of being repetitive, we need to reiterate that investors must always adopt a Systematic Approach to investing in equity mutual funds. That is what a SIP is all about. Instead of trying to invest in lump-sum you invest regularly. For instance, a small SIP of Rs10,000 per month over 25 years can generate a huge corpus. SIP gives the benefit of rupee cost averaging resulting in a reduction in the cost of acquisition of the fund. That also eventually enhances your ROI. Above all, investing via SIPs in equity funds builds long term commitment to equities and also instils a savings habit in people early on in life.

The last point is about being consistent about your goals and having a clear glide path towards these goals. That is achieved by a financial plan and for that you must ensure that you do not invest in equity funds at random. Of course, there is one important takeaway for investors. When it comes to equity funds, you must always be conservative in your return expectations. That way you are less likely to be disappointed.