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Stock Mutual Fund Classifications
Commonly stock mutual funds are divided into 5 basic categories:
1) Growth funds – Seeks long term capital appreciation by reinvesting the dividends.
2) Dividend Yield/Equity Income funds – Invest in high dividend-yield stocks with the objective of regular income.
3) Value funds – Invest in companies which are trading at discount to their intrinsic value. It seeks a combination of growth and income funds, often focusing on stocks with above average yield and below average Price-to-Earning ratio
4) Broad-based specialty funds – These are sub sector funds like Large cap, Midcap, Small cap funds, international funds, etc
5) Sectoral/Concentrated specialty funds – Invests in stocks of single industry like Pharma, healthcare, etc
The most critical determinant of an stock mutual fund is the performance of stock market as a whole. On average, the market explains about 85% of the total return of most growth, value and stock income funds.
One common mistake is to invest based on funds past returns rather than the appropriateness of fund’s investment objective. You should always read the fund’s investment objective.
If you are in the accumulation phase of your life cycle – unconcerned with generating current income and interested in minimizing taxable income, you may prefer a growth fund. Conversely if you are in distribution phase you may prefer an stock income fund or a value fund.
Structural characteristics of stock mutual fund
Too many investors select a common stock fund based solely on its past performance record. You should look at the past performance but only after a review of the fund’s principal structural characteristics.
1) Size of fund –
As a general rule you should probably avoid the funds with assets less than 100 crores (bottom 10%). There are two reasons, one, relatively higher expenses associated with small funds. Second, fund may not survive or may change its investment objective to get more traction. If you are seeking high returns, you should also exclude funds with more than 15000 crore (top 5%). It is not because
larger funds will fall short of returns than smaller fund. But because of Regression to Mean principle.
2) Age of fund-
For a fund to prove its merit, it should be in market from at least 5 years.
3) Tenure of Portfolio Manager –
Generally, funds are run by a team of managers and performance depends on lot of factors especially, market conditions. If a fund manager’s investment style contributed to the past growth, then a recent change in manager may also be a factor to consider.
4) Cost of Ownership –
The conclusion is not that you should always select the lowest-cost fund, but other things being equal lower costs would translate to higher returns. Generally, people look into exit load and expense ratio only, there is also an invisible transaction cost which is a result of Portfolio Turnover, make sure you take that into account as well. We will cover costs in detail in a separate article.
5) Portfolio Characteristics –
Here the most important factors to look for are Portfolio concentration, Market capitalization, Portfolio turnover, cash position.
Portfolio concentration – One good measure to check for funds concentration is checking the funds 10 largest holdings. In most concentrated funds it might comprise up to 50% of the portfolio, in less concentrated funds it might comprise up to 15% of portfolio.
As a general rule, the greater the concentration, the greater is opportunity to provide for differentiated performance. (The differentiation can be positive or negative). It is also important to check the industry concentration in a fund’s portfolio as
a further measure of its level of diversification.
Market Capitalization – It tells whether the fund emphasizes on the stocks of blue-chip companies with large market capitalization, emerging companies with small market capitalization or something in between. There is no right or wrong average market capitalization but knowing this gives you a sense of investment philosophy of the fund.
Portfolio Turnover – The purchase and sale of stocks in a fund’s portfolio is often too ignored by investors. But it is an important indicator of funds’ fundamental investment strategy. Low turnover tends to indicate a longer-term investment orientation, high turnover indicates a short-term investment horizon of fund manager.
Impacts of turnover
1) Cost of managing the fund – higher the fund turnover, higher the transaction costs
2) Realization of capital gains – higher the turnover, higher portion of total return is realized and thus taxable for capital gains, if distributed.
6) Portfolio Statistics
To compare various funds that are similar in their investment approaches, you need to understand three measures.
R squared – this indicates the relationship between a fund’s return and the benchmark market
index.
In a typical mainstream stock mutual fund R squared is something around 80-90%, meaning 90% of the overall returns are explained by the performance of overall stock market. Only the remaining 10-20% is explained by some combination of fund
investment strategy, tactics, stock selections, etc.
A R-squared of less than 80% indicates less predictability of relative performance. A R-squared of 95% or more indicates the fund is similar to index, but charging high fees with little opportunity to add value over benchmark market’s return.
Beta– Beta is a measure of risk. It indicates a fund’s past price volatility relative to a benchmark. Most mainstream stock mutual funds have beta in the range of 0.85 to 1.05. If beta is 0.75, it means for a -10% market decline, fund values might be expected to fall
-7.5%.
Beta gives you an idea of general volatility in fund asset values.
Gross Dividend yield – Gross yield is the profit percentage before taxes and expenses are taken into account. Clearly, gross yield is a more reliable differentiator of fund’s investment philosophy.
Taken these R squared, Beta and gross dividend yield together will help you compare the funds in similar category. Remember different categories like Growth fund or Value funds, or small cap fund will have different characteristics, so when you
compare just make sure to compare funds in the similar category. Fare comparison will require you to compare funds where investment policies characteristics are more or less similar.
These three statistics taken together should substantially narrow the parameters with which to evaluate a fund’s relative performance. But statistics are no substitute for judgement. Most of this data regarding fund size, age, management tenure,
costs, portfolio statistics are available in fund’s Key Information Memorandum (KIM) & SID (Scheme Information Document).
When you are done with above factors than evaluating past performance of stock mutual fund makes sense.
Most investors choose the stock mutual funds based on the past performance, while time and again many cautions are expressed about picking stock mutual funds based solely on past performance.
First of all, define your need whether it is income generation, capital growth or some combination of two.
As you observe the performance of fund over longer duration also check the year over year returns to check for consistency in returns. Be aware of attributing too much attention to past returns in which top performance is concentrated in just few short periods.
Based on the research over long time periods, the record suggests that past performance has virtually no predictive value.
Hope you got your answer with How To Analyse a Stock Mutual Fund .
What if you don’t want to do all this or don’t have the time to do all things. There is an easy way. You can Invest in Index Funds, around 80% of funds underperform Index over long durations, or You can consult us here.
You can see the previous article on advantages and disadvantages of investing via mutual fund here.