Mutual Funds primarily invest in equity (stocks) or debt (bonds). (iStock)
Mutual Funds primarily invest in equity (stocks) or debt (bonds). (iStock)

Why picking the right mutual fund is key in a tough market

  • The “mutual funds sahi hai” (mutual funds are good) catchline hasn’t amused investors, given their poor returns in the last two-three years when the industry faced setbacks
  • Mint analyses the reasons for the lacklustre performance of the funds and suggests what you should do

Why have mutual fund (MF) returns fallen?

Mutual funds primarily invest in equity (stocks) or debt (bonds). On the equity side, mid and small cap MFs have given poor returns over the past two years, hence, many funds investing in them have suffered. Fund managers gave two chief reasons for this. First, the toll exacted by the note ban on supply chains and customers of these types of MFs; second, they had become pricey (high valuations) in the preceding bull run. On the debt side, a crisis erupted in September 2018, with the IL&FS group defaults, which spread to others, including Essel Group and DHFL. Several debt funds were exposed to these troubled groups.

Did market regulator’s move to reclassify schemes have an impact?

No. The reclassification of schemes was announced in October 2017 and took effect over the following six months or so. It was aimed at making mutual fund schemes “true to label" and clearly spelling out what investments they can and cannot make. In some categories, the reclassification by market regulator Securities and Exchange Board of India (Sebi) did restrict the investment universe. For example, large cap funds, post reclassification, can only invest in the top 100 stocks by size (market capitalization). However, these are not the categories that have delivered the lowest returns.

(Photo: Sarvesh Kumar Sharma/Mint)
(Photo: Sarvesh Kumar Sharma/Mint)

Will the situation change?

Some of the factors hurting returns are being resolved. Sebi forced liquid MFs to hold 20% of their assets in cash and cash equivalents. Mid and small cap MFs are likely to recover as the effects of demonetization wear off.

How can you improve your MF returns?

The primary lesson of the past two years is that fund selection matters. Two schemes in similar categories can give vastly different returns, so you must spend time analysing a scheme and its manager. Else, you can find a good adviser, who will do this job for you. If you are investing through a bank or distributor, check for any conflicts of interest. A recent study showed that banks recommended a disproportionately high number of schemes from their associated mutual fund arms rather than taking an unbiased view.

Should you exit underperforming mutual funds?

No MF will outperform the broader markets always; there will be periods of underperformance. You should weather these storms. If there is a sustained slide in the fund compared to its benchmark and peers, you may take the exit route. Many of the exposed debt funds already wrote down their entire investments in bad debt. Exiting such MFs may not yield much benefit. Keep an eye out for deterioration in the remaining debt paper held by your schemes or rating downgrades in the paper.