Chapter 9. Scheme Selection

Learning Points

This unit will help you do this. It also informs you about the sources where you can easily access data related to mutual fund schemes.

Asset allocation is the approach of spreading one’s investments between multiple asset classes to diversify the underlying risk.

The sequence of decision making in selecting a scheme is: Step 1 – Deciding on the scheme category (based on asset allocation); Step 2 – Selecting a scheme within the category; Step 3 – Selecting the right option within the scheme.

While investing in equity funds, a principle to internalize is that markets are more predictable in the long term, than in the short term. So, it is better to consider equity funds, when the investment horizon is adequately long.

In an actively managed diversified fund, the fund manager performs the role of ensuring higher exposure to the better performing sectors or stocks. An investor, investing or taking money out of a sector fund has effectively taken up the role of making the sector choices.

It can be risky to invest in mid-cap / small cap funds during periods of economic turmoil. As the economy recovers, and investors start investing in the market, the valuations in front-line stocks turn expensive. At this stage, the mid-cap / small cap funds offer attractive investment opportunities. Over longer periods, some of the mid/small cap companies have the potential to become large cap companies thus rewarding investors.

Arbitrage funds are not meant for equity risk exposure, but to lock into a better risk-return relationship than liquid funds – and ride on the tax benefits that equity schemes offer.

The comparable for a liquid scheme in the case of retail investors is a savings bank account. Switching some of the savings bank deposits into liquid schemes can improve the returns for him. Businesses, which in any case do not earn a return on their current account, can transfer some of the surpluses to liquid schemes.

Balanced schemes offer the benefit of diversity of asset classes within the scheme. A single investment gives exposure to both debt and equity.

Investors need to understand the structure of the gold schemes more closely, before investing.

Equity investors would like to convince themselves that the sectors and companies where the scheme has taken higher exposure, are sectors / companies that are indeed promising.

Debt investors would ensure that the weighted average maturity of the portfolio is in line with their view on interest rates.

Investors in non-gilt debt schemes will keep an eye on credit quality of the portfolio – and watch out for sector concentration in the portfolio, even if the securities have a high credit rating.

Any cost is a drag on investor’s returns. Investors need to be particularly careful about the cost structure of debt schemes.

Amongst index schemes, tracking error is a basis to select the better scheme. Lower the tracking error, the better it is. Similarly,

Gold ETFs need to be selected based on how well they track gold prices.

Mutual fund research agencies assign a rank to the performance of each scheme within a scheme category (ranking). Some of these analyses cluster the schemes within a category into groups, based on well-defined performance traits (rating).

Seeking to be invested in the best fund in every category in every quarter is neither an ideal objective, nor a feasible target proposition. Indeed, the costs associated with switching between schemes are likely to severely impact the investors’ returns.

The underlying returns in a scheme, arising out of its portfolio and cost economics, is what is available for investors in its various options viz. Dividend payout, dividend re-investment and growth options.

Dividend payout option has the benefit of money flow to the investor; growth option has the benefit of letting the money grow in the fund on gross basis (i.e. without annual taxation). Dividend re- investment option neither gives the cash flows nor allows the money to grow in the fund on gross basis. Taxation and liquidity needs are a factor in deciding between the options. The advisor needs to understand the investor’s situation before advising.

Many AMCs, distribution houses and mutual fund research houses offer free tools in their website to help understand performance of schemes.

  • Investors generally compute Return on Investment (ROI). Change in NAV is a very easy approach to find out the ROI. The following are the important characteristics:

The Expense Ratio:

  • It is the ratio of total expenses to average net assets of the fund.
  • It indicates the fund’s efficiency and cost effectiveness.
  • It is important to note that brokerage commissions on the fund’s transactions are not included in the fund expenses figure while computing this ratio.
  • The expense ratio is most important in case of bond funds or debt funds, since such funds performance can be adversely affected if a large proportion of its income is spent on expenses.

The Income Ratio:

  • It is the net investment income divided by its net assets for the period. For evaluating income oriented fund, particularly debt funds.

Portfolio Turnover Rate:

  • It is defined as the lesser of assets purchased or sold divided by the funds net assets.
  • Portfolio turnover rate measures the amount of buying and selling of securities done by a fund. And hence net return can be lower with high transactions costs.

Transaction Costs:

  • It includes all expenses related to trading such as the brokerage commissions paid, stamp duty on transfers, registration fees and custodian’s fees.
  • Brokerage commission is an important component of transaction costs. Transaction costs therefore have a significant bearing on fund performance and its total return.
  • Funds with small size or small returns have to be judged more on their expense ratios and transactions costs, given their impact on total return.

Fund Size:

  • Fund size can affect performance.
  • Small funds are easier to manage and can achieve their objectives in a focused manner with limited holdings.
  • Large funds benefit from economies of scale with lower expense ratios and superior fund management skills.
  • They also gain through greater risk bearing and management capacity.

Cash Holdings:

  • Mutual funds allocate their assets among equity shares, debt securities and cash or bank deposits.
  • The percentage of the funds portfolio held in cash equivalent can be an important element in its successful performance.
  • A large cash holding allows the fund to strengthen its position in preferred securities without liquidation its other portfolios.
  • Cash also allows the fund a cushion against decline in the market prices of shares or bonds.


  • There are 3 types of Benchmarks for evaluating funds performance.
  • Benchmarking relative to the market: If invested need to choose equity index fund than investor should compare return to the index fund with index only. This is passive investment management style. The fund would invest in the index stocks and expect its NAV changes to mirror the changes in the index itself.
  • Benchmarking relating to the other similar MFs: These are those which compare the performance of different schemes with that of other fund manager’s schemes. Such comparisons are called “peer group comparisons”. Only average annualized compound returns are comparable.
  • Benchmarking relative to other investment options or financial products: Means comparing with the market other financial products like FD, PPF, and NSC etc.

Ranking by external agencies:

  • Lipper Analytical Services, CRISIL, etc are the Credit rating agency which evaluated the fund performance of MF.
  • CRISIL evaluates fund performance and ranks the schemes by performance. CRISIL ranks both debt and equity funds.
  • The basic thing here for evaluating performance is funds financial performance, income/expense ration and total return etc.
  • AMFI’s Website: provides meaningful guidance like past NAV history of fund, benchmark for all MF schemes etc. Financial Press like daily news paper “the economic times, business standard etc
  • News letters by AMCs, renowned national stock brokers etc, Offer Document and KIM

Borrowing by MF:

  • In India, MF is not allowed to borrow to increase their corpus.
  • SEBI regulations allow MF to borrow only for the purpose of meeting temporary liquidity needs for a period not exceeding six months and to the extent of 20% of its net assets.
  • Hence, it would be uncommon to be fund schemes with borrowings on their balance sheets, and if borrowings are seen, caution may need to be exercised in evaluating the fund performance.

Tracking Error:

  • In order to obtain the same returns as the index, an index fund invests in all of the stock included in the index calculation, in the same proportion the stocks weight-age in the index.
  • An index funds actual return may, however, be better or worse by what is called “the tracking error”
  • The tracking error arises from the practical difficulties faced by the fund manager in trying to always buy or sell stocks to remain in line with the weightage that the stocks enjoy in the index.

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