Don’t Ignore These Warning Signs While Investing in Mutual Funds

Apart from selecting the right fund, an investor needs to also focus on selecting the right ‘type’ of fund.

Identifying what not to do while investing in mutual funds is more important than knowing what to do.

That’s the word from independent financial advisor Harsh Roongta.

There’s a huge emphasis on selecting the right fund. But an investor should focus on selecting the right ‘type’ of fund, he said on BloombergQuint’s weekly series The Mutual Fund Show. “The correct asset allocation will ultimately play a larger role.”

Amol Joshi, founder of PlanRupee Investment Services, agreed. “Red flags are equally important while selecting a mutual fund scheme.” This, Joshi said, will enable an investor to accomplish the goal.

Roongta Advises

• Stay away from a scheme with dividend option as dividend is simply the investors’ money coming back to them.
• Watch out for regular changes in the fund management team.

Joshi’s Suggestions

• Asset management companies which have been scrutinised by a regulatory body should be a good learning for the fund house, investors and advisors.
• Watch out for frequent and extraordinary changes in expense ratio.

Watch the full conversation here:

Here are the edited excerpts from the conversation:

Would you recommend staying away from dividend schemes?

Harsh Roongta: Absolutely. Irrespective of who is doing it. The only exception is in terms of arbitrage fund and it is the exception that proves the rule. Except from arbitrage fund where the dividend might make sense. Any other fund when somebody is recommending a scheme with a dividend in a mutual fund then it does not make sense. Stay away from the person who is recommending it. Dividend in a mutual fund is meaningless. It is your own money coming back to you. There are far better ways to get back that money. The tax on dividend, with that one exception, even if you need the money you will be able to get back far cheaper, more efficiently by withdrawing the money rather than by taking it as dividend. The tax payout will be far higher if you take it as a dividend. Dividend is used to mis-sell funds. We see the results today. Today dividend is use only for mis-selling. Stay away. That is the red fla .

Amol, what is your red flag?

Amol Joshi: If you go on choosing a mutual fund scheme or type you will ultimately zero down to A, B, C, large cap, mid cap or something like that. You would want to choose what kind of AMC you are dealing with. AMC have adverse comments or observations by the regulator. That is the kind of AMC you would not want to go with. Or you should have the conviction that any such incident was one off incident. There have been a couple of cases like this in past. There have been explanations put out by those by AMCs. If those sounds genuine to you, then you go to them. However, any adverse comments from any regulatory body should be a good red flag.

Can you give us some examples of adverse comments?

Joshi: Several years back, for HDFC Equity, dealers had a case of front-running. Even the HDFC AMC initial public offering was stalled for a few days because a regulator wanted explanation of that case which is several years old. That is one example. It is a large and decent fund house having good performing schemes and a good team. But this is one observation that the Securities and Exchange Board of India came on it twice—once while it happened and second for IPO.

There’s the instance of ICICI Prudential Mutual Fund IPO. There is SEBI’s note as such. But there have been leaked report to the press that the regulator do not look at it very favorably. There were changes in application and the subscription amount of IPO which was placed by the particular mutual fund. This two have been large, reputed and established fund houses. But sometimes this is a good learning experience as what go wrong and how fund houses react to it, how you look at the fund house and whether you want to place your money over there.

What is the second red flag?

Roongta: Like any other industry there is a lot of staff change. The fund manager leads and he is the key person. I would not say it is a red flag, but an amber flag. It puts it on a watch list. But it is just happening way too much for you to turn. Because if you treat that as a red flag, you won’t be able to invest. Today every fund house has seen a fund manager moment. It is very few houses who do not have a fund manager.

Amol, what is your second red flag?

Joshi: Recently, there was a notification from a regulator that AMCs will disclose all changes in total expense ratios. My red flag is watch out for any fund which has frequent and ordinary kind of expense ratio changes. The regulator is keeping a watch on expense ratio. As the investor awareness increases, the expense ratio will be very important to watch out for. So, any fund house that has frequent changes, which is out of the standard practice in the market, is also a red flag, simply because it effects your returns. However, if any fund house reduces your expense ratio by all means, then that is the good fund house and a good scheme to be in.

Are there any examples?

Joshi: I wouldn’t name a scheme. There have been instances that instead of normal fluctuation, total expense ratio could be down by some basis point. For instance, a fund which is 181, if it becomes 182, then that’s okay. That could be just the rounding error in largest scheme of things. But if 181 goes to 191, 5-10 basis-point change, then that’s one red flag you should look at.

This is even more important in debt funds because in equity funds you are likely to make above average or double-digit or more returns. In debt mutual funds, rates are currently down, barring today’s event. But for debt your large expectation is 7-7.5 percent depending on portfolio quality, and slightly lower-rated credit may be 7.5-8. But 10 basis point on a 7 percent portfolio will be a significant change and that is important for the debt space to watch out for expense ratio change.

Investors who have a six-month horizon and wondering to go in equity fund as it will give more returns. Under most cases, is that a red flag?

Joshi: Absolutely. Six months by no means is a right reason. Anywhere close to it for an equity-related investment, then equity mutual funds are not the option. The product that you should look at for six-month investment is diametrically opposite in risk metrics in mutual fund product box. The product is nothing but a liquid or an ultra-short-term fund. Six-month equity fund is a bad advice and bad execution if somebody does it.

ULIPS may be the good product for particular case. But for people who have returns over three years and not asking for product protection and are being sold ULIPS, then is that a red flag?

Roongta: Yes. My personal view is that ULIPs just don’t make sense. They are not bad as they used to be. But to say everything good, so say good about ULIPs. The point is why you want to mix your protection and investment requirements. Better get the protection you need. There is no alternative to insurance. But that needs to be pure risk insurance. Be it term insurance, critical insurance, accidental disability, mediclaim, there is no alternative. But to mix an investment with it makes zero sense. If somebody is selling you an ULIP as an investment product, then it is akin to dividend. If somebody mentions dividend in context of a mutual fund except arbitrage, or if somebody mentions ULIPs as investment products then they are the same.

(This story was originally published on BloombergQuint.)