Mutual funds have become quite a hit and many young people now choose Systematic Investment Plans (SIPs) as their first investment. But the problem is, many new investors also do not take the help of SEBI-registered advisers and try to build a MF portfolio on their own. They end up making some big mistakes that can hurt their wealth in the long run.

In this episode of Question of Money, I’m going to flag three big mistakes that I’ve seen new investors make.

Chasing past returns

SEBI allows Indian mutual fund houses to offer 36 categories of funds. How do you choose the right ones? Well, many investors quickly log onto Value Research or other performance ranking websites and choose the categories that show the best 1 year or 3 year returns. But you need to stop right there and recognise that the 1 year, 3 year or 5 year returns that you see there are the past returns of these categories. Often future returns can be the exact opposite of past returns. For instance, history shows that the best time to buy small-cap funds is when their past returns are deeply in the red. If you buy them when their 3 year returns are 25% or 30%, your returns over the next 3 or 5 years may turn out much lower. Your decision to invest in any fund category should be based on how it has fared across say 10 years or more, during both bull and bear phases of the stock market. To gauge this, rolling returns are a far better bet than the trailing returns – the past returns that you see today.

Owning too many funds

Not sure of which categories or funds to own, some investors go by ‘more the merrier.’ They keep adding new funds to their collection like clothes to a fashionista’s wardrobe.

Do be aware that owning too many funds actually worsens your long-term returns and reduces diversification.

How does this happen? Well, the best performing funds across categories in India today have become quite large and manage Rs 10,000 crore or more. As funds get larger, the fund manager tends to own more and more stocks in the portfolio. That’s how you find the most popular small-cap fund owning over 200 stocks in its portfolio and the favourite mid-cap fund owning 68. These portfolio in themselves own most of the investment worthy stocks and provide enough diversification. Now if you were to own three or four of the top performing funds in these categories, imagine how many stocks you would end up owning! You may end up having a 300-400 stock portfolio. That’s practically the entire investment universe of good stocks. When you own almost every stock in the market it becomes very tough to outperform the market. So you can only expect mediocre returns from such portfolios.

The other thing is that most of the top funds in a category also end up owning the same set of stocks. When the funds you own have a lot of portfolio overlap, you will end up with tons

of HDFC Bank, Reliance, SBI or whatever are the fund manager favourites at the moment. This is the opposite of diversification.

To avoid these pitfalls, you need to own MF portfolios with no more than 6-7 funds. If you are a new investor with small sums, just 2-3 funds are enough.

Too much churn

One of the big pluses of investing in MFs is that they are transparent and declare NAVs every day. There are also real-time databases like Value Research or Primeinvestor where you can compare fund performance across categories and with benchmarks. Many of them also assign ratings or rankings to individual schemes based on quantitative models.

These ratings are a good starting point to screen funds that you would like to buy. But ratings cannot be your only criteria to decide whether to buy or sell a fund. I say this for 3 reasons. One, in order to be objective fund ratings are usually based purely on numbers and quantitative criteria such as rolling returns, downside capture, upside capture etc. While these are good ways to assess past returns, they don’t tell you much about the future. To choose the right funds, qualitative factors such as the fund’s investing style, fund manager skills and portfolio quality need to be factored in, along with past performance.

Two, because they are strictly data-driven, fund ratings can change very often. If you keep churning your portfolio every time a fund goes from 5 star to 4 star ratings, you’d end up paying enormous capital gains tax, apart from always chasing past returns.

Three, the ratings tell you if a fund is underperforming or outperforming its peers. But they don’t tell you if it is a good fit for your goals and your risk appetite. If you need only a 13% return from your fund to get to your goals, there may no need to sell a fund that has delivered that consistently but is at a 3 star rating because peers have done much better.

Therefore, do monitor your fund portfolios using ratings. But do not churn your fund portfolio so often that you interrupt compounding, forget your own goals and end up sharing a big part of your returns with the taxman.

(Host: Aarati Krishnan, Producer & Edits: Anjana PV, Camera: Bijoy Ghosh)