Would you buy a tomato by its colour alone?

How do people choose their mutual funds? Most investors seem to simply buy the top four or five funds in the year's return rankings. But it would be wise to consider a few other factors as well.

The first question to ask is where the returns come from. The answer will determine their sustainability.

Take 2011. While plain vanilla equity funds lost 24 per cent in value, FMCG sector funds, buoyed by the fancy for FMCG stocks, delivered an 8 per cent gain.

ICICI Pru FMCG Fund, in fact, managed a 13 per cent gain. But this performance was based on the fund's 51 per cent holding across just three stocks — Hindustan Unilever, ITC and VST Industries.

Can this fund repeat its performance in 2012? For that, either the same three stocks will do have to do an encore or the fund will have to find equally good replacements within the FMCG sector.

Both seem unlikely. That's why a fund that manages good performance from a diversified portfolio of stocks is more reliable than one that has hit the jackpot on just a few stocks or sectors.

Look at the entrails

The second criterion is if the fund stuck to its mandate. Consider an equity fund that suffered much lower losses than its peers in 2011 because it held a high cash balance.

The cash-in-the-mattress approach may work splendidly when the stock market is falling. But not when market revives. In a rising market, it is the fund manager's skills on stock selection that will matter.

For the same reasons, a gilt fund that makes money by straying into corporate bonds or an index fund that performs by taking derivative exposures can't be counted as successes, even if they manage good returns.

Three, how risky is the fund? Consider two funds — Magnum Equity and Franklin India Prima Plus. Both funds today sport a five-year annualised return of about 7 per cent. But their year-to-year performance has been vastly different from each other.

Magnum Equity has been more volatile, zooming ahead by 88 per cent and 18 per cent in the bull markets of 2009 and 2010, but falling quite sharply by 56 per cent and 20 per cent in the market crashes of 2008 and 2011.

Franklin Prima Plus has been a more sedate performer, losing much less than the markets in 2008 (down 47 per cent) and 2011 (down 16 per cent) but turning in less stellar gains in the bull markets too.

Investors in both funds have reaped similar rewards over five years. But those in Franklin India Prima Plus have had a smoother ride.

Consistency or lower volatility is a desirable trait because it ensures that investors who enter or exit the fund at different times don't have widely divergent experiences.

It's all about risk

This underlying volatility in a fund's performance is captured in risk measures such as standard deviation or beta. In order to get the best results out of mutual fund investing, along with the fund's returns these also need to be evaluated.

If statistical measures like these are difficult to interpret, investors can simply go by how much the NAV fell in the market's worst month or quarter.

These days, when fund houses are being bought and sold often, investors can add a fourth criterion — who is responsible for the fund's returns? A fund that has turned in a stellar performance could be doing so because of a particular area of expertise of the sponsoring institution or the skills of an individual manager.

If these change, the fund's track record, which investors rely on, may simply turn irrelevant.

COMMENT NOW