Don't get swayed by returns

If following an asset allocation approach, check if the scheme's investments are in line with its mandate.

Whenever we compare the performance of mutual fund schemes, we often rely on tried and tested parameters such as standard deviation, alpha, etc. A scheme ranking high on these tends to be a popular choice among advisors and, in turn, with investors.

However, many a time, the numbers hide as much as they reveal. An important thing one should be looking at is the 'label'. This happens when a fund deviates from its stated mandate to either protect itself from adverse market conditions or show relative outperformance compared to category peers.

These are many instances of such schemes that have not remained 'True-to-label'. An example would be a mid-cap fund that emerged as a hot favourite in recent times, owing to its actually giving a positive return while many peers floundered. Sure, the fund manager has had a good track record and deserves the accolades he is getting. However, a closer look reveals it has invested over 20 per cent of its assets in large-cap stocks. This is nearly double that of other known mid-cap funds. It is known that large-cap stocks are more resilient in a downturn. But isn't a mid-cap fund mandated to invest in mid-cap stocks? If it outperforms others in its ilk by broadening its universe, should we not treat such outperformance with a pinch of salt?

Then, there are income funds. Differentiated from short-term funds, as their average maturity is usually between one to five years, while the latter's is up to a year. However, the rising interest rate regime has recently prompted several 'income' funds to reduce the average portfolio maturity to less than a year, to mitigate the negative impact on their Net Asset Value. Though this helps to protect investors' capital, is it right for an income fund to morph into a quasi-short term debt fund?

Since such schemes are performing well, there should be no complaint from investors. But what if one has invested in such schemes as a strategic allocation to longer tenure debt instruments, not as a tactical investor who purchases such funds to capitalise on falling interest rates?

Some schemes attempt to skirt this limitation by being vague about their mandates, so that they do not sacrifice flexibility. Anyway, in most cases, the managers do not specifically violate any regulation of the Securities and Exchange Board of India. However, as advisors, our job is to recommend suitable products to a client based on his/her objectives and such changes in the attributes of a fund make the task of recommending a scheme that bit more difficult.

The opposite is also true. There are instances of index funds launched with the aim of replicating an index but suffering from significant tracking errors because the fund manager sought to undertake active management of the constituents' weightages. This lapse is more egregious than the instances mentioned above, as the manager has violated an express mandate to undertake passive management.

Sometimes, peer funds which stringently adhere to the mandate are penalised, as they are often unable to match the short-term performance numbers posted by more 'flexible' funds. However, it has been seen that over the longer term, these 'true-to-label' funds regain their lustre. A large-cap fund regarded as a pioneer in the private sector is a case in point. This fund assiduously avoided the temptation to dabble in mid-caps during the gung-ho period of 2006-2007. It lost its 5-star rating for a while and was written off as a has-been. However, the subsequent period saw its process-driven approach triumph.

Both direct investors and advisors need to keep this in mind while selecting schemes. For someone looking to invest through proper asset allocation, some of these schemes may not work. A star performer is of limited use to a client if not congruent with their objectives.

The writer is VP, Parag Parikh Financial Advisory Services