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When hunting for a fund, star ratings are a great starting point. They provide a composite, visual measure of a fund’s historical risk-adjusted return compared to peers: in any particular category, funds clocking the top-10% risk-adjusted returns get a five-star rating, followed by the next 22.5%, 35%, 22.5% and 10%, respectively, from four to one stars.

But they can also be misleading. Here are five don’ts to consider when checking out the 5-star rated funds.

1) Don’t treat it as a blind buy.

If all you do while considering a fund for investment is going for the ones with the highest star rating, it is a grave error, but unfortunately, a common one. Just because a fund has performed brilliantly does not mean it is great one.

Whenever you come across a five-star fund, look for the drivers behind its performance. Don’t just stick to the latest numbers but get a grasp on how the fund stacked up in different market environments (bull, bear and sideways markets).

For instance, BNP Paribas Long Term Equity, an ELSS, is currently rated 5 star. Its performance between 2008 and 2010 was below average. Since 2011, it has been quite impressive. The reason? Fund manager Anand Shah joined the asset management company in the first quarter of 2011 resulting in an uptick in performance.

2) Don’t ignore your portfolio.

Not many investors make asset allocation a priority though it is crucial in determining whether or not you achieve your financial goals.

For instance, even a diversified, large cap, equity fund is a strict no-no for an investor with only a one- to two-year horizon as short-term returns from equity are always volatile, disparate and unpredictable. So even if you invest in a 5-star rated fund for such a short time horizon, you could be in for a rude shock should the market turn, or turn volatile.

Alternatively, it could be that your portfolio is already packed with mid-cap funds which are fairly good performers. So adding another mid-cap fund, even though it sports a 5-star rating, is not a great idea. It would be better to opt for a large-cap one.

3) Don’t ignore the fund’s strategy. 

Funds come in various hues and even after you have decided on whether it would be an equity or debt fund and the amount to be invested, you will have to zero in on the categories of the fund (large cap/ flexi cap/ mid and small cap/ sector / long-term bond/ liquid fund and so on).

If that’s not enough, funds within each of those categories vary greatly by nature. A mid-cap fund could be a value oriented one or a growth oriented one. A large-cap fund could be an index fund, or one that tracks its benchmark index closely (apt for a relatively-conservative risk-taker), or one that does not do so at all.

The fund manager could opt for a very concentrated portfolio or opt for a very diversified one.

Similarly, a fund may have undergone a strategy over time. So your perception of the fund may be wrong, in the sense it is based on what you once knew of the fund, not what it currently is.

4) Don’t assume all 5-star rated funds are equal.

While many investors are aware that a five-star rated large-cap fund is not the same as a five-star rated mid-cap fund, they may not be aware that this holds within a category too. Even if two funds have the same strategy, it does not necessarily mean that they are equal.

As soon as a fund completes three years in a relevant category, it gets awarded with a star rating on the basis of its three-year performance.

But as soon as it goes on to complete five years, its overall star rating becomes a mix of its three- and five-year performances, with greater weightage given to the longer-term period of five years. A similar exercise is done when a fund completes 10 years where its overall rating is a weighted average of its performances across the three-, five- and 10-year periods, with greater emphasis on the 10-year period.

The above methodology means that a five-star fund that has been in existence for three years will not be the same as a five-star fund that has been around for more than 10 years, as the latter has proved its performance across market cycles and over a longer period.

Let’s look at three funds that fall under the ‘Equity: Large Cap’ category.

Mirae Asset India Opportunities is a 5-star rated fund, but its rating is constituted from across three- and five-year periods. Axis Focused 25 has a 4-star rating based on its three-year period. Another 4-star, Franklin India Bluechip has been around for a while so three, five and 10 year periods have been taken into account.

5) Don’t ignore it once you buy it.

Funds undergo changes. The AMC may get sold out. The fund manager may quit. The fund’s strategy may undergo a change. What might have been a good fit for your portfolio once upon a time may no longer be valid.

Different fund houses have different investing cultures, with some putting an institutionalized process in place largely followed by fund managers or where teams take collective investment decisions, in which case a fund manager departure may not be a signal to rush for the exits.

But there are several cases where a star fund manager single-handedly drives investment decisions and after whom, the fund’s past performance could simply become irrelevant.

This old article may have references to outdated tax rules and laws. For up-to-date information on taxation of mutual funds, refer to https://www.valueresearchonline.com/tax/

There are several benefits of investing through mutual funds instead of directly investing in stocks. Mutual funds combine the savings of a large number of investors and manage it as a single pool of money. So, instead of investors worrying about which stock or bond to invest in, professional fund managers do the job.

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Equities are complex and stocks you can buy come in a bewildering array of sectors, industries, size, financial structure, promoter track record, competitive scenarios and a lot more. When you invest in a fund from a good fund house, there is a full-fledged research department to keep tabs on all this; and there’s an experienced full-time fund manager who has years –often decades — of track record of making equity investments. Moreover, his track record is publicly known and thoroughly analysed by researchers.

Compared to directly picking stocks, mutual funds are a more suitable route for a lot of people. It simply takes less effort, less time, less experience and less specialised knowledge to get good returns from equity mutual funds than it does from directly trading in equities.

Diversification — the most crucial aspect of investing — is much easier to practice for a fund investor. This is true of all kinds of diversification, including sectoral and of asset type. Many fixed income asset types like bonds are simply not available to individual investors.

Besides time, money and diversification, there are other advantages too. Generally, mutual funds are more tax efficient. They are certainly a lot more convenient. Extremely beneficial methods like systematic investing (SIPs) are very hard to implement for equities but simple for funds.

There’s a more complicated psychological problem with directly picking stocks. Basically, what we’ve said here is that if you are skilled enough, then you can do it. However, equity investors are by nature optimistic and that makes them overestimate their own skills. That’s often an expensive mistake.

In What is a core holding, we explained why sector funds must never be core holdings. These funds should never corner the bulk of your portfolio and are the stop-and-go investments that may juice returns.

They could make an appearance in your portfolio as they allow for the possibility of extraordinary returns. Of course, they also generally carry a higher level of risk, but as long as you limit the more risky portion of your portfolio, you aren’t in any great danger.

An issue with sector funds is that investors rarely act on a well thought out strategy. They simply gravitate towards the flavour of the year, which means that they are already behind. A financial planner noted that people who invest in today’s winners are “buying backward”.

For instance, energy funds (Morningstar category: Sector – Energy), put up a stellar performance in 2007 with a return of 105% that year. Investors piled onto funds in the sector. The next year the category average was -53%. No doubt, the mayhem that year hit every single sector. While it bounced back the next year, its returns in 2010, 2011 and 2013 were abysmal. Last year it made a comeback with a return of 47%, but still a far cry from its 2007 feat.

Or, take a look at financial services (Morningstar category: Sector – Financial Services). For three years it kept sliding: 76% (2009) to 29% (2010) and -33% (2011). It picked up in 2012 to deliver a category average of 56% but once again dipped in 2013 to again pick up in 2014.

An essential characteristic of sector funds is that they can shoot out the lights one year and be a loser the next because they essentially lack the diversification to ride out trouble. One should never commit the grave error of investing in a sector fund simply because it has had a great run that year. Unlike a regular equity diversified fund, the fund manager does not have much latitude if the sector falls from favour.

Could you do without them entirely?

John Bogle, the founder of Vanguard funds, believes you can. He is known to have said: “You could go your entire life without ever owning a sector fund and probably never miss it.” Bogle’s point is simply that a well-diversified portfolio doesn’t need sector funds.

Sector funds concentrate their investments in a single sector, such as FMCG, financial services, healthcare, and technology. These are sectors which an investor would find represented in a diversified equity fund.

By and large, buy-and-hold investors should steer clear of sector funds altogether, because not only are they betting on a single sector, but they are betting heavily on a few companies.

On the other hand, sector funds can be useful tools for investors with strong views who want to give a tactical slant to their portfolio. In areas of the market you are confident about or see an upturn in the future, you can employ a sector strategy to increase exposure. But if you invest in them, you need to understand exactly what you’re buying — and how much risk is involved.

Before you invest in a sector fund, you should be in a position to articulate your stance on why you believe that sector is likely to outperform, and what your criteria are for exiting it.

It’s always tempting to jump into sectors when they are hot. And sector funds will be able to deliver some stupendous returns on and off, giving your portfolio the muscle to outperform the market. Yet don’t lose sight of the fact that they can also log some dizzy falls. Instead, decide on your sector allocation based on your risk capacity, not on how well that particular sector is doing.

Finally, when you invest in a sector funds, you should be geared to take a hit. After all, you may get your call wrong. Alternatively, when the relevant sector is on a roll, don’t be afraid to leave potential gains on the table. Staying on in the hope that the sector will keep sizzling could backfire. And, as long as you are invested, don’t let hair-raising volatility disturb you or prevent you from sticking to your investment strategy.

Follow these guidelines when investing in sector funds:

• They must corner a very small portion of your portfolio.
• They must never be a core holding.
• Don’t be afraid to take losses. You will lose if your call is wrong.
• On the other hand, if you have earned substantially well, walk away. Don’t get upset about leaving potential gains on the table.
• Volatility is a given; don’t let it shake you. Have a clear investment strategy as to why you want to invest in that sector and stick to it.

People don’t become wealthy by accident. You have to be determined to do the right things to create wealth. Since it starts with mindsets, we suggest that you nix these three common, yet costly, habits.

1) Procrastination

“I can’t afford to invest right now. I’ll do it next year once the company reinstates bonuses.” Sounds familiar?

Procrastination is a bad trait in itself, but can be disastrous when it comes to investing. Procrastinate on your diet if you need to (not that we are suggesting it). But don’t delay on your savings plan. The longer you wait, the more it works against you. Compounding is a mathematical computation that works with time on its side.

Don’t wait for your next bonus to invest. Also, as your salary or income increases, let the allocation to investments also rise. The more you delay, the more it reduces the amount of time your money has to work for you. If you had invested Rs 2,000 per year over a decade, the value of your investments at the end of the time period would be far greater than had you started investing Rs 4,000 per year halfway through that period.

Let’s say that you start saving at the age of 25 with the purpose of accumulating Rs 1 crore by 65. For ease of understanding, let’s assume the rate of return as 9%. To amass this corpus, one would need to invest Rs 2,140 on a monthly basis for the next 40 years.

Delay this exercise by just 5 years. If one starts investing at the age of 30, acquiring the same corpus would require an investment of Rs 5,460 every month. Alright, that too sounds doable. Now let’s push it back further.

If one starts investing by 50, s/he would have to shell out Rs 51,700 every month for the next 10 years to reach the target of Rs 1 crore.

Start now.

2) Taking useless advice

Cynicism isn’t a particularly positive attribute, but it has its place. Be cynical of tips when it comes to investing. In fact, it makes sense to avoid them altogether. Tips are for waiters, not investors.

When investing in an equity product – be it stocks or a mutual fund, you need to make an informed decision.

Besides tips, avoid hunches and speculation. Don’t risk gambling away your savings.

To be a successful stock market investor, you need to think and behave like an owner. If you are buying businesses, it makes sense to act like a business owner. This means reading and analysing financial statements on a regular basis, weighing the competitive strengths of businesses, as well as having conviction and not acting impulsively.

It also means you have to pay wisely for quality. The difference between a great company and a great investment is the price you pay. You decide to enter the stock market at a time of frothy valuations, you will have a very, very long wait to get a decent return on your investments.

Similarly, don’t invest in a fund just because a friend or colleague or family member pointed out what a great run it had. Make the effort to understand the fund’s investing mandate and how it would fit in with your overall portfolio.

3) Avoiding equity

Investors can fall short of their financial goals for many reasons–key among them is under saving. But even if you are saving sufficiently but not giving the savings a chance to grow, you could be high on shortfall risk.

If you are avoiding equity on the premise that it is more volatile and hence more risky, you are not seeing the whole board, to borrow an analogy from chess.

Where your long-term goals are concerned, don’t shy away from maintaining an equity exposure in your portfolio. If you choose to do so, you could be jeopardising your entire financial plan.

No one is suggesting you go out and randomly invest in equity. If you do not have the expertise to buy into stocks, consider equity funds that are consistent and invest in them systematically.  For instance, the 10-year annualised return of the flexi-cap category of equity mutual funds is around 11%. Do note, this is just the category average. There would be funds that have delivered much more. Or take the case of the mid- and small-cap category over the same time period – 13.18%.

Not only is this  much higher than what you would get in a fixed return instrument, it also has no tax implications in the sense of long-term capital gains being nil in equity mutual funds.

Neither are we suggesting that your entire portfolio be tilted towards equity—there are various considerations that will go into such a decision, namely your age, the number of years you have left before you throw in the towel, various sources of income, and your risk capacity. But a too-conservative portfolio–one that emphasizes cash and fixed deposits and bonds at the expense of stocks–can actually enhance shortfall risk. Have a sensible asset allocation fine-tuned to your circumstances.

Tax planning will help you pay less income tax. Something everyone wants. But smart tax planning will help you boost your portfolio. The actual tax strategy will have a different meaning and emphasis depending upon an individual’s personal circumstances.

1) Don’t view any investment in isolation.

Good tax management can go a long way toward enhancing your return. But the decision needs to be made in conjunction with your overall portfolio and not in an ad-hoc fashion.

Most individuals rarely think about tax planning from an investment point of view. Hence one finds that they do not approach an investment with a perspective of whether or not it fits in with their overall portfolio. The approach is often just grabbing up investments that will give them the tax break, irrespective of whether or not it will help them reach their determined financial goals or fit into an overall investment strategy.

Tax planning investments are no different from conventional investments. Hence, it is imperative to obtain an in-depth understanding of all investment avenues available which offer tax benefits and choose suitable ones that will help save tax and achieve goals.

Most investors in a crazy dash to meet their Section 80C requirement will opt for unit linked insurance plans, or ULIPs, and endowment plans and often end up with products that do not suit their need.

Life insurance should never be bought with the intention of saving tax. Tax saving is just one of the benefits that come along with it. The main benefit is the provision of finances in the case of death of the policy holder.

Approach tax saving with a holistic mindset. For instance, if your portfolio is heavily tilted towards debt, it would not be wise to opt for an investment in National Savings Certificate, or NSC. Instead, think of an equity linked savings scheme, or ELSS.

Which brings us to our next point.

2) Don’t limit tax saving to just fixed-return instruments.

Individuals tend to look at the Senior Citizen Savings Scheme, or SCSS, 5-year deposits, National Savings Certificate (NSC) and Public Provident (PPF) as the tax-saving investment avenues. But you can also invest in an equity linked savings scheme, or ELSS. These are diversified equity mutual funds that offer a tax benefit under Section 80C. They have the lowest lock-in period of just three years.

As on January 9, 2017, the ELSS category average delivered an annualised 3-year return of 18.52%. Do note, that was just the category average. The highest return was 27% while the lowest was 12%.

Having said that, keep in mind that these are equity funds which means, the return is far from guaranteed. So pick a good fund that has shown consistent performance and stick with it over the long haul. Don’t be in a tearing hurry to sell your fund units on completion of three years. Exit from the fund when the market is rallying so you walk away with a profit. If this means hanging on for a few more years, do so.

Do read: 3 don’ts when investing in ELSS.

3) Don’t ignore the big picture.

Tax saving is more than just investments and goes beyond Section 80C.

If you have made a donation to a charity that offers a tax deduction, avail of it. If you are paying premium on a medical insurance policy for yourself and dependents, be sure to claim the deduction.

Also, if you are servicing a home loan or an education loan, you are eligible for income tax deductions. Under Section 80C, you can even show the expenses of your child’s education to avail of a deduction.

When deciding how much to invest to max your deduction under Section 80C, take into account children’s tuition fees, principal repayment on home loan, contribution to employees provident fund (EPF), and any life insurance premium you are paying.

How do you go about picking the right stocks in the mid-cap space?

Compared to large-caps, mid-caps are relatively less researched, and we have to be careful while handling public money. On-the-ground research is important before deciding to invest in mid- and small-sized companies.

Having said that, irrespective of size, aspects of the stock selection process remain the same. It includes selecting companies in a sector, management analysis and valuation. We look for companies in quality businesses with decent growth prospects as well as good return on capital employed.

The second filter is with respect to management analysis, which is a bit subjective, but you have to look at the track record. Qualitative evaluation of the management in terms of thought leadership and governance is also an important factor to evaluate the prospect of a company.

The last factor is to arrive at a particular valuation for the company. For mid-cap stocks, the value has to be more than the market price so that there is enough ‘margin of safety’. Overall, the approach is to buy quality growing businesses that have the potential to scale up, at an early stage.

Given the recent run-up in valuations and the fact that there seem to be only tepid signs of a revival in business prospects, is there a bubble building up in mid-cap stocks?

I do not believe that there is a board-based bubble building in mid-caps, though valuation excesses do exist in select sectors. However, the mid-cap space is large and growing, with more than 400 companies. Despite the run-up in valuations, there are enough opportunities to build a profitable portfolio of select stocks.

If returns from the mid-cap space are not going to be as attractive, is it time for investors to cut their exposure to mid- and small-cap funds?

We always advocate that the allocation to multi-caps should be sizeable and mid-caps should be relatively less. My suggestion is that investors should limit their exposure to 20-30 per cent of their overall investment in equity. Despite the high volatility, I think investors can still maintain the same limit of exposure to mid- and small-cap schemes. It is not a time for rejigging of portfolios —either to increase exposure or to reduce their allocation to this sector.

Going forward, it is important for investors to temper their expectations; they should not extrapolate from the high returns delivered for the past three to five years. They should understand that the high returns in the past were derived from a lower base.

The government has implemented major economic and financial reforms. Which among them do you think will help SME companies the most?

These are still early days to gauge the impact of government policies as they have been rolled out only recently. We need to track the sector for a considerable length of time to take a call on the policy impact. Most government policies will have a bearing across businesses, and will not be restricted to mid-caps.

I think GST is one of the more significant reforms that will help the organised sector compete with relatively less-complaint unorganised players. Many businesses in India have a large share of the unorganised sector represented in their space. Hence many listed companies, which are leaders in their sector, are still treated as mid-caps. For instance, there are large listed companies in sectors such as tiles, plywood, footwear, luggage and apparels, but they are still treated as mid-caps. GST will bridge the gap between tax-compliant companies and relatively less tax-compliant unorganised players.

Given the current valuations, do you still see a value play in SME stocks? Is there a possibility of a sharp correction in mid-cap stocks?

It is difficult to predict near-term movements of markets and it is hazardous to guess the long-term trend. However, some of the areas that look interesting are financials, consumer discretionary, global cyclicals, gas utilities and healthcare. There are enough opportunities for investment as the spectrum of the small- and mid-cap space is broad. There is enough room to make decent return in mid-caps. However, the time-frame should be long term and the returns expectation should be reasonable.

If investors want try their luck in SME stocks, what are your suggestions in resepct of value picks?

While the market offers decent value opportunities for long-term investors, it is always more risky for individual investors to invest on their own in SME companies. Some things are best left to experts to handle. Like I said earlier, it needs a lot of research to select the right SME companies that will deliver the right return. Individual investors will not have enough time and energy to do a thorough research on companies before deciding on their investment in a particular small-sized company.