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Importance of Strong Investment Process - A Step-by-Step Guide

We often overhear conversations on the following lines:

  • I have decided to invest in ABC Mutual Fund
  • Why? Are their investment and risk management processes better than others?
  • No, it's headed by a rockstar fund manager who has recently been awarded as fund manager of the year.
  • Are you sure they will be successful next year too? What if they quit ABC and join some other fund house?

And it's easy to see why people go after names/ reputations/track records.

Returns on mutual fund investments are unpredictable. There are lots of uncertainties in the way markets behave. One, therefore, tends to take comfort in past performance/ image. But investors often forget that what worked in the last decade, last year or even last week may not continue to work in the future.
Strong processes, therefore, are critical when you choose your investment managers.
Fund managers do not have a magic wand. It is often said that fund management is a combination of science and art - both processes and people play an essential role. But processes are paramount, and people need to work within the boundaries set by processes, and their actions must bound the processes. This is to avoid human biases and errors that may otherwise creep in.
This is not to say that fund managers are unnecessary, and processes alone can run the fund. It is the systems and processes that help the manager make optimal decisions.
The priority of the fund manager is to generate alpha, that is, returns that are higher than the benchmark. This is done by allocating funds and portfolio construction within the broader framework set by the fund house.
Don't go by what your investment advisor or relationship manager says about the star fund manager. They may be highlighting the manager's performance during a bull run. However, the real test of a manager is their performance during various market cycles.

Mutual funds driven by strong processes with a robust risk management framework are less likely to witness extreme variations in returns.

Risk Management in Mutual Funds - Managing Risks Are Important

There is risk involved in every sphere of life, from driving a car to swimming in a pool.

Does that mean you will stop driving or swimming? The answer is no. A trained driver or swimmer knows how to manage the risks and enjoy the activity.

"MUTUAL FUND INVESTMENTS ARE SUBJECT TO MARKET RISKS, READ ALL SCHEME RELATED DOCUMENTS CAREFULLY." - this is a line we hear frequently.

We all know Mutual Funds have trained resources who aim to manage these risks. However, investors must also be mindful of their Mutual Fund's Risk Management Philosophy and Processes on the ground.

The key to successful investing is managing risks. There is always a trade-off between risks and returns - more significant risks are associated with higher returns potential, and vice versa. Therefore, Risk Management is a critical parameter to differentiate between mutual funds.

Mutual funds are investment vehicles - they invest in equity funds, debt, and precious metals like gold etc. Each asset class has its own risk, and your mutual fund must have experience and trained professionals to manage these.

Here are some of the risks associated with investing, which a mutual fund helps you navigate.

Market risk

Financial markets are volatile. They react to real-time developments about the economy, the investment environment, and external factors like the COVID-19 pandemic. Volatility means the value of an instrument goes up and down quickly. Investments in mutual funds in regular intervals helps to manage the volatility risk against investing a lump sum, which might entail taking a sudden risk.

Concentration risk

Concentration risk is when you put your investment in one stock, sector, or theme. One development related to one industry or theme can impact the entire investment since it is concentrated in one industry, stock, or theme. Diversified mutual funds invest in multiple stocks across sectors/industries, which reduces the concentration risk.

Credit risk

Debt mutual funds are subject to credit risks. Credit risks are when the issuer of a debt instrument, like a corporate bond, defaults in interest or principal payment.

Interest rate risk

When interest rates go up in an economy, returns from debt securities tend to be lower, and vice versa. Interest rate cycles are normal in an economy over a longer timeframe.

Inflation risk

Inflation erodes the returns of an investment. If the value of investments cannot cover inflation, then the returns become negative.
These are some of the risks of investing in financial assets. A mutual fund with a proven track record and strong risk management framework is more likely to mitigate such risks.

Consistency over spurts

It's a familiar story during every bull run...

The stock price of the company keeps scaling new highs every few days. It lures you to jump on the bandwagon. And within a few days, you exit with healthy returns.

You repeat the same with another well-performing stock and are rewarded handsomely again.

The experience lures you to try this with another stock with all the gains you have made so far. But by this time, the prices start to correct. You persist for some time, waiting for the cycle to reverse and press the panic button.

It is more common to the stock trading than stories of people who exit with handsome profits. Therefore, experts advise that one should not try to time the market and/or run after abnormal returns. Because you rarely know when the next downturn would begin, let alone predict a Lehman or COVID-19 pandemic-type collapse of the stock or bond market. The market goes through ups and down; cycles are the only thing predictable about the financial markets.

If you are investing consistently over time with an objective in mind, then your investment might be shielded from the stock market cycles.

What pays, in the end, is investing at regular intervals, as the returns will get averaged out.

How will you know if returns are consistent returns?

Returns should not be seen in isolation. One way to see if returns are consistent is to compare with the benchmark over time. The fund's net asset value can go up or down, but as long as it is more than the benchmark over the long term, the returns are seen as consistent.

Equally important is checking the consistency of a mutual fund in delivering returns before investing. A fund may have delivered consistent returns for one or two years but not have performed well over a five or ten-year period.

Choosing a mutual fund is the first step in ensuring consistent returns to get you closer to the desired goal.

However, there is a caveat: merely investing in mutual funds does not guarantee consistent returns, as returns are a function of market conditions. There could be volatility in the short run, but investing over a longer timeframe could help beat volatility and help increase your returns.

Professional experts manage your money in mutual funds with real-time and crucial market information. It is the most significant advantage of investing in mutual funds.

A mutual fund with strong processes and risk management is more likely to deliver consistent returns. Trust an investment manager who will invest in the highest-rated companies to minimize credit risks and the schemes which are in sync with the investor's risk appetite.

Funds investing in various asset classes with low correlation can help deliver relatively consistent returns - by making investments in debt and equity in a predetermined ratio. If the balance gets altered due to market fluctuations, assets are reallocated to get back to the predetermined level. Some funds have an inherent asset allocation mechanism, like balanced advantage funds.

So, pick a mutual fund with strong processes and risk management.

Fund Performance Important, Investment Experience Very Important!

Ravi and his wife, Tina, wanted to chill out in Goa. Ravi instantly booked an early morning flight, which was the cheapest one. They reached the airport with heavy eyes. Sadly, the flight was delayed. Then came a big shocker‚it had a stopover which Ravi missed while booking. And guess what, the meal was not included in the offer cost. Finally, they reached Goa around 2 PM, disappointed, sleep-deprived, and hungry.

If you find this story horrifying, there is one more - when people invest in mutual funds just looking at past returns and without thinking about the overall investment experience.

It's not funny. Because it is their money.

That is why it is important to choose a fund that comes with a hassle-free end-to-end investment experience.

A fund house or AMC is an entity that invests pooled money, gathered from investors, in financial instruments like shares and bonds issued by companies.

The fund house decides when to invest, how much to invest, and where to invest, depending on the investment mandate. The investor's money is managed by professionals who are known as fund managers. The fund manager assesses various risks before investing in a particular security.

While past returns might be an important consideration for selecting a mutual fund, the investment experience is equally important. Will the mutual fund update you regularly on your investments? How smooth is the process of making the investment or the onboarding into a fund house as a customer? How soon are your grievances addressed?

These are the questions one must seek answers to before investing. If the overall investment experience is not comforting or not dependable, investors may face problems at the time of application, regular service instances and/or redemption. Also, mutual fund investments are made over a reasonably long period of time. That is why one needs to be doubly sure about the overall experience of a particular AMC. So, choose funds that come with a hassle-free investing experience.

That why while fund performance is important, Investment experience is also very important. That's why one should invest with a Fund house that offers an easy onboarding process, accessibility, regular updates, and a robust customer grievance redressal mechanism.

Thinking of Investing? What's your Goal?

Many of you would laugh at the question. The goal behind any kind of investment is to make the money grow. Isn't that simple?

No worries; let's stick to this line of reasoning.

Next question: how much growth are you looking at?

"As much as possible," would be your answer. "I want to always put my money in an asset class where it grows the maximum"

No problem. How will you make sure that you are always invested in an asset class/ fund that is doing the best?

"I'll keep tracking the returns of all funds and keep shifting to the ones doing well."

Have you started to realize the problem with this reasoning?

Investments Experts call this "trying to time the market" and they have been saying, for decades now, that no one can time the market.
But the quest continues in all earnestness. No wonder, then, that many mutual fund investors end up withdrawing their investments prematurely and often do not make the money they aimed to make.

Obviously, something is wrong fundamentally. Turns out, the thing that is wrong here is the belief that your investment always has to be in an asset class that is performing the best. The experts will tell you that this is an unrealistic, and more importantly, an untenable expectation.

What actually builds long-term wealth is 'compounding over a number of years.'

Let's understand compounding first.
Compounding is a mathematical process that can multiply your potential earnings from an investment. The compounding process ensures that you earn interest on your original invested amount and also earn interest on the returns.
Compound interest may make your money grow faster because interest is calculated on the accumulated interest over time as well as on your original principal. Compounding can create a snowball effect, as the original investments plus the income earned from those investments grow together.

This magic is called 'Power of compounding'.
The first lesson of today, therefore, is that one needs to invest for a longer period of time if one wants to build wealth.

However, the trouble is, most investors don't keep investing for this long. They often get influenced by market fluctuations or spending temptations and end up not giving their mutual fund investments enough time.

This is where a 'Goal' comes in.
If you attach a long-term goal to your investment, you would invest till the time the amount is actually needed. For example, if your goal is to create a corpus for your daughter's higher education, and if she is 2 years old today, the chances of you investing, for say 20 years (till she is 18 and needs that amount), are higher.

Astute investors, therefore, always link their investment to a goal and keep investing diligently until it is time for the goal to be achieved. This helps them stay focused on the goal and not be impacted by the market volatility or other similar distractions.

So, what is the goal you are investing for?

ESG Investing - A Step-by-Step Guide

While returns are an essential factor of an investment, sustainability is vital, too. Sustainability is not just about 'continuation of similar returns in the foreseeable future,' but also about the returns being 'good/ clean/ ethical.'

Why is that important?

Quest for returns on capital may push humanity to commit mistakes. It is, therefore, important that, as an investor, you invest your money in the 'right' businesses. Responsible Investment Managers follow the ESG framework. That's short for Environment, Social & Governance. The approach favors businesses that are mindful about the impact of their operations on the environment (not just the raw materials and manufacturing methods but also the impact of the product packaging/ pollution caused by their products while being used) and the Society (their recruitment and employee management practices as well as their location and conduct with the society they are a part of), and businesses that adopt transparent Governance practices (how well are they managed, how well do they report and how conscious they are about the law of the land in letter and spirit) Some Mutual Funds offer funds that invest exclusively in companies that are evaluated on environmental (E), social (S), and governance (G) practices. Companies are assessed on their sustainability before they are given ESG ratings. Several parameters are examined, including culture, management, risks involved, business strategies, environment strategies, and their efforts in the preservation and conservation of natural resources, to name a few.

However, it does not mean that returns do not matter. One invests in financial assets because of the returns potential. The point here is returns should not be the only criteria while investing. Only chasing returns may force you to take more risk than you need to, not just for yourself but also for humankind. Socially responsible companies treat their employees well and with the utmost respect, do not discriminate between employees, and are equal opportunity workplaces. Similarly, a company is a governance compliant organisation when it practices the highest standard of financial disclosure. They are also involved in CSR(Corporate Social Responsibilities) activities. These companies consistently maintain the highest standard of governance, making them relatively better investment destinations. Socially responsible investors may view successful investment returns, and responsible corporate behaviour is not mutually exclusive but complementary. Such investors understand that combining social criteria and high governance standards may help them to fetch good returns and make the world a better place to live. They believe that peace of mind is worth investing in.

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Disclaimer:
This is an investor education and awareness initiative by Nippon India Mutual Fund.
Helpful information for investors: All Mutual Fund investors have to go through a one-time KYC (know your Customer) process. Investors should deal only with registered mutual funds, to be verified on SEBI website under 'Intermediaries/ Market Infrastructure Institutions'. For redressal of your complaints, you may please visit www.scores.gov.in . For more info on KYC, change in various details & redressal of complaints, visit mf.nipponindiaim.com/investoreducation/what-to-know-when-investing This is an investor education and awareness initiative by Nippon India Mutual Fund.

The information herein is meant only for general reading purposes and the views being expressed only constitute opinions and therefore cannot be considered as guidelines, recommendations or as a professional guide for the readers. The document has been prepared on the basis of publicly available information, internally developed data and other sources believed to be reliable. The sponsor, the Investment Manager, the Trustee or any of their directors, employees, associates or representatives (“entities & their associates”) do not assume any responsibility for, or warrant the accuracy, completeness, adequacy and reliability of such information. Recipients of this information are advised to rely on their own analysis, interpretations & investigations. Readers are also advised to seek independent professional advice in order to arrive at an informed investment decision. Entities & their associates including persons involved in the preparation or issuance of this material shall not be liable in any way for any direct, indirect, special, incidental, consequential, punitive or exemplary damages, including on account of lost profits arising from the information contained in this material. Recipient alone shall be fully responsible for any decision taken on the basis of this document.
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While utmost care has been taken in translating the article into respective regional language(s), in case of any confusion or difference of opinion, article available in English language should be deemed as final. The article provided herein is meant only for general reading purposes and the views being expressed only constitute opinions and therefore cannot be considered as guidelines, recommendations or as a professional advice for the readers. The document has been prepared on the basis of publicly available data/ information, internally developed data and other sources believed to be reliable. The sponsor, the Investment Manager, the Trustee or any of their directors, employees, associates or representatives (“entities & their associates”) do not assume any responsibility for, or warrant the accuracy, completeness, adequacy and reliability of such information. Recipients of this information are advised to rely on their own analysis, interpretations & investigations. Readers are also advised to seek independent professional advice in order to arrive at an informed investment decision. Entities & their associates including persons involved in the preparation or issuance of this material shall not be liable in any way for any direct, indirect, special, incidental, consequential, punitive or exemplary damages, including on account of loss of profits arising from the information contained in this material. Recipient alone shall be fully responsible for any decision taken on the basis of this article.
"ABOVE ILLUSTRATIONS ARE ONLY FOR UNDERSTANDING, IT IS NOT DIRECTLY OR INDIRECTLY RELATED TO THE PERFORMANCE OF ANY SCHEME OF NIMF. THE VIEWS EXPRESSED HEREIN CONSTITUTE ONLY THE OPINIONS AND DO NOT CONSTITUTE ANY GUIDELINES OR RECOMMENDATION ON ANY COURSE OF ACTION TO BE FOLLOWED BY THE READER. THIS INFORMATION IS MEANT FOR GENERAL READING PURPOSES ONLY AND IS NOT MEANT TO SERVE AS A PROFESSIONAL GUIDE FOR THE READERS."

MUTUAL FUND INVESTMENTS ARE SUBJECT TO MARKET RISKS, READ ALL SCHEME RELATED DOCUMENTS CAREFULLY.
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