Last week we discussed the massive churn in mutual fund portfolios and how it nibbled away at your returns.

Individual mutual fund schemes, particularly the equity and liquid/money market ones, have been affected by the asset churn.

The effect on liquid schemes may not be of great significance to retail investors, but the impact on returns from equity funds is definitely a concern for them.

Mutual funds, however, can’t do without corporate investments. If they keep them out, they won’t have much of a cash pool because households park only 5 per cent of their overall savings in mutual funds. Therefore, for a small investor, the catch is to select the right scheme.

Pick the right fund

The search begins with the fund house itself.

Fund houses do not charge an entry load from big-ticket investors, some even dole out a higher commission to agents or distributors to attract corporate clients. The agent often offers a cut from his/her commission to such investors.

Therefore, the cost of acquisition of business is higher for these fund houses compared with those that don’t indulge in such practices.

A higher cost of acquisition translates into a low profitability (read, profit margin) in a competitive market where there are 40 fund houses offering over 500 schemes.

Take a look at their respective balance sheets or financial results; some mutual fund houses have a higher profit margin than their competitors with similar assets under management.

Look at the expenses

Next, look up how much a fund house spends on managing a particular scheme. A scheme can give a better return if its expenses are low. A large part of the total operational cost of running an actively managed equity scheme is constituted by brokerages, stamp duty and security transaction tax.

The more often a fund manager purchases and sells shares, the higher will be the cost on these accounts.

Prevailing market conditions, the investment objective of the scheme and a change in the valuation of the underlying stock usually determine how often a fund manager will buy or sell shares.

However, fund managers often have to sell stocks under sudden redemption pressure. Generally, they keep 3 to 5 per cent of the net asset of a scheme in cash.

But if the redemption pressure is more than that, the fund manager is forced to sell stocks purchased for long-term holding .

Portfolio turnover

Another way of gauging the extent of churning in a scheme is the portfolio turnover ratio of the plan. The portfolio turnover ratio measures the degree of stock shuffling in a scheme during a year. The more a fund manager reshuffles stocks under a scheme, the less likely he/she would be to generate a good return because such exercises entail high costs. Go for a scheme with a low portfolio turnover ratio.

Standard deviation

High investment churns mean greater inflows and outflows of funds in a particular scheme. A fund manager often finds it difficult to generate a consistent return from the scheme’s portfolio of investment. This is an unsystematic risk and is reflected in the volatility of returns on investment in these schemes.

The overall unsystematic and systematic risk and volatility in returns is measured by standard deviation. Returns from a scheme that has a higher standard deviation has seen wild fluctuations in the past and should be avoided.

Go for ELSS

You can safely opt for close-ended and equity-linked saving schemes (they usually have a three-year lock-in). Corporate and institutional investors churn their investments in mutual funds in quick succession because they invest their idle money for shorter durations, say for a few months. Hence, a close-ended fund does not attract them. Though mutual funds are now offering an exit route in close-ended funds as well by providing a repurchase facility once in every six months or three months, there is a heavy exit load.

This exit load could be as high as 5 per cent and corporate and institutional investors are unwilling to pay this because they flit their investments in and out of a scheme in three to four months once a return between 3 to 5 per cent is ensured (annualised return between 12 and 20 per cent).

Exchange traded funds are totally insulated from investment churning because these mutual fund schemes can only be bought and sold like any other stock on the bourses.