Mutual Fund Scheme Selection

Selection is where the rest of the syllabus is put to work. A scheme is chosen for a particular investor, with a particular goal and a particular tolerance for a bad year, and the choice has to still look defensible three years later when one of those years has gone badly. It is one of the heaviest units in the examination and the one closest to the daily job. Almost all of the work is comparison, and a comparison is only worth anything when the two things being compared are alike — which is why the unit begins with SEBI's categories. Before they existed, two schemes could both be called 'equity opportunities' and hold entirely different things.

How does SEBI define large, mid and small cap?

By rank, not by size in rupees. Companies are ordered by full market capitalisation, and the first 100 are large cap, the 101st to the 250th are mid cap, and the 251st onwards are small cap. AMFI publishes the list, and it is revised half-yearly.

Two consequences follow, and both make good questions. A company can move from one band to another without doing anything unusual, simply because others around it moved. And the bands are relative, so 'small cap' in India is not defined by an absolute value that could be memorised.

Why categories matter for comparison

A category is what makes a comparison meaningful. Ranking a small-cap scheme against a large-cap one over a period when small companies did well tells you about small companies, not about either fund manager. Within a category, the schemes face broadly the same opportunity set, so the difference between them is closer to being the manager's doing.

The same logic applies to benchmarks and to time periods. Like for like, over the same window, or the comparison is measuring something other than what it appears to.

What is worth looking at within a category?

• Performance across several periods and market phases, not one flattering window.
• Consistency — whether the scheme keeps turning up near the top of its category or occasionally spikes.
• The risk taken to get there: two schemes with the same return did not necessarily do the same thing.
• The expense ratio, which comes out of the return every year regardless of how the year went.
• Portfolio turnover, which says how much the manager trades, and the costs that implies.
• How long the current fund manager has been running it, since the record belongs partly to whoever produced it.

The expense ratio deserves a line of its own. It is the only one of these inputs that is knowable in advance with certainty. Every other item is an inference from the past; the expense ratio is a fact about the future.

What is not a selection criterion

The level of the NAV. A scheme at 15 is not cheaper than one at 300, and buying the lower one does not get you more of anything that matters. NAV is a per-unit value of a pool, not a share price set by demand — a point Unit 1 makes and this unit tests.

Nor is the size of a recent dividend, or a scheme being new. A new fund offer has no record to judge, which makes it harder to assess rather than more attractive, and the ten-rupee starting NAV is a convention rather than a discount.

Choosing the option: growth or IDCW

Both options are the same scheme, the same portfolio and the same manager. What differs is what happens to what the scheme earns. Under growth, nothing leaves; gains stay in the pool and show up as a higher NAV. Under Income Distribution cum Capital Withdrawal, the trustees may declare a distribution, and at the close of business on the record date the NAV is reduced to the extent of the payout and any statutory levy. A payout is therefore not income arriving on top of the investment. It is part of the investment being handed back, and the NAV says so the next morning.

The name carries the point that the old word 'dividend' hid. An amount distributed can come partly out of the investor's own subscription money sitting in the equalisation reserve, offer documents have to disclose that this is possible, and the consolidated account statement has to show the split between income distribution and capital distribution. Unit premium reserve — the part of a sale price not attributable to realised gains — cannot be used to pay IDCW at all. A distributor who describes a payout as the fund's profit being shared is describing something else.

Three named facilities sit under the option: payout of IDCW, reinvestment of IDCW, and the IDCW transfer plan. Reinvestment is a payout followed immediately by a fresh purchase, so it is taxed exactly as a payout is and the units bought start a fresh holding period. Income distributions are taxable in the investor's hands and the AMC deducts tax at source under section 194K of the Income-tax Act. Where an investor genuinely needs regular cash, a systematic withdrawal plan is the more controllable instrument: the amount and the dates are the investor's. IDCW is declared by the trustees, subject to distributable surplus, so neither the size nor the timing belongs to the investor.

Regular plan or direct plan

Every scheme must offer a separate plan for investments not routed through a distributor. That direct plan pays no distribution commission, so it carries a lower expense ratio and has its own NAV. Everything else is identical — the same securities bought on the same day at the same prices, the same fund manager, the same riskometer, the same exit load. There is one portfolio and two prices for access to it, and the gap between them compounds over the holding period rather than being a one-off charge.

The size of that gap is not a matter of opinion: the scheme information document has to illustrate the effect of the expense ratio on the returns of both plans, and the disclosed expense ratios are published separately for each. The honest framing for a distributor is that the regular plan is buying advice and service, and whether the service is worth the differential is a question about the service, not about the fund. Rebating part of the commission back to an investor to close that gap is prohibited.

In practice the plan follows the application rather than a tick box: where a distributor's ARN is quoted the transaction is processed under the regular plan, and where none is quoted it goes to the direct plan. That is an AMFI operational matter rather than a regulation, but it is how the choice actually gets made. Worth keeping the two layers straight — a scheme has plans, direct and regular; within each plan there are options, growth and IDCW; and the scheme information document names a default for each where the investor specifies nothing.

Risk levels, and what the riskometer settles

Every scheme carries a riskometer with six levels: low, low to moderate, moderate, moderately high, high, and very high. The level is not a description the AMC chooses. It is computed from the scheme's actual portfolio by a prescribed method, evaluated monthly, and disclosed along with the portfolio on the AMC's website and AMFI's within ten calendar days of each month end.

Because it is recomputed every month it can move, and a change has to be communicated to unitholders by notice cum addendum and by email or SMS. The annual report carries the risk level as on 31 March together with the number of times it changed during the year, which is a useful thing to look at: a scheme whose level keeps shifting is telling the reader something about how it is being run that the return figures alone will not.

What the riskometer does not do is rank schemes inside a category — two large-cap funds will usually sit at the same level — and it says nothing about whether that risk suits the person in front of the distributor. It answers how risky this portfolio is. Risk profiling answers how much of that this investor can carry, financially and temperamentally. Selection is the point at which those two answers are matched, and money needed in eight months does not sit in equity whatever the riskometer says.

What the examination tends to ask here

The categorisation bands are the most reliably examined thing in the unit and are worth knowing exactly, as ranks rather than rupee values, with AMFI's half-yearly revision attached. Beyond that the questions turn on distinctions rather than recall: what makes two schemes comparable and what quietly makes them not; the expense ratio's certainty set against performance's uncertainty; growth against IDCW, where the trap is treating a payout as income arriving on top of the investment rather than part of it being returned; direct against regular, where the only difference is the cost of distribution; and the riskometer, which grades a portfolio and not an investor. The NAV-level trap can appear in almost any of these — a scheme is not cheap because its NAV is low, and a new fund offer at ten rupees is not a bargain but a record that does not yet exist.