Selecting a mutual fund: why and how

As a small investor you may not have the expertise to understand the market. In the Mena (Middle East and North Africa) region, there are about 12 markets, with about 700 to 800 stocks, and it could be difficult for average investors to do their own research, even if they are well versed in finance and economics.

Two, most of such small investors don't have the time to do the required research and it may not be a bad idea to hand this job to someone knowledgeable. This is not to say or discourage ordinary investors from spending time doing their own research and investing.

Third, as a retail investor you may not have lot of money and you need to have a diversified portfolio. You can't buy just two or three stocks. Buying two or three stocks would mean taking a lot of risk. But if you want to buy 20 or 30 stocks, you need a considerable sum. A fund is, therefore, considered to be a cost effective way of achieving that diversification.

But, experts suggest, you should not invest in one type of fund only, such as equity funds, even if you have diversified stocks ranging from US and other markets around the world. As an investor you need to have a balanced fund, which according to your risk and return should be balanced between equities, fixed income and perhaps some alternatives such as real estate and hedge funds.

How do you select a fund?

It's not just the fees that determine the choice of a fund.

Choose the right manager. If you look at international markets, academic studies suggest over 80 per cent of the managers have failed to beat the benchmark on a long term basis, says Shakeel Sarwar, head of asset management, SICO, Bahrain. Hence, it's important for an investor to select the right person that regularly on a long term basis have been outperforming the markets and therefore the fees that they are charging are justified. For selecting the right manager, you can do your own research or again get help from a consultant or tap into rating agencies such as Standard and Poor's, Zawya.com or Reuters' Lipper that rate fund managers.

Look at the fund's structure. If you look at a typical fund for example in the region, its investment manager, its broker, its custodian-administrator—they are all the same entity. Sarwar views this as a huge conflict of interest, and investors, therefore, take a huge risk when they invest in such a structure.

"If I am the manager and at the same time I am calculating the NAV of the fund, there is a big probability that if I decide to commit a big fraud I can easily do that," Sarwar says. So, it is important to look at the right structure of the fund. Invest in funds, where the custodian/administrator is independent. Similarly, look for funds, where the brokerage and audit are done independently.

Consider the historical performance. Check whether the fund managers have a good track record. In this region look at least two to three year track record. Very few funds were launched earlier. There are two benchmarks—you compare the fund manager's performance with the appropriate benchmark. If the fund manager is a GCC or a Mena fund manager, you compare it with MSCI GCC or MSCI Arabian index. The second benchmark is, you compare the fund manager's performance with his peer group—how does he stack up with his competitors? Is he within the top 10 or 20 per cent quarterly? But keep in mind, past performance is not always necessarily an indicator of future success.