10 Mistakes You Shouldn't Make When Investing in Mutual Funds

Created By Labh.io

Investing in mutual funds is a popular and often rewarding way to build wealth, but it involves many complex calculations, assessments, and decisions. Beyond picking a fund, there are intricate aspects of fund management that require expertise, precision, and constant monitoring. The good news is, as a fund manager, we handle these complexities for our clients, so they can enjoy the benefits of a well-curated portfolio without getting lost in the technical details.

1. Misinterpreting NAV Fluctuations

A common misunderstanding is that a lower Net Asset Value (NAV) implies that a fund is “cheaper” or a better value. NAV is simply the price per unit of the mutual fund and reflects the fund's asset price on a specific day. Unlike stocks, a lower NAV doesn’t necessarily indicate a better deal; instead, it may indicate that the fund recently paid out dividends, underwent a split, or is a newer fund.

Example: Comparing a fund with an NAV of ₹10 to one with an NAV of ₹100 doesn’t mean the former is a better buy. For a true assessment, investors should consider the fund’s historical performance, the quality of its assets, and its management style rather than the NAV alone.

2. Not Analyzing the Fund's Standard Deviation and Beta

While many investors consider past performance, few analyze metrics like standard deviation and beta, which measure the fund’s volatility and correlation with the market. A higher standard deviation means a fund’s returns fluctuate significantly, indicating higher risk. Beta, on the other hand, shows how much the fund’s returns move in sync with the market.

Example: If a fund has a beta of 1.5, it’s 50% more volatile than the market, which might be undesirable for conservative investors. Using both metrics together can help avoid over-allocating to highly volatile or overly correlated funds.

3. Neglecting Sector and Style Drift in Funds

Style drift (when a fund changes its investment strategy) and sector drift (when a fund's sector allocation changes significantly) can expose investors to unintended risk. By monitoring style and sector drift, fund managers maintain the integrity of investment strategies, ensuring that funds perform as expected and adhere to their defined objectives.

Example: A mutual fund listed as a “large-cap” fund may gradually start allocating more towards mid-cap or small-cap stocks to capture growth opportunities. While this drift might boost returns temporarily, it increases volatility and risk unexpectedly.

4. Overlooking the Impact of Portfolio Turnover Ratio

The portfolio turnover ratio measures the fund manager’s trading activity within a specific period, often annually. A high turnover ratio implies frequent buying and selling of securities, which can lead to higher transaction costs and tax liabilities.

Example: A turnover ratio above 100% indicates that the entire portfolio was traded more than once in a year. For investors in a high-turnover fund, capital gains taxes on profits can quickly erode returns, particularly in equity funds where gains are taxed if held less than a year.

 5. Not Adjusting for Inflation-Adjusted Returns (Real Returns)

One of the lesser-known calculations is the inflation-adjusted return, also known as the real return. Many investors focus on nominal returns (the return stated without adjusting for inflation), but inflation can significantly reduce the actual purchasing power of returns.

Example: If a mutual fund provides a return of 8% and the inflation rate is 6%, the real return is only 2%. Over time, high inflation can erode the gains from nominal returns, particularly in low-growth funds, making high real-return funds a better choice for wealth-building.

6. Ignoring Sharpe Ratio for Risk-Adjusted Performance

The Sharpe ratio measures a fund’s returns relative to the risk it takes, offering a more comprehensive view of performance compared to absolute returns alone. A higher Sharpe ratio suggests that the fund is offering better returns for each unit of risk.

Example: Two funds might deliver a 10% return, but if Fund A has a Sharpe ratio of 1.2 while Fund B’s is 0.8, Fund A provides better risk-adjusted returns. Opting for funds with a higher Sharpe ratio can ensure that investors are rewarded for the risk taken.

7. Failing to Consider the Fund's Active Share

Active share measures how much a fund’s portfolio differs from its benchmark. This is a particularly relevant metric for actively managed funds. A high active share means the fund manager is making distinct choices rather than closely following an index. Funds with a low active share may not be worth the higher management fees if they closely track an index.

Example: If a mutual fund has an active share below 60%, it indicates that a significant portion of its holdings overlap with the benchmark index. In such cases, it may be more cost-effective to invest in a low-fee index fund rather than pay for active management.

8. Overlooking Hidden Costs in the Expense Ratio

The expense ratio isn’t just the annual fee; it can include hidden costs like administrative fees, marketing fees, and 12b-1 fees, which can take a larger bite out of returns than expected. These fees aren’t always transparent, especially in funds with high management turnover or frequent marketing costs.

Example: A fund might have an expense ratio of 2.0%, but if 0.5% of that is attributed to 12b-1 fees, investors are indirectly paying for the fund's marketing expenses rather than performance. Opting for funds with lower expense ratios, like index funds, can reduce the impact of these hidden costs.

9. Neglecting Dividend Reinvestment and its Tax Implications

Some investors choose dividend-paying mutual funds expecting regular income but fail to understand the tax implications of reinvested dividends. In India, dividends are now taxed as per the investor’s income tax slab, which can erode returns for investors in higher tax brackets.

Example: If a mutual fund distributes dividends worth ₹10,000 and the investor falls in the 30% tax bracket, they would pay ₹3,000 in taxes. Opting for a growth option where gains are reinvested and taxed only upon redemption could lead to better compounding benefits and reduced tax liabilities over the long term.

10. Failure to Calculate the Time-Weighted Rate of Return (TWRR) in SIP Investments

Many investors in SIP investment plans mistakenly rely on simple rate of return metrics, which don’t account for the timing of cash flows. The Time-Weighted Rate of Return (TWRR), in contrast, provides a clearer picture by excluding the effects of deposits or withdrawals, giving a more accurate view of a fund’s performance.

Example: Suppose an investor contributes to an SIP in a fund yielding high returns initially but suffers losses later. The TWRR shows how the fund actually performed, independent of contribution amounts. Calculating TWRR, instead of using simple returns, helps in comparing SIP investment options more objectively.

Investing in mutual funds might seem straightforward, but as these points highlight, there are numerous technical and calculative aspects that require constant attention and expertise. From managing risk metrics to optimizing tax strategies, professional fund managers employ in-depth analysis and sophisticated techniques to protect and grow client wealth.

Working with a skilled fund manager allows you to benefit from these complex strategies without worrying about the technical details. We handle the calculations, research, and adjustments, leaving you free to focus on your financial goals and life.

Ready to take your first step toward smarter investing? At Labh, our team, founded by alumni from IIM Ahmedabad, offers research-backed mutual fund services to help optimize your returns while minimizing risk. As an NISM VA Certified firm, we tailor portfolios to suit your financial goals and secure your future.

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