Here is how you can choose a good Mutual Fund that suits your requirement:
Choosing a Mutual Fund might look like a daunting task for many. But believe me, it’s not a rocket science. Anybody who can devote some time and has a willingness to create wealth can do it.
Let me simplify the process as well the jargon for you.
First, let’s look at the intrinsic factors that influence your choice of mutual funds. Intrinsic factors are personal factors which pertain to your behavior and objectives.
1. Investment Objective
Your financial goals should be the basis of your investment plan, therefore before you choose any Mutual Fund, identify your financial goals. Some of the investment goals could be children’s education/marriage, retirement planning, regular monthly income, wealth creation, etc. In addition to this, you need to determine the time horizon during which the funds would remain invested.
So, for fulfilling a long-term objective, you can choose a fund with the higher component of a riskier asset class like equity and vice versa. Thus, investment objective, as well as the time horizon, plays a crucial part in fund selection.
2. Risk Profile
Risk profile or risk appetite implies your tolerance levels in case of loss of the invested amount. It is dependent on your willingness as well as your ability to take the risk. It determines your extent of preference for the safety of principal and your comfort levels with a fall in the rate of return. Accordingly, several investor categories have been identified like conservative, moderate, aggressive, etc. Based on the above, determine your risk profile which would help you to choose the mutual fund scheme.
3. Asset Allocation
It’s now time to arrive at asset allocation. Asset allocation is a combination of least correlated assets like Equity, Debt, Gold, etc. designed to give you optimal return after considering your risk as well as liquidity needs.
Therefore, if you have significant risk appetite & want high returns, then you may put more money into riskier funds like equity. If a moderate return with the safety of capital is your preference, then you may divert more money into debt funds. If you want to take advantage of growth opportunities & safety of investment simultaneously, then you may choose a balanced fund which is a mix of debt & equity.
1. Pedigree of the AMC
It is necessary to check the record of the company before putting your money in its hands. It is beneficial to invest in mutual fund scheme of an asset management company which has an excellent reputation & wealth of experience in the financial markets.
Moreover, the fund manager’s experience in the said profession also needs to be considered as it will affect overall returns of the fund. Look for an AMC, which features a stable management team.
2. Risk-Return Ratios
Risk-Return Ratios are the key metrics used to compare/choose a mutual fund scheme. Remember that these metrics should not be viewed on a stand alone basis but in conjunction to get a holistic view. Moreover, keep in mind that you are comparing apple to apple, i.e. compare large-cap fund with another large cap instead of comparing it with a small cap fund. The following indicators play a crucial role in determining the relative strengths of the schemes.
It tells you the correlation between fund performance and benchmark index performance. It indicates the sensitivity of the returns of the fund with respect to the index. Usually, the beta of the index is assumed to be 1.
A beta of 1.4 shows the tendency of the fund to give 40% better return in the bullish market & 40% worse return in bearish markets in comparison to the index. In contrast, a beta of 0.75 indicates that the fund performs 25% worse in the bullish market & 25% better in bearish markets as compared to the index.
Beta is a useful measure only when the historical performance of the fund is available. Standalone, low beta values just indicate that there will be minor fluctuation in the fund returns on account of changes in the index. However, a low beta does not guarantee consistency of returns. You need to consider beta values according to your risk appetite.
b. Standard Deviation
It tells you about the volatility of returns of the fund. It indicates the degree of variation of return of the fund from its average return in the long-run. You come to know about the consistency in the returns given by the fund. Suppose if a fund gives an average return of 15%, then the standard deviation of 5% indicates that the returns may lie in the range of 10-20%.
Thus, go for a fund that has low standard deviation as there will be higher consistency in returns.
c. Sharpe Ratio
It gives return generated by the fund on per unit of risk taken. In the denominator, Sharpe Ratio considers standard deviation related to both the positive & negative asset returns. A Sharpe ratio of 1.25 indicates that for every unit of risk taken, the fund would generate 1.25 times returns. It is calculated as follows:
Sharpe Ratio = (Portfolio return – Risk-free return) / (Standard Deviation)
You may choose a fund that has high Sharpe ratio as it may give you returns commensurate with the risk taken.
d. Information Ratio
It shows the ability of the fund manager to deliver superior risk-adjusted returns consistently. A higher ratio indicates that the fund manager has outperformed other fund managers to provide consistent returns over the period under consideration. This ratio compares the performance of a group of funds having identical management styles. It is calculated as follows:
Information Ratio = (Portfolio Return – Benchmark Return) / (Tracking Error)
You may consider a fund that has a high information ratio.
e. Upside & Downside Capture Ratio
These ratios tell you that how much more the fund gained when markets went up & how much less the fund lost when markets went down.
Upside Capture Ratio measures the efficiency of the fund to gain more during the upward movements of the index. It is calculated as follows:
Upside Capture Ratio = (Upside CAGR of fund) / (Upside CAGR of benchmark)
where, both numerator & denominator considers growth rate of only those months when the benchmark returns are more than zero. A ratio of more than 100 indicates that the fund was able to gain more in comparison to the benchmark when the benchmark was bullish. You may select a fund which has high Upside Capture Ratio.
Downside Capture Ratio measures the efficiency of the fund to lose less during the downward movements of the index. It is calculated as follows:
Downside Capture Ratio = (Downside CAGR of fund) / (Downside CAGR of benchmark)
where, both numerator & denominator considers returns of only those months when the benchmark returns are less than zero. A ratio of less than 100 is indicative of the fact that the fund lost less as compared to benchmark losses when the benchmark was bearish. The ratio is positive when both the numerator & denominator are negative. If only one of them is negative, then the ratio is negative. You may select a fund which has low Downside Capture Ratio.
The risk-return ratios mentioned above are not exhaustive. You may consider other metrics as well. What’s more important here is to develop your strategy keeping in mind your preferences & proceed accordingly.
3. Expenses Management
Mutual funds charge several types of fees by way of fund management fees, selling & promotion, agency commission, registration, etc. The AMC clubs the charges under the umbrella of Expense Ratio. The expense ratio is used to assess per unit cost incurred by the Asset Management Company towards the management of the fund. It is calculated as follows:
Expense Ratio = (Management Fee + Operating Expenses) / (Assets under Management)
Different mutual funds have a different expense ratio, but the maximum limit established by SEBI are 2.5% for equity fund & 2.25% for debt fund. The Net Asset Value is declared after deducting the fund management charges from the fund value. You should understand that the higher the expense ratio of a mutual fund, the lower the rate of returns.
For instance- If a mutual fund gives return at the rate of 10% & has 2% as expense ratio, then you as an investor earn a net return of only 8%. Thus, you may choose the mutual fund scheme which has low expense ratio.
4. Frequency of Turnover
This ratio indicates the frequency with which your fund manager has traded securities over the year. A ratio of 1 means that the entire portfolio has been churned once during the year. The point to be noted is that trading activity entails a cost & increases the expense ratio of the fund. It translates as lesser return on investment in your kitty. Turnover ratio is calculated as follows:
Turnover Ratio = (Lesser of purchases or sales) / (Average monthly net assets)
A lower turnover ratio indicates buy & hold strategy while higher turnover ratio indicates aggressive trading strategy. Ultimately, it depends on upon the objective of the fund & market conditions. However, it is not necessary that low turnover ratio schemes will outperform high turnover ratio schemes. But then, my advice is that you may opt for a scheme that gives returns commensurate with its turnover ratio.
Mutual fund investments are always subject to market risk. Past performance serves only as a reference point and is not an indicator of future returns. Selection of a mutual fund is an activity that should be performed with diligence. Consider the intrinsic factors as well as fund facts thoroughly, do read the terms & conditions of the offer document carefully before putting your money in any mutual fund scheme.