There are thousands of different schemes from various mutual fund schemes and selecting the best ones can sometimes get hard.
Most folks ask friends and family or research popular online websites to get the top fund recommendations and invest in the top rated funds.
The biggest mistake that mutual fund investors can make, is selecting mutual funds only on the basis of past performance.
Then there are some who consider the star ratings given by various research agencies. These star ratings can be one of the factors to look at, but there are other important parameters that one should also consider before finalizing a mutual fund portfolio.
The most important step in selecting mutual funds is to first have an investment goal and timeline i.e. how long do you plan to stay invested in that fund to meet your goal.
A fund selection done without an investment goal may not give the best results. You should know the reason for your investment, how long you can stay invested and at what stage you will re-allocate / redeem before you make your first investment.
Once your investment objectives are finalized, you may evaluate a fund based on the following parameters:
1. Performance Ranking
More than recent or long-term performance of any scheme it’s ranking among peers is very critical.
Firstly, you must compare the mutual fund with its peer group.
Secondly, you must compare the performance of the scheme with its benchmark.
The fund, which has performed well in one quarter, may not perform well in the next quarter. Funds with a good long-term top quartile performance are far superior to a fund scheme, which has one top position and one bottom position.
2. Total expense ratio
As a fund starts to do well it starts to attract a lot of investors, and as its assets increase it should keep dropping its asset management charges.
Look at well-managed funds with charges below 1.9% p.a. – there are many.
Though mutual fund’s total expense ratio has been capped by SEBI, still lower the fees, the better it is for you unless you get some extraordinary return by paying higher expenses for a specific fund.
3. Fund manager tenure and experience
Fund managers play a very important role in the fund’s performance. Though managing a mutual fund is a process-oriented approach, the fund manager is still the ultimate decision maker and their experience and viewpoint counts for a lot. You should know who the fund manager of the scheme is and what their past track record is.
If you find that due to change in the fund manager there is considerable effect on the fund’s performance, which does not suit your risk appetite then you may decide to exit from that fund.
4. Scheme asset size
The lesser the assets under management (AUM) in any scheme, the more risky it’s likely to be. This is because you don’t know who the investors in the scheme are and what quantum of investments they may have in that particular scheme. An exit by any big investor from the mutual fund may impact its overall performance and the remaining investors in a scheme will have to bear the impact. In schemes with larger AUMs this risk gets minimized.
It is recommended to invest in 3-4 funds that match and/ or complement your investment objectives. This is to avoid dependence on any one fund and avert risks of market downturns.
In addition to these, there are some additional indicators, which you can look at if you are inclined:
Alpha: This is a measure of a funds performance with respect to the index. If an alpha is 1%, it means the fund has performed 1% better than the market performance.
Beta: This indicates the level of volatility of a fund with respect to the market index. The larger the beta of a fund, the more volatile it will be.
Information ratio: The information ratio (IR) is a ratio of portfolio returns above the returns of a benchmark - usually an index - to the volatility of those returns. The information ratio identifies whether a manager has beaten the benchmark by a lot in a few months or a little every month. The higher the IR, the more consistent a manager, with consistency being an ideal trait. Conversely, the lower the IR, the less consistency.
Standard Deviation: This indicates how much the current performance of the fund is changing from its past performance. A high standard deviation may not be a good indicator for the fund.
Sharpe Ratio: This ratio indicates the source of a funds performance and how much of risk the fund was exposed to, to get higher returns. The larger a fund’s Sharpe ratio, the better will be its risk adjusted performance.
While you may shortlist mutual funds based on the above parameters, it’s a good idea to have a financial advisor on retainer who you can use as a sounding board to discuss potentially good and bad funds.