Choosing a mutual fund...
Mutual Funds (MF) are possibly the most economical and convenient way to explore investment. Be it active or passive management, the choice is galore through MF in India. From about 44 fund houses we have over two thousand and five hundred schemes to choose from. It’s difficult if not impossible to identify which fund to invest. This universe imitates a stock selection from an exchange which require both fundamental and technical aspects to evaluate. Similarly, in MF, one could employ a strategy to distill from the vast choice. The fundamental parameters to focus in a fund are: History of the fund house, Fund Performance, Fund Size and Expense ratio.
The track record of a fund house helps one to evaluate on the consistency in launching and retaining its funds. The investment philosophy defines how they approach the market and hence the results. It helps portray how they keep investors interests over their business priorities. Also, the range and the performance across the asset classes indicate an ability of the fund house to attract the right talent pool of highly skilled research teams and experienced fund managers. This is critical especially in the long-term investment nature of investing.
The fund performance across the market cycles needs to be checked not just for a particular period. This helps in getting insights of how it responds or reacts during a bull or bear phase of the market. Also, look beyond the performance of the fund vis-à-vis the benchmark but versus the category average to identify how it stacks up against the peer group. Though, one could avoid investing in new fund offers (NFO), the fund manager’s past performance and the fund house’s investment philosophy could help us take a decision at such times. If an innovative fund is brought into the market, it could be explored considering their track record.
Though there is inconclusive evidence linking the size of the fund to the performance, it’s always ideal to pick a moderate sized fund. This is because a smaller fund has constraints of optimal allocation leading to concentration risk and possible underperformance, while very larger funds tend to become less nimble and near-replication of the benchmarks in the long run, hindering outperformance. Also, the fund size could become detrimental when the exposure is predominantly into small- and mid-cap stocks where liquidity becomes a prime concern in these stocks.
Expense ratio shouldn’t be the sole parameter for deciding on a fund, though, the lesser the better. When puzzled with funds with good track record, opt for a fund with lower expenses. However, be aware that expenses are higher with actively managed funds and tend to decrease as corpus increases. While passive funds like index funds are still at a nascent stage, one could have a mix of these to a good measure to bring down the overall cost of the portfolio.
Then there are the technical parameters or statistical tools to evaluate a fund, viz., Standard Deviation, Beta, Alpha, Sharp Ratio and R-Squared. Standard deviation (SD) measures the degree of the fund’s volatility. It provides information about how much the fund fluctuates from its mean or average return. The larger the deviation the higher the risk; so ideally opt for a lower SD when comparing two equal performing funds of the same category.
Beta measures the volatility with respect to the market. So, it throws the sensitivity of the fund with respect to the market swings. Note that market beta is always one and any higher beta depicts higher volatility of the fund. Risk-averse investors are better off avoiding funds with higher beta. Alpha defines the fund’s value addition or the performance over its benchmark. A positive alpha suggests an outperformance over the index by that much measure while a negative alpha represents underperformance. So, it’s always better to avoid funds with negative alpha.
Sharp Ratio gives the measure of risk-to-return or risk-adjusted return. It estimates the level of risk the fund takes to achieve the returns. Higher sharp ratio indicates higher return at lower risk and vice-versa. Opting funds of higher sharp ratio within its peer group makes sense. R-squared helps one to understand how much of the fund’s performance could be attributed to that of the market. It brings out the correlation between the fund and the benchmark. A ‘zero’ indicates no correlation and 1 indicates perfect correlation. It’s better to opt an index fund as it has lesser expense ratio instead of higher R-squared equity fund.
Most of these technical parameters are easily available from the fact sheet of each of the fund and so one needn’t sweat too much. The basic analysis is also available across credible sources on the internet. What one needs keep in mind however, that the most important factor to consider are not in the fund but ourselves as investors. One must understand their own risk appetite and timelines to arrive at a best-suited fund.
This article was originally published in "The Hans India" daily, on 21st Mar '22.