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Select the right diversified MF to prosper

June 23, 2009 09:24 IST

Diversified funds are one of the most popular mutual funds around. They are the oldest funds in India, and there is a wide range of funds in the market from various fund houses.

So it comes as no surprise that it is quite confusing for a normal investor to select the right fund for his investment needs. Hence, if you are in a dilemma about how to select the right fund, then read on to get help on the selection criteria.

Check the fund's returns against its peers: When you are choosing the fund for its performance, always compare its returns against those of its peers. E.g. it doesn't make sense to compare the returns of a large-cap fund against a mid-cap fund as mid-cap funds tend to offer higher returns by taking higher risks. Also ensure that the performance is compared against longer time-frames, since the fund can give extraordinary returns for a short period but may fail to deliver over longer periods. It will help you check the performance of the fund during various market cycles.

Check the fund's returns against its benchmark index: Find out how the fund has fared against its benchmark index. Always ensure the fund's performance is consistent with the returns from its benchmark index, if not better. In case of market crash, ensure the fall in the fund's value is not more than its benchmark index.

Watch out for the past performance of the fund: This is another important comparison, as during the stock market rally, all the funds benefit. But during the market crash, many of these funds show dismal performance. So take care to ensure the fund is not a one-off winner, but a steady performer. It also means avoid new funds, since they do not have any history to prove their performance.

Risks taken by the fund to generate returns: With returns being the prime focus of the investors at the time of choosing the fund for investment, many funds tend to take higher risks to generate high returns. If the fund takes exceptionally high risks, it is very likely to be affected when the market crash comes.

To find out the risks associated with the fund, take a look at Standard Deviation (SD) and Sharpe Ratio (SR), which is the risk-adjusted returns. SD for the fund chosen must be lesser than its peers, while SR should exceed its peers. These values are available at various mutual fund websites that rate the funds based on these two parameters.

When selecting the mutual fund for investment, remember to carry out your research carefully. This is because it is your money at stake. Once you are invested, it is difficult to redeem your investment without paying penalty.

Always avoid new funds and NFOs since they do not have any track record. Also certain funds like mid-cap and small-cap funds will be riskier than large-cap funds due to the inherent volatility of the underlying assets.

Similarly, ETFs and index funds will be less risky than actively managed funds, since they just replicate their benchmark index. But in the process of playing safe, don't give up on earning good returns. Hence ensure you establish a balance between risk-reward ratio, to earn good returns while minimizing your risks.

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