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Here's how to select a good mutual fund

Last updated on: November 19, 2009 20:01 IST

Mutual funds offer the most convenient way of investing in equity, debt and money markets.

The increased participation of Indian investors bears testimony to the fact that there is a widespread realisation of the same. Also over the years, the Indian mutual fund industry has grown manifold, not only in terms of size but also in terms of offerings.

While on the one hand that is good, the increased number of offerings has also given rise to a dilemma in the mind of investors. They often get confused when it comes to selecting the right fund from the plethora of funds available. And even worse, many investors think that 'any' mutual fund can help them achieve their desired goals.

The fact is, not all funds are the same. There are various aspects within a fund that an investor must carefully consider before short-listing it for making investments. In this article we highlight some of those aspects.

Performance: The past performance of a fund is important in analysing a mutual fund. However, one must remember that simply because a fund has performed well in the past does not mean that it will perform well in the future as well.

But it indicates the fund's ability to clock returns across market conditions. And if the fund has a well-established track record, the likelihood of it performing well in the future is higher than a fund which has not performed well.

The following factors should be considered while evaluating a fund's performance:

1) Comparisons: A fund's performance in isolation does not indicate anything. Hence, it becomes crucial to compare the fund with its benchmark index and its peers, so as to deduce a meaningful inference. Again, one must be careful while selecting the peers for comparison. For instance, it doesn't make sense comparing the performance of a mid-cap fund to that of a large-cap.

Don't compare apples with oranges.

2) Time period: It's pertinent for investors to have a long-term (at least 3 to 5 years') horizon if they wish to invest in equity-oriented funds. Hence, it becomes important for them to evaluate the long term performance of the funds. This does not imply that the short term performance be ignored.

Performance over the short term should also be evaluated; however, the focus should be more on the long term performance.

Besides, it is equally important to evaluate how a fund has performed over different market cycles (especially during the downturn). During a rally it is easy for a fund to deliver above-average returns; but the true measure of its performance is when it posts superior returns than its benchmark and peers during the downturn.

Choose a fund like you choose a wife: one that will stand by you in sickness and in health.

3) Returns: Returns are obviously an important parameter that one must look at while evaluating a fund. But remember, although it is one of the most important, it is not the only parameter.

Many investors simply invest in a fund because it has given higher returns. In our opinion, such an approach for making investments is flawed. In addition to the returns, investors must also look at the risk parameters, which in-turn explain how much risk the fund has taken to clock higher returns.

4) Risk: Risk is normally measured by standard deviation. It signifies the degree of risk the fund has exposed its investors to. Higher the standard deviation, higher the risk taken by the fund to clock returns.

From an investor's perspective, evaluating a fund on risk parameters is important because it will help them to check whether the fund's risk profile is in line with their risk profile or not. For example, if two funds have delivered similar returns, then a prudent investor will invest in the fund which has taken less risk.

5) Risk-adjusted return: This is normally measured by Sharpe Ratio. It signifies how much return a fund has delivered vis-a-vis the risk taken. Higher the Sharpe Ratio, better is the fund's performance.

From an investor's perspective it is important because they should choose a fund which has delivered higher risk-adjusted returns. Infact, this ratio tells us whether the high returns of a fund are attributed to good investment decisions, or to higher risk.

6) Portfolio concentration: Funds that have a high concentration in particular stocks or sectors tend to be very risky and volatile.

Hence, investors should invest in these funds only if they have a high risk appetite. Ideally, a well diversified fund should hold no more than 40% of its assets in its top 10 stock holdings.

Make sure your fund does not put all its eggs in one basket.

7) Portfolio churning: The portfolio turnover rate measures the frequency with which stocks are bought and sold. Higher the churning, higher the volatility. The fund might not be able to compensate the investors adequately for the higher risk taken.

Invest in funds with a low turnover rate.

Fund management: The performance of a mutual fund scheme is largely linked to the fund manager and his team. Hence, it's important that the team managing the fund should have considerable experience in dealing with market ups and downs.

Also, investors should avoid fund's that owe their performance to a 'star' fund manager. Even if the fund manager is present today, he might quit tomorrow, and then the fund will be unable to deliver its 'star' performance without its 'star' fund manager. Therefore, the focus should be on the fund houses which are strong in their systems and processes.

Fund house should be process-driven and not 'star' fund-manager driven.

Costs: If two funds are similar in most contexts, it might not be worth buying the high cost fund if it is only marginally better than the other. Simply put, there is no reason for an AMC to incur higher costs, other than its desire to have higher margins.

The two main costs incurred are:

1) Expense Ratio: Annual expenses involved in running the mutual fund include administrative costs, management salary, overheads etc. Expense Ratio is the percentage of assets that go towards these expenses.

Every time the fund manager churns his portfolio, he pays a brokerage fee, which is ultimately borne by investors in the form of an Expense Ratio. Therefore, higher churning not only leads to higher risk but also higher cost for the investor.

2) Exit Load: Due to the ban by the Securities and Exchange Board of India on entry loads, investors now have only exit loads to worry about.

An exit load is charged to investors when they sell units of a mutual fund within a particular tenure; most funds charge if the units are sold before a year. As exit load is a fraction of the NAV, it eats into your investment.

Try investing in a fund with a low expense ratio and stay invested in them for longer duration.

Among the factors listed above, while few can be easily gauged by investors, there are others on which information is not widely available in public domain. This makes analysis of a fund difficult for investors and this is where the importance of taking the help of a mutual fund advisor comes into fore.


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