How to Select the Best Mutual Fund?

Mutual fund Sahi Haii!!
Be it for SIP or Lump-Sum investment, every Tom, Dick and Harry is aware of this slogan!
However, very few are aware or have knowledge of a structured way to screen thousands of schemes, across 44 odd mutual fund houses. More often than not, people end up relying on tips or recommendation that flows across social media sites to make an investment.
No worries!
We have come out with a solution for you.
In this article, we have emulated a list of checks, that you must perform diligently to select the best mutual fund scheme.They are:

  1. Know your fund manager – Imagine a situation where you have invested your money in a scheme based on a recommendation, but you don’t know who is the guy in charge of your money! Seems strange, but sadly that is the case in our country. There are hundreds and thousands of people who don’t even know the name of the person managing their money. Let alone his/her qualifications or experience.

Ideally, you shouldn’t bring yourself in this situation. So, before selecting any scheme you must do a thorough background check of your fund manager. Like in case of selecting any stock we check the integrity of the company’s management, similar is the case for mutual fund. Any individual should perform checks like investment philosophy of the fund manager, his past performance in terms of managing different schemes, how his schemes have fared in stressed economic scenario and so on. This will help the individual to develop an intangible connect with the fund manager. It is not considered a good signal where fund manager has deviated from his past philosophies or thesis and has changed mutual fund houses frequently. (You can check any fund manager’s profile in the StockEdge app for free)

  1. Measuring past performance – How often we have linked past scenarios to make a view of the future? Most of the time, right!!!
    Analysing fund’s past performance is also no exception. However, people blatantly look at the past returns of different schemes and get over-excited by seeing such high return numbers and end up investing in those. But, while doing the exercise, there are two things that you must look at:

First, ask yourself what is your investment period. Typically, one must have a longer-term view while investing in mutual funds. So, if you fall in this category, then you must not be scared or get excited by looking at 3m, 6m or 1-year returns. What matters for you is 5-year, 7-year and 10-year returns. This is because a longer time horizon better will capture the market cycle accurately and will help you to gauge the resilience of fund’s performance in challenging times.

Secondly, returns should be looked at in terms of ROLLING Returns and not TRAILING or ABSOLUTE returns. This is because trailing returns show a distorted picture of fund performance due to a recency bias while rolling returns give a much clearer picture by measuring the fund’s performance across all time frames.
For example: Suppose you want to find out how a fund has performed over a 5-year period from 1st Jan 2014 to 31st December 2019. If you measure the fund’s performance based on trailing returns, then you simply need the Net Asset Value (NAV) as on the aforementioned dates and then you can annualize it by the number of years. However, the problem with this is that it has a recency bias, as said above. Suppose if the fund has not performed well or has given muted returns till the first 4 years and in the last year it made up for it by delivering stellar results, then trailing returns would not capture the period of below-average performance and show a better/biased picture of the fund than what it is in reality.

But with the help of Rolling Returns, you won’t get a distorted picture. Instead, it will capture the movement of fund’s performance across the 5-year period. So, if you calculate rolling returns for the same fund say on a monthly basis, then it will take into account returns generated every month between 1st Jan 2014 and 31st December 2019 and take an average of it to come out with the final return number. Having said that, we mostly see data in terms of trailing returns by various fund houses as they are easier to calculate. (You can check rolling return of a Mutual Fund on rupeevest.com for free)

  1. Expense ratio – Expense ratio is an annual fee that all mutual funds charge you for managing your money. It is expressed in percentage terms and the fees include management fees, administrative fees, operating costs, commissions and so on. For example: if you invest ₹50,000 in a fund with an annual expense ratio of 2%, then you need to pay ₹1,000 every year in fees. In return terms, if the fund generates an annual return of 15%, then the net return comes out to be 13 %. Expense ratio plays a vital role in determining how much corpus you would be able to build for your future. A higher expense ratio will eat into your returns and consequently will have a much greater impact on your final corpus ,than a fund with a lower expense ratio. But it doesn’t mean that a fund with a higher expense ratio is necessarily a bad investment.
  2. Exit Load – Exit Load is levied when you sell your units of a mutual fund within a particular time period; for most mutual funds it’s one year. In case of SIPs, a time period of 12 months is necessary to complete for each SIP instalment to escape the exit load. For instance, if you have invested in a SIP for 2 years, you need to wait 1 more year to get rid of the exit load. It is expressed as a percentage of NAV. Since it will impact your investment value, you should invest in a fund with a low exit load and more importantly stay invested for the longer term, specifically in the case of SIPs,
  3. Performance metrics – There are some key performance metrics one should look at before selecting any mutual fund scheme. Some of them are:
    a) Portfolio turnover – Portfolio turnover, expressed as a percentage is used to measure how frequently assets are bought and sold by the fund managers. It is calculated as lower of purchase and sales divided by the average AUM. Generally, a low portfolio turnover is desirable as it indicates that the scheme has been following a buy and hold strategy, and the fund manager has conviction over his stock selection. Moreover, a lower portfolio turnover would subsequently lead to a lower expense ratio and higher returns because of lower transaction costs.
    b) Sharpe Ratio – Sharpe Ratio is a measure of risk adjusted return of a fund i.e. how much excess return a fund generates relative to the risk taken. So, if two funds offer similar returns over a particular time period then the fund with a higher Sharpe Ratio would be an ideal investment.
    c) Information Ratio – Information Ratio (IR) helps in measuring the extra return generated by the fund vis-à-vis the benchmark in relation to the additional risk it has taken vis-à-vis the benchmark. Generally, a ratio greater than 1 would mean that the fund manager has a greater ability to generate excess return and outperform the benchmark.
    d) Standard Deviation & Beta – Standard Deviation shows the relative volatility in returns of a scheme vis-à-vis its historical average. Typically, a lower standard deviation implies lower fluctuation in returns from the historical average return. Beta measures the sensitivity of funds performance in relation to the benchmark i.e. by how much percentage a fund’s NAV will move for a 1 per cent change in the benchmark. So, if beta of a fund is 1.2, it means for every 1 per cent upside or downside, the fund’s NAV would move by 1.2 per cent.

One can research on the performance of various mutual fund schemes through online portals like Morningstar, Moneycontrol.com or even by downloading the FACTSHEET of a particular scheme of a fund house from their website.

So, from now on if you think to invest in a mutual fund, don’t forget to do a due diligence based on the aforementioned points. These checks will surely go a long way in helping you to choose the best mutual fund scheme based on your investment profile.

Remember, when you are investing in mutual fund, you are trusting someone else for your hard earned money!

#rare4share

Don’t forget to share with the friend, who is looking to invest in mutual fund!

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s