When it comes to making investments in mutual funds, it all boils down to which fund to invest in. There is no dearth of choices, but then not all the options available merit consideration.
There are 30 asset management companies (AMC) currently in the mutual fund industry, and many more lining up for launches. The variety of schemes offered by these AMCs is enormous. So it can be a challenge for the investor when it comes down to identifying a handful of mutual fund schemes from this rather large universe.
The good news for the investor is that based on performance, most of these schemes fall short of making the grade. Thus the real challenge lies in finding those few schemes that do make the grade.
Often when it comes to evaluating their investment decisions, investors appear confused. The simplest of decisions proves elusive to them. This confusion is further enhanced by misrepresentation made by `commission-hungry' mutual fund agents.
With so many forces working against them, it's essential for investors to have a set of objective parameters based on which the performance of mutual fund schemes can be evaluated. These parameters should serve as benchmarks for investors while selecting funds for their portfolios. We present a 4-step strategy for selecting the right diversified equity fund.
1. Compare returns across funds within the same category
One of the most basic forms of benchmarking involves comparing funds within a category. For instance, if you are evaluating Franklin India Bluechip Fund for investment, you should compare its returns with other predominantly large cap diversified equity funds. Comparing it with mid cap funds for example, will deliver erroneous results, because the risk-reward relationship between mid cap and large cap funds are not comparable.
As equities are best equipped to deliver returns over longer time frames (3-5 years), investments in diversified equity funds should be made with a long-term perspective. Hence, while comparing returns, investors must consider longer time frames (of 3-5 years) before taking a conclusive decision about investing in a fund.
Comparing a fund over a longer time frame will also give investors a good idea about how the fund has fared over a stock market cycle (boom and bust).
2. Compare returns against those of the benchmark index
Regulations demand that every fund mentions a benchmark index in the Offer Document. The benchmark index serves the dual purpose of being a guidepost for both the fund manager and the investing community. All eyes must be on the benchmark index and how the fund has fared against it.
Again with an equity fund, investors should consider the performance of the fund over the longer time frame, while comparing it to its benchmark index. In the Indian context, most equity funds outperform their benchmark indices over the long-term (3-5 years).
However, during market turbulence, like the one witnessed over May-June this year, investors will find many equity funds trailing their benchmark indices. This is something we have observed on more than one occasion. The funds that can outperform their benchmark indices during stock market volatility must be marked closely.
3. Compare against the fund's own performance
Besides comparing a fund with its peers and benchmark index, investors should evaluate its historical performance. Not all funds show stability in performance over the years.
Many of them slip up; only a few manage to sustain the good work they have done year after year, market cycle after market cycle. By evaluating a fund against its own historical performance, you ensure that you get the most consistent performers in your mutual fund portfolio.
The inconsistent performers (the one rally wonders) are available a dime a dozen and must be filtered effectively.
4. Risk-related parameters
While NAV returns are important, one area, which should never be ignored by investors is the risk taken on by the fund. Mutual funds being market-linked, are prime candidates for stock market related risks. The two aspects that investors should take into account are volatility of the fund as indicated by the Standard Deviation (SD) and risk-adjusted returns as calculated by the Sharpe Ratio (SR).
While SD shows the degree of risk taken on by the fund, SR shows the return generated by the fund per unit of risk taken. The SD (volatility) of a fund should be lower than its peers; on the other hand, the SR should be higher.
The best fund is the one with the lowest SD and the highest SR within its peer group. Again, it is advisable for investors to evaluate the SD and SR of the fund on a historical basis so as to identify the most consistent performers.
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