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You might have come across a plethora of mutual funds offering various benefits at nominal investment. However, in the first instance, all the funds in a particular category look similar. This makes it challenging to make a wise decision. After all, investing is indeed a long-term venture, and you need to be aware of what you are getting into. Most of the investors look at the fund returns as the only criteria to measure and compare the performance of funds.
Basically, fund returns are the difference between the Net Asset Value at the beginning and Net Asset Value at the end for a given period of time. Annualised returns only tell you about the value addition/reduction during a given period. But what about the consistency of returns, quality of fund house and risk-adjusted returns? For choosing the right fund, you need to compare mutual funds on these grounds as well. By using some of the financial ratios, you will be able to make the right decision.
Selecting the right mutual funds is the first step towards earning returns on the expected lines. To arrive at the best mutual funds, you need to compare various funds available. You can start with your investment objective. When you know your goals, you can easily decide what to look for in a fund. You may use the following parameters to compare mutual funds:
It provides a yardstick against which you can measure fund performance. It indicates the returns the fund has generated as against how much it should have delivered. As per SEBI‘s mandate, each fund declares its benchmark and considers it as a target to analyse performance. If the index rises by 12% but NAV of the fund rises by 14%, then the fund is said to have outperformed the index. Conversely, if the index falls by 10%, but the fund loses by 12%, then the fund is said to have underperformed the index. Basically, the comparison should be made to look for a fund which gains more in a market rally and loses less in a slump.
Your investment horizon becomes a driving factor for fund selection and comparison. Investment horizon relates to the time period for which you stay invested in the given fund. The type of fund chosen for comparison should be according to the investment horizon. Equity funds are suitable for a long-term horizon of at least seven years or more. The fund objective in this time period is wealth accumulation at relatively high risk. Similarly, for investing surplus funds for a short term, liquid funds give better returns than a savings bank account. Here, the fund objective is the safety of capital along with moderate returns.
From this context, the fund returns selected for comparison should match the investment horizon. It means that while comparing two equity funds, you may consider fund returns of the past 5 to 10 years. In the same way, for comparing two liquid funds, consider fund returns of the past six months to 1 year. Select the fund which has given superior performance across different time intervals.
Whenever you invest in any mutual fund, you undertake some risk. This risk relates to the variability of fund NAV as per the overall market movements. According to the investment thumb rule, higher risk needs to be rewarded with higher returns. But regular returns do not reflect this aspect of a mutual fund. Thus, you need to use a better measure for comparing two funds on the grounds of risk-adjusted returns.
You may use alpha and beta for this. These are financial ratios which tell you about the rewarding potential of a mutual fund. Beta tells you how much risk is involved in investing in a fund. Alpha tells you how much extra return will the fund generate over and above the underlying benchmark. Your target is to beat the benchmark and not to imitate it. Suppose two funds are at the same level of beta, i.e. 1.5. Fund A and Fund B have an alpha of 2 and 2.5; respectively, here, Fund B is better because it gives higher risk-adjusted returns than Fund A.
Your investment in mutual funds comes at a cost called the expense ratio. It is an annual fee which the fund house charges to the unitholders to manage the portfolio on their behalf. The level of expense ratio has a direct impact on the level of fund returns earned by the investors. It is because the expense ratio is charged as a percentage of the fund’s asset under management. A higher expense ratio ultimately dents the profits earned by the investors. Look for a fund which has the lowest expense ratio in the given category.
While using the expense ratio, you need to keep a few things in mind. The expense ratio of direct plans is lower than that of regular plans due to the absence of a distributor commission. Compare one regular fund with another and one direct plan with another. Do not compare index funds with an actively managed fund. The expense ratio of the index fund is lower due to the low fund management fee. Compare active funds with active funds. Do not compare equity funds with debt funds. Owing to higher transaction cost and brokerage, equity funds have higher expense ratio than debt funds.
A mutual fund scheme allocates your invested capital according to its investment objective. As regards asset allocation, SEBI has given a mandate which every fund in a particular category follows. If you consider a multi-cap equity fund, it will have at least 65% of capital allocated to equity shares of different companies. Such an allocation impacts the risk profile of the fund. But two funds of the same category need not have identical sector allocation.
Fund A might have invested more in financial services, whereas Fund B might have invested more in FMCG companies while staying within SEBI mandate. So, this makes Fund A less risky than Fund B. Similarly, some fund might be taking concentrated bets to earn higher returns. While comparing two funds, you should compare the sector allocations also. Match the fund risk profile with your risk appetite and choose accordingly.
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