1. Compare Fund Performance against a Benchmark
You may start by comparing the performance of a fund against the benchmark. When you compare, use a fair and appropriate benchmark. It should always be an apple-to-apple comparison. Using the wrong yardstick will only give misleading data.
Let’s take the case of a Large-Cap Equity Fund. Compare its performance with a broad-based index like Nifty 500. The fund returns for a period were 15% whereas the benchmark returns were only around 12%. If your fund has delivered such higher returns consistently, then it’s good to go fund.
2. Compare Fund history
A mutual fund’s real worth can be understood only during difficult market phases, and a fund history can validate that. Look for a fund which has a relatively longer fund history say 5 to 10 years. Compare fund performance across different time intervals and business cycles.Suppose a fund has delivered performance in line with the expected returns consistently during a market rally is a good one. Moreover, during a slump, if it lost 8% returns while the benchmark lost 10% returns, then you can easily stick around the fund.
3. Compare Fund Expense Ratio
Expense Ratio is the annual fee charged by the fund for managing your money. As per SEBI guidelines, they cannot charge more than 2.5% of the fund’s average asset under management (AUM). You need to check the expense ratio of mutual funds before finalizing a fund.
Expense ratios are charged out of the fund returns. So, the higher the expense ratio, the lower would be your take-home returns. Always look for a fund which offers similar returns at relatively lower expense ratio.
The same mutual fund is available as a direct plan and a regular plan. Direct plans of mutual funds come at a lower expense ratio; which translates into higher returns. Investing in direct plans of mutual funds, instead of regular plans, can save you loads on commissions.
If returns delivered by your expensive fund are not in line with the amount of fee charged, you may try passive investing as well. Look for index funds that fit your budget — these are relatively cheaper and deliver returns equal to the underlying benchmark returns.
4. Compare Risk-Adjusted Returns
Instead of looking at plain vanilla returns, look for risk-adjusted returns of the fund. As per risk-return tradeoff, a higher degree of risk should be compensated by a higher level of returns. The risk is measured with the help of standard deviation.
Using Sharpe ratio helps to ascertain whether the fund is giving higher returns on every additional unit of risk taken. The fund having Sharpe ratio higher than the category average shows that the fund manager delivered higher returns for the extra risk taken.
Consider two equity funds A and B having standard deviation i.e. 12% and 15% respectively. If the Sharpe Ratio of A and B is 0.48 and 0.60, then go for fund B because it’s a better bet for the risk taken. However, if B’s Sharpe ratio was around 0.50, then you could even have gone for A.
It is because a mere 0.02 extra return isn’t worth it for assuming an extra 3% risk.
5. Compare Average Maturity and Duration
These are essentially used to evaluate debt funds. Average maturity relates to the period after which the securities held by a debt fund will mature. The longer the maturity, the higher is its sensitivity to interest rate movements. And higher are chances of a fall in the fund NAV due to a rise in interest rates.
Duration means how long does each underlying security of the debt fund take to reach a break-even point i.e. point of no profit no loss. The shorter the duration, the quicker will it return your original investment. In such a scenario, you will be able to accumulate money to reach your goals.
While investing in debt funds, the average maturity and duration of the fund should match your investment horizon.
6. Compare fund’s Alpha and BetaAlpha measures the number of extra returns generated by the fund in excess of the benchmark returns. Beta measures the riskiness of a fund. Moreover, it shows whether the fund loses/gains more/less than the benchmark. If the beta value is more than one, it shows that the fund gains/loses more than the benchmark. A beta value of one indicates that the mutual fund’s returns move the same as the benchmark. If the beta is less than one, then the fund gains/loses less than the benchmark. Consider two funds A and B which have the same level of beta i.e. 2. If alpha of A and B is 2 and 1.75 respectively, then you may go for fund A. It’s because, for the same level of risk, the fund manager is able to generate higher returns than the benchmark.
7. Compare Portfolio Turnover Ratio (PTR)
The portfolio turnover ratio tells you how often the fund manager buys/sells securities in the portfolio. In case of equity funds, it shows the level of trading taking place in the fund. You need to know that whenever an equity share is bought/sold, it attracts transaction charges like the brokerage.
Frequent trading going on in a portfolio ultimately increases the expenses and is reflected as a higher expense ratio. It might reduce your take-home returns from the fund. Thus, PTR is an important criterion for fund selection.
While choosing a fund, look for one with a lower PTR. If you want to go for a fund with a high PTR, then check whether such high PTR is being justified by way of higher returns.
8. How ClearTax can help you
Unless you are an active investor who closely follows the market trends and related metrics, it can be difficult for you to choose a mutual fund according to the above parameters. ClearTax can help you here by handpicking the most suitable and best-performing investment portfolios for you based on your financial goals.