How to choose a Mutual Fund?

An investor should analyze the following important factors of a mutual fund before selecting it:-

1] AUM of the Mutual Fund–

Assets under management are the overall market value of assets/capital that a mutual fund holds. AUM is an indicator of the size and success of a fund house. One can easily compare its assets under management in various timelines and market phases performed as opposed to its peers. The AUM-value also includes the returns that a mutual fund earns. The asset manager can invest this in securities, distribute to investors as dividends or hold as per the investment mandate.

You should avoid funds with too low AUM as that would mean less inflows and less focus from fund house.

2] Alpha of the Mutual Fund–

Alpha measures the difference between a fund’s actual returns and its expected performance given the level of risk. It indicates the risk-adjusted performance of a portfolio.

It takes the volatility (price risk) of a security or fund portfolio and compares its risk-adjusted performance to a benchmark index. The excess return of the investment relative to the return of the benchmark index is its “alpha”. Alpha is often considered to represent the value that a portfolio manager adds or subtracts from a fund portfolio’s return.

3] Mutual Fund Portfolio P/E Ratio –

In mutual funds, the PE Ratio multiple of a scheme is arrived at by using a weighted average of underlying stocks. A high portfolio PE would show that the scheme mostly holds stocks that are quoting a valuation premium. This indicates a preference for growth oriented businesses.

But, if the PE of the mutual fund is on the lower side, it signifies a value-conscious approach. Growth oriented funds tend to exhibit strong returns within a short span of time but are more volatile. Value conscious funds typically yield great results over a longer period of time and come with lesser volatility in returns.

4] Beta –

Beta measures the sensitivity of a portfolio against its benchmark, which can be in the range of 1, >1 or <1 for equity funds, wherein 1 indicates fund’s NAV will move in same direction as that of benchmark index and that of less than 1 indicates the fund’s NAV would be less volatile than the benchmark index.

Beta is a risk ratio that investors use as a tool to calculate, compare and predict returns. It utilizes benchmark indexes, such as the BSE Sensex. And compares them against the individual security to highlight a particular performance tendency. Beta is based on the volatility in prices or trading, of the stock or fund, something not measured by alpha. But beta, too, is compared to a benchmark.

5] Mutual Fund performance –

The performance needs to be considered because it gives you an idea of how it has handled money in the past over a period of time. Ensure that you measure the performance over a significantly long period so that you know the pattern and can make a good judgment. You may want to look into what kind of risks the fund has exposed you to over a period of time.

Performance can be considered as a scorecard of the past behavior of the scheme. In mutual funds, performance analysis depicts the results of the fund managers’ skills and caliber in outperformingthe benchmark returns. Thus, the funds with consistency in performance and high-risk management during volatility in the market are best suitable funds for the long-term investment.

6] Mutual Fund Sharpe Ratio

Sharpe ratio measures the extra return a fund has generated relative to the risk taken. The higher the sharpe ratio, the better a fund’s return in lieu of the risk.

It is calculated as,

Sharpe ratio = (Return of the fund – Risk free rate of return) / Standard Deviation

Sharpe ratio is a measure of excess portfolio return over the risk-free rate relative to its standard deviation. If two funds offer similar returns, the one with higher standard deviation will have a lower Sharpe ratio. To compensate for the higher standard deviation, the fund needs to generate a higher return to maintain a higher Sharpe ratio.

7] Exit load –

Exit load is another cost that you directly incur. It is a fraction of the NAV that you receive and thus, leaves a hole in your investment value. So, the lower exit load a fund offers, the better is it for you. It only comes into play if you wish to sell your units.

8] Mutual Fund Manager Information –

A good fund manager helps create a strategy that can deliver better risk adjusted returns for the fund scheme within the mandate. But, a fund that delivers only because of the presence of a particular fund manager is unlikely to sustain its performance in the long term.

The experience and tenure of the fund manager play significant role in the performance of the fund and its returns generating capability. Moving the capital in the right possible way by predicting the various future market trends is not a simple task. They have to keep their eagle’s eye on the continuous behavior of the market to grab the best opportunity to fetch more returns. So, you should know a little detail about the fund manager of the scheme and his/her records of excellence. You can also check the performance of other schemes which are being managed by the fund manager. This provides with more clarification of the expertise of the fund manager.

Over the long-term, it pays to have your money managed by a group of fund managers, rather than one star fund manager. As he could quit the fund house any time and take the performance with him.

9] Expense ratio –

This is usually considered when you invest in anequity fund. The higher the expense ratio, the more it affects you directly. It comprises of the brokerage fees and other costs that the mutual fund houses charge from investors. Hence, you need to see if the charges are not over the top. But, there are funds that charge high but make it up by offering a higher NAV or better returns. So consider these also while checking the expense ratio.

Expense ratio is the very important parameter to be looked at before selecting any mutual fund scheme.

10] Standard Deviation –

Standard deviation tells you how much have the fund returns fluctuated. It means how far the returns of the fund have deviated from its average over a period of time. More the deviation, more volatile the fund is.

One can use the above-mentioned factors as a checklist for next time you choose a mutual fund to invest in.

Below is a photo of a fact sheet of HDFC Equity Fund as on May 2018. The fact sheet is used just an example.We are neither promoting the fund house nor the fund.

HDFC Equity Fund May 2018 FactSheet
HDFC Equity Fund May 2018 FactSheet