How to pick the best mutual funds?


Posted By : Kushal Kothari
Tags :  Funds

As investors, isn't that something we are always trying to figure out? Partly because we want the best bang for our buck (who doesn't?). But also because we want a methodical process for figuring out the same. A process, that not only makes sure that the selection is logical, but also ensures the results so obtained will be replicable. After all, we are not looking for one-hit wonders, rather solutions that we can follow repetitively to build our investment portfolio. 

 

The truth, however, is that there is no single secret answer to finding the best mutual fund. The problem lies in the definition of "best mutual funds". Many investors, still think the best fund is the one that gives the most returns. Some others think it's the one that has the most star ratings. The investment advisory community the world over is grappling to clear many pre-conceived notions that investors have about mutual funds. Part of the problem is that there are so many parameters to evaluate mutual fund schemes, that the average investors stick to features they understand best - performance and star rating. We have tried to explain some of the key features of mutual funds that can help you arrive at best mutual funds, for you!

 

Asset allocation - This is where all investment planning begins. Before going about selecting the best mutual fund schemes, we need to understand what is it that we want to invest for. Well earning, long term investors may perhaps want to look at only equity-oriented schemes. Many others, who have a planned expense in near future, or are close to retirement, perhaps would want to look at debt schemes. So before you start, understand how much of your portfolio needs to be in equity and debt.

 

Fund category - Let's say you've decided to invest 70% of your portfolio in equity, the rest in debt. That's a good start. But there are more than two dozen categories of mutual funds between them. How do you decide the category you need to invest in? That's where risk profiling comes in. For those who look for long term appreciation in equity without too much risk, may perhaps prefer only large cap equity schemes. For those looking to invest in debt securities without any credit risk, may perhaps want to look only at Gilt schemes. There are a bunch of categories to choose from, perhaps this image from Valueresearch will serve as an excellent resource.

types of mutual funds

 

Past returns (Even better, rolling returns) - Now that you have decided to invest in a particular category of funds, its time to drill down to specific details of the schemes. There's no better place to start than the performance of the scheme. And the best way to judge performance is to look at the historical returns of the scheme up to about 3 years back and compare them with the category returns. Try not focussing too much on benchmark returns. The benchmarks are selected by the fund houses themselves, so clearly there's a possibility of a bias in choosing the benchmark. Also, for an investor, the choice is between choosing one of the many schemes within the category. It is not easy for an investor to invest in the passive benchmark anyway. Hence we prefer to look at the performance of the scheme with its category returns, even better, its rolling returns. Read more about rolling returns here.

 

Expense ratio - It basically says, how expensive or cheap the mutual fund scheme is. For every rupee invested, the fund house charges a percentage as fees, called expense ratio. 1% expense ratio means you'd end up paying 1 rupee on every hundred rupees invested with the fund house, every year. Usually, for liquid/short-term debt funds, the ratio would be less than 0.5%. For equity and hybrid schemes, it goes up to 1.2%. For some small cap schemes, the ratio could be as high as 2%. These numbers are all for direct schemes. For regular schemes, the expense ratio would be even higher. That's also the reason why we think you should avoid regular schemes and invest directly unless you really need services from your distributor. Whether the scheme gives positive or negative returns, you'd always be charged the expense ratio. Hence, when choosing a scheme to invest in, make sure the expense ratio is not too high compared to its peers. 

 

AUM - AUM stands for assets under management. It basically indicates the amount that has been invested in the scheme. The general rule of thumb would be to avoid any categories with AUM less than, say, 300 crores or so. Many schemes at launch receive investments from promoters, related entities and anchor investors. A scheme with low AUM and a small number of investors indicates that the wider markets do not find it attractive enough to participate in it. Also usually, schemes with low AUM has a high expense ratio to cover their fixed costs. Hence, make sure not to invest in schemes with low AUM.

 

Sharpe ratio - All mutual fund investments are subject to price risk, arising from fluctuation in NAV of the schemes. Risks exist in all investments. The important factor is to ensure the returns you get from the investment justify the risk. That's exactly what Sharpe ratio indicates. In simple words, it is the ratio of excess returns from the investment (extra returns you earn above risk-free investments) to the amount of risk in the investments. Logically, one would want the ratio to be greater than 1. Any ratio less than one indicates that you are taking more risk than the extra returns you are earning from the investment. 

 

Average maturity and Average Credit rating - This is of high importance when investing in debt funds. The maturity of the scheme and the credit rating explain most of the returns of the debt schemes. Higher the average maturity of the scheme, higher the returns but also higher the price fluctuations. We'd ideally want to avoid any debt scheme with an average maturity higher than our horizon of investment, lest we could be adding undue volatility in the investment portfolio.

Lower the credit rating of the scheme, higher the returns, but also higher the default risk. We ideally would avoid any scheme with average credit rating less than AA to ensure only high-grade debt investments are introduced in your portfolio. 

 

Fund manager - Finally, for the expert investors, it may be important to track your fund manager. All investments are eventually done by the fund managers. Their decisions eventually decide the outperformance of your investments. Hence, it is useful to have a look at the track record of the fund managers (many of them manage multiple schemes) to decide if a particular scheme suits your investment portfolio or not.

 

 

Summary

Looking only at the recent historical performance of a scheme does not necessarily indicate anything about its future performance. While many star ratings of mutual fund research portals try to encompass multiple parameters, they convey very limited information about the suitability of the scheme in your investment portfolio. There's absolutely no alternative to doing basic homework about your schemes before investing in them.

 

At Expowealth, we help investors with a shortlist of schemes based on above parameters (updated every six months). We also help investors construct their portfolio with a basic risk profile test. Log in to Expowealth to know more about the same.