1. The first rule is not to focus too much on short term returns but rather look at long term returns. What is a long term is hard to gauge but note that when such equity funds are held for a period of more than 8 years your downside risk is almost zero. Otherwise, you can evaluate funds based on the last 3 years returns on a rolling basis. That may mean that new funds are out of the question, but that is risk worth taking.
2. Focus on the total returns index benchmarking rather than absolute returns benchmarking. Let us understand this little better. When you calculate fund returns, you calculate the full returns from point to point. But, when you calculate index returns, you ignore the dividends. This overstates the performance of the equity fund vis-??-vis the index. Instead, look at equity benchmarking from the perspective of the total returns index (TRI) where the index returns are calculated including the dividend yield on the index.
3. Size matters and it matters a lot. Should you invest in a fund with an AUM of Rs.3000 crore or a fund with an AUM of Rs.300 crore? The pressure of redemptions and sub-optimal decisions is lower in larger funds. Costs are also lower in the case of larger fund as the lower Total Expense Ratio (TER) is inversely proportional to the size of the fund. The TER structure prescribed by SEBI is in such a way that your TER goes down as the size of the fund increases. Also, funds are large because they have delivered over time.
4. Like it or not, but risk matters as much as returns. If Fund A earns 18 % returns with 20 % standard deviation (risk) then it is a good performance. There is another Fund B which has given 22 % returns but that has come with a standard deviation of 50 %. You will obviously choose Fund A because you are getting a better deal on a risk-adjusted basis. You can use ratios like Sharpe and Treynor which measure returns on a risk-adjusted basis.
5. When it comes to equity funds, consistency mattes a lot because equity as an asset class is quite risky. Let us consider 2 funds which game the same CAGR returns over the last 3 years. Can you be indifferent between these funds? Not exactly! For example, Fund Alpha delivers returns of 15 % per annum and the NAV moves from Rs.100 to Rs.152 in 3 years. Another Fund Beta delivers 18 %, 28 % and 0.75 % returns in 3 years and the NAV at the end of 3 years is also at Rs.152. CAGR returns are the same in both cases, but Fund Alpha is more consistent and consistent funds are a lot more predictable.
6. Be wary of equity funds where there is a constant churn at the top. That means; if the CEO, CIO, fund managers etc are constantly moving in and out then you have a problem of continuity. You may wonder why this is relevant. When key people like CEO, CIO and fund managers keep changing, there is no consistency of policy and strategy. When fund teams stick around longer, they build rapport and that enhances performance. Normally, churn in manpower is indicative of larger problems, which is not great news for an investor.
7. A phased approach or a SIP approach works best in case of equity funds. These funds are the most vulnerable to volatility and an SIP approach help you to make the most of the volatility. Also SIP is a good wealth creator over a longer period of time.