The first rule that any financial planner will tell you is that your mutual fund selection should be in tune with your goals and your risk appetite. But for the purpose of simplicity, let us assume that most of the ground work has been done. You have finally drilled down to your equity fund allocation. You also know the corpus that you need to invest in the equity fund; now the big challenge is how to choose equity mutual funds. Apart from the factors to consider when choosing the fund, let us also look at a 7-factor mutual fund selection tool.
1. Performance vis-a-vis the index based on TRI
That is the basic test of an equity fund. Short term returns do not really matter. What matters is whether your fund has outperformed over a longer time frame of 5-7 years. That straight away rules out new funds that have just been launched. You may miss out on future outperformers but your first priority is to go with the tried and tested names. Remember; when you benchmark your funds don’t look at point-to-point returns on the index. Instead, look at the total returns index (TRI) that incorporates dividends too. That is only being fair because the mutual fund enjoys dividends too and therefore you need to compare apples with apples. Look at 3 year and 5-year rolling returns each quarter. You are likely to weed out most of the non-performers.
2. Consistency of returns
What do we understand by consistency of fund returns? Take an example of a Fund that delivers returns of 15% per annum and the NAV moves from Rs.100 to Rs.152 in 3 years. Another fund delivers 18%, 28% and 0.75% returns in 3 years and the NAV at the end of 3 years is also at Rs.152. Which fund is better? Obviously, the first fund is better because its performance is more consistent. When funds perform consistently, they are more predictable and give you comfort for the future.
3. Prefer the fund with the lower expense ratio
Normally, funds with a larger AUM tend to load a lower expense ratio on the investors. Expense ratio can range from 1.5% to 2.2%. This is the sum total of the fund costs including transaction costs, legal costs, administrative costs which are loaded on the fund and reduce the NAV of the fund proportionately. Over a longer period of time, you need funds that are efficient and load lower expense ratios on you. This is an important factor.
4. AUM matters when you choose your equity fund
There is no hard and fast benchmark but you should ideally opt for an equity fund that has an AUM of over Rs.5,000 crore. This is the bare minimum and with the SEBI norms for reclassifying funds the AUM requirement can be even higher. Higher AUM ensures that the fund is able to leverage on opportunities and is not forced to resort to distress sale in the face of redemption pressures. Fund managers in these funds are able to take a more long term approach to investing. That suits your purpose too.
5. Not just returns, but look at risk-adjusted returns
Returns, by themselves, can be quite deceptive. 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%. Obviously, the fund manager is taking on too much risk to generate higher returns. That is what risk adjusted measures like the Sharpe Ratio and the Treynor ratio capture. They measure return per unit of risk. In the above case, Fund A will have a Sharpe Ratio of 0.90 while Fund B will have a Sharpe Ratio of 0.44. Now you know which fund to choose!
6. Has the team at the fund been stable over time
This is a fairly subjective parameter but important nevertheless! When you invest in an equity fund you want the CEO, CIO and the fund managers to be with the fund for a long time. If these key personnel keep changing then there is no consistency of fund management policy and strategy. Also, when fund teams stick around longer, they build a certain tacit rapport and that helps them in enhancing performance. Even as an investor, you get comfortable with a fund management team and do not want it changing constantly.
7. Finally, don’t forget the capture ratio
This is a measure that is not often used in India but globally it is a very important measure. At the end of the day, the job of a fund manager is to outperform the index. Otherwise you would have been better off in an index fund. You need to break up this outperformance. That is where capture ratio come in handy. It has two parts. The Upside Capture Ratio (UCR) calculates if the fund outperformed when the index was in bullish phase. The Downside Capture Ratio (DCR) measures if the fund lost less when the index was in a bearish phase. Therefore, an upside capture ratio of above 100% and a downside capture ratio of below 100% is what you need to look for.
Selecting the equity fund is a fairly tricky process. The above factors can help you make a more intelligent decision in the process.