How to Choose Best Mutual Funds
Before investing in Mutual funds from any category, like Large Cap, Mid Cap, Small Cap, or Multi-Cap. Mutual Fund investor normally checks different parameters related to that MF, like past performance, Fund Portfolio, Fund Manager, etc. Out of so many options available in any category, investors should choose the best mutual fund available in that category. Only past performance should not be the criterion for selecting MF. There are many other parameters and ratios related to Mutual Funds that should be checked before making a final decision. The investor should check the following parameters and ratios of investing MF with those of other MFs of the same category, and then make a decision.
 |
Parameters of Mutual Fund
Fund Size (AUM): AUM (Asset under Management) is the amount of money invested by investors in a particular mutual fund. Newly launched MFs have less AUM as compared to MFs that have been in the market for a long time. Greater AUM indicates the popularity of MF in the market. It also indicates that the investment made by MF is giving good returns. Larger AUM-sized MFs can invest more in R&D activities and give better services to investors. Large-sized AUM mutual funds tend to charge a lower expense ratio to their investors.
It is not a thumb rule that Large AUM MFs are always good for investment. It can differ from category to category. For a small-cap mutual Fund, less AUM is better. Small-cap MFs are investing in small-cap companies, which is a risky investment. If AUM is small, out of the total AUM, a smaller amount will get invested in stocks. This will reduce the investment risk for investors. Well-established MFs have large AUMs, and newly launched MFs have small AUMs. New MFs have yet to establish their reputation in the market. AUM is one of the important factors while selecting the MF, but it is not the only criterion. There are other important parameters also.
Expense Ratio:– It is the fees charged by a mutual fund house for managing its expenses. The mutual fund house has to hire professional managers, They have to invest in R&D activities and various infrastructure expenses. Also, it provides various services to its investors. For all this, it requires money. For this, they charge a small amount of fee from investors. While doing an MF selection, the Investor should compare the expense ratio of the MF with its competitors. The lower the Expense ratio
better it is. But if a mutual fund gives extraordinary returns, then it is worth paying a higher expense ratio.
better it is. But if a mutual fund gives extraordinary returns, then it is worth paying a higher expense ratio.
Standard Deviation: Standard deviation is used to measure the fluctuations in returns of Mutual Funds. It shows how much it deviates from its average return over a period. If the standard deviation is more means that MF is more volatile. Investors should compare the investing MF standard deviation with its competitors’ MF while making decisions.
Sharpe ratio:- This ratio is used to determine the risk-adjusted return. The higher the Sharpe ratio indicates better the performance of MF against the risk taken. MFs are taking certain risks while investing in securities. Against that risk how much reward it is getting in terms of return? Investors should compare the Sharpe ratio of investing in MF with another mutual fund of the same category.
Sharpe Ration = (Average expected Return of portfolio — Returns of Risk-Free Investment ) / Standard Deviation of MF
Sharpe Ratio tells us the return generated per unit of risk taken. If some MF has a Sharpe ratio of 1.5 means that for 1 unit of risk taken, the MF is given a return of 1.5.
Turnover ratio: This ratio shows the frequency of buying and selling of stocks in a mutual fund’s portfolio. This ratio helps to determine the investment strategy of mutual funds. Some MFs have a buy-and-hold strategy, and some buy-and-sell strategy. MF, having a strategy of buy-and-hold, holds the stocks for a longer duration in its portfolio. MF has a buy-and-sell strategy, frequently by and selling the stocks in their portfolio. This ratio will help to judge whether MF has a long-term or short-term vision while investing.
Alpha Ratio:- Alpha Ratio indicates the extra return given by a Mutual Fund over its Benchmark index. If the Alpha Ratio is Zero, it shows that MF has given the same return as that of a benchmark index. If some MF has Alpha 1.5%, that means it has given returns of 1.5% more than that of its Benchmark Index. Suppose Benchmark Index funds have given a return of 100, then MF will give a return of 101.50. If the Alpha of MF is -2 and if the Bench Mart index gives a return of 100, then MF will give a return of 98%. You should not invest in an MF having a negative alpha. The greater the value of alpha better the performance of MF as compared to its Benchmark Index.
Beta Ratio:- One ‘1’ is considered as the ideal Beta ratio. Beta Ratio is related to Market volatility. If some MF has a beta of 1.5 then with every increase in the market of 1 Unit, MF will increase by 1.5. and if the market falls by 1 Unit, MF will decrease to -1.5. MFs having a Beta of more than 1 is considered as more risky. Funds having less beta ratio are less risky Fund. Low-risk appetite customers can invest in MF having low beta.
Comparison with benchmark index:- Every mutual fund has a benchmark index it follows. Investors should compare the return of a mutual fund return with its benchmark index return. MF return should at least beat the benchmark index returns. Investors should at least check 5 years of MF returns against its bench. MF should consistently beat the returns of its benchmark index.
Rolling Returns:– Investors should check Mutual Funds’ rolling returns for at least five years. This will give a fair idea about its past performance. He can also predict the future returns from mutual funds. Rolling return means average return over a period.
Conclusion:
The investor should study all the basic parameters like MF’s AUM, its past Rolling Return (i.e., Yearly Return) from its inception, its comparative return with the Benchmark index, the Fund manager’s reputation, and the fund’s portfolio. Investors should also check these ratios related to MF like Sharpe Ratio, Alpha & Beta Ratio, Turnover Ratio, and Standard Deviation. It should compare all these parameters and ratios with those of the top 3 MFs of the same category and then take the final call to invest. Of course, it is always advisable to consult a Qualified Financial Professional in case of any doubt.
The reader will also like to read about the following topics
3. PE Ratio
5. Bull vs Bear Phase in Stock Market
6 . XIRR vs CAGR vs Absolute Return
7. Home