Critical factors to consider before choosing the right mutual funds

There are over 30 asset management companies, each offering variety of mutual fund schemes to choose from. In total, there are over 2000 primary choices available.

Dec 20, 2016 11:12 IST others

Choosing a mutual fund scheme can be a challenging task. There are over 30 asset management companies, each offering variety of mutual fund schemes to choose from. In total, there are over 2000 primary choices available. This can be a daunting task even for a knowledgeable investor let alone an uninitiated one. So, how does one sift through the maze of options available.
 
Asset Allocation comes first. Before you start the selection process the main question you need to ask yourself is what are you investing for. The answer is not that simple. Choices can be either short term or long term. Are you investing for your child’s education, wedding, property purchase, a car, retirement or a vacation.
 
Lets tackle the duration choice first since it addresses what kind of an asset class an investor would invest in. If your investment duration is three years or less, I would recommend 100% allocation to Debt funds.

Ideally it is prudent to match the investment horizon with the Average maturity of a debt fund. For an investment horizon of a year or less, I would recommend a liquid fund or an ultra-short term bond fund, which carries very little interest rate risk due to the short duration. Make sure to choose one with AAA credit quality to minimize credit risk. Other factors to consider when it comes to debt funds are Expense ratio and size of the fund. For two funds with similar characteristics but differing Expense ratios, choose the one with the lesser expense ratio. Size of the fund comes in to play where liquidity is concerned. Larger funds tend to have higher liquidity hence redemptions can be made easily. 
 
For an investment horizon of over three years, it is prudent to introduce equity funds in to the mix in increasing proportion based on the length of investment.
 
When considering Equity funds we look at the following criteria for fund selection.

  1. AUM: Whether the fund is large enough for liquidity events. While AUM in the 100’s of crores is sufficient for Equity funds it should be in the 1000’s for debt funds as the investment amount per investor tends to be a lot higher in debt funds vs equity funds.
  2. Performance of the Scheme vs. its category: Whether the scheme has outperformed the category average over 1-year, 3-year and 5-year timeframe.
  3. Expense Ratio: This is a key metric to look at when considering an Equity fund. High expense ratio will impact fund returns directly.
  4. Risk factors to consider include Sharpe ratio, Alpha and Beta: A good mutual fund is one which gives better returns than others for the same kind of risk taken. Sharpe ratio is a measure for calculating risk adjusted return. The higher a fund's Sharpe ratio, the better a fund's returns have been relative to the risk it has taken on. Alpha is the excess return earned by a fund vs. its benchmark index.  
  5. Fund manager tenure: Fund managers play an important role in the fund’s performance. Past returns are a valid metric to consider only if the fund manager has been around as long. We recommend avoiding funds with relatively new fund manager hires until the fund manager has had a chance to prove himself/herself.
  6. Capture ratio: Another very important factor to consider but which often gets neglected is Capture ratio.

Capture ratio = Upside Capture Ratio/ Downside Capture Ratio.

Upcapture and Downcapture ratios, offer a relatively straightforward way to evaluate a fund's historical performance during both rallies and down markets.  In short, the statistics show you whether a given fund has outperformed--gained more or lost less than--a broad market benchmark during periods of market strength and weakness, and if so, by how much. When used in conjunction with other risk measures, upside/downside capture ratios can be a handy tool for evaluating a fund’s performance and conducting due diligence on possible additions to your portfolio. An upside capture ratio over 100 indicates a fund has generally outperformed the benchmark during periods of positive returns for the benchmark. Meanwhile, a downside capture ratio of less than 100 indicates that a fund has lost less than its benchmark in periods when the benchmark has been in the red.Hope this article has helped you and you are now armed with the tools and criteria to select just the right funds for your portfolio.

The author, Manish Hermajani is CEO, Co Founder, FinAskus.

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