Are you tired of relying on other people for fund recommendations? Want to take control of your portfolio and choose the right mutual funds for your needs? Look no further, as we dive into an elaborate approach to selecting the perfect funds for your financial journey. While you may say that you use past performance and fund ratings as selection criteria, it may not provide a comprehensive approach to choosing the right funds for your portfolio and demand a more detailed approach. In this article, we will walk you through the process of evaluating a mutual fund's portfolio, performance and other key factors to help you make an informed decision and select the best mutual funds for your investment portfolio.
Fund Manager
When considering a fund manager, it is best to invest in a fund where the manager who built the successful track record is still in charge as ultimately it is the fund manager who has to make the final decisions about which stocks to buy and sell. Many experienced investors believe that the fund manager can greatly impact the performance of the fund, particularly in terms of his ability to identify and adapt to changes in market trends. As a result, it can be helpful for investors to develop a view on the track record, experience and consistency of the fund manager when selecting a mutual fund.
Fund Performance and Returns
When evaluating a mutual fund, it is important to consider the fund's past performance and how it has performed relative to its benchmark and peer group inspite of the fact that past returns are not a guarantee of future performance. The fund's returns should be evaluated over a period of time, with longer periods being more relevant for equity funds and shorter periods being more relevant for debt funds.
To evaluate the fund, examine its trailing returns over various time horizons such as year-to-date, one-year, three-year and five-year period. The fund should have consistently performed better than its benchmark. An investor must opt for a fund that has demonstrated consistency in its performance, not only performing well in a rising market but also providing downside protection in a declining market. This characteristic makes it easier for an investor to stay invested during bear market phases.
When selecting a fund, it is important to consider both returns and risk. It is recommended to choose a fund that has higher risk-adjusted returns as measured by parameters such as Sharpe ratio* and Treynor ratio**, compared to the average in its category. Additionally, the fund's level of risk, as measured by criteria such as standard deviation and beta should be lower than the category average. This will ensure that the fund not only provides high returns, but also has a lower level of risk.
*The Sharpe ratio is a measure of risk-adjusted return that compares the excess return of an investment (i.e. return above the risk-free rate) to its volatility. It is calculated as follows: Sharpe Ratio = (Rs minus Rf) ÷ Standard Deviation where, Rf = risk-free return, Rs = return earned on the investment and Rs-Rf = risk premium The higher the Sharpe ratio, the better the investment's risk-adjusted return. Since the Sharpe Ratio uses standard deviation as a measure of risk, it's often used to compare the performance of different investments and determine if an investment's returns are due to smart investment decisions or simply a result of excessive risk-taking. **The Treynor ratio is a measure of risk-adjusted return similar to the Sharpe ratio that compares the excess return of an investment to the investment's systematic risk (also known as market risk or non-diversifiable risk) and is calculated as follows: Treynor Ratio = (Rs minus Rf) ÷ Beta A higher Treynor ratio indicates a better risk-adjusted return. The use of beta makes this ratio more applicable to diversified equity funds. It's important to note that while both Sharpe and Treynor ratios measure risk-adjusted return, they use different measures of risk. Sharpe ratio uses volatility as a measure of risk, while the Treynor ratio uses systematic risk as a measure of risk. |
Fund Portfolio
When evaluating a mutual fund, it is important to assess the risk and return of the fund's portfolio. For an equity fund investor, this may involve considering the level of diversification across sectors and stocks, the market segment in which the fund is investing, the amount of cash held, holding period in stocks and portfolio churn.
For debt funds, investors should consider the average maturity and duration of the portfolio, the credit risk profile, the extent to which interest and capital gains contribute to the total returns of the fund and the level of liquidity in the portfolio. By carefully evaluating these factors, investors can better understand the risks and potential returns associated with the fund they choose to invest in.
Fund Age
When evaluating a mutual fund, it is important to consider its performance history over a sufficient time frame. A track record of at least five years is generally considered to be a good benchmark, but it is also important to look at funds that have performed well over a minimum of three years, as it will include a complete market or business cycle with both an upswing and a downswing. This will give an idea of how the fund performs in different market conditions. Thus, a fund with a long history has a track record that can be studied, while a new fund managed by a portfolio manager with a poor track record may be avoided.
Fund Size
The size of a mutual fund, as measured by its assets under management (AUM), can be an important factor to consider when selecting a fund. When evaluating the size of a mutual fund, it is important to consider the investment universe that the fund is targeting. As a fund's AUM increases, it may become more challenging for the fund to outperform its benchmark. This is because a larger AUM requires more investment ideas to deploy the additional funds and there may not be enough good ideas available in a shallow market. Additionally, there are limits on how much of the fund's AUM can be invested in a single stock, which may limit the fund manager's options.
Here are some points to consider when deciding to invest in large and small mutual funds:
Diversification: Large mutual funds may offer a more diversified portfolio, as they may have a greater number of holdings and a broader range of sectors represented and also allow economies of scale. This can potentially reduce risk for investors. Thus, for large-cap oriented equity and equity-related funds, a large fund size may be beneficial. This also holds true for certain categories of funds such as liquid, low duration and short-term income funds which have a large investment universe.
Risk: Small-cap funds may be more prone to fluctuating in value compared to large-cap funds as these funds invest in smaller companies that may be more volatile and carry greater risk than larger, more established companies. Although these funds have limited investment options, they may be more agile and able to take advantage of market opportunities more easily. Thus, for small-cap and mid-cap, sectoral, and thematic funds, a smaller size may be an advantage as stock picking is often a key factor in the performance of these types of funds.
Performance: Some research has suggested that small-cap funds may have the potential to outperform large-cap funds in the long run, due to the greater growth potential of smaller companies. However, it is important to note that past performance is not indicative of future results and both large and small funds can experience periods of underperformance.
Portfolio Turnover
This is cost of buying and selling securities, known as broking costs, that can impact the performance of a mutual fund. Frequent portfolio churn, or the buying and selling of securities, can not only add to these costs, but may also suggest unstable investment management. When a fund manager frequently buys and sells securities, it results in a higher turnover ratio. This strategy can lead to strong performance if successful, but it also incurs additional costs. If the approach does not work, the costs may outweigh any potential gains. Therefore, it is generally more favourable to choose funds with a lower turnover ratio, as this suggests the fund manager has confidence in his investments and is willing to hold onto them for a longer period of time. At the same time, it is also important for investors to consider the portfolio turnover of a fund in relation to the fund's investment style. For example, six months holding period may be too short for a value fund, but may be acceptable for a momentum-oriented fund. Investors should therefore carefully consider the portfolio turnover of a fund and how it aligns with their own investment goals.
Expense Ratio
Expense ratio is an important factor to be considered when selecting a fund. The expense ratio tends to decrease as a fund's asset size increases. Therefore, expense ratio may favour larger funds which typically have a longer and more established track record and it's recommended to give preference to funds with a lower expense ratio. Investors should also be aware of the expenses like exit load that apply on exiting a mutual fund, as they can impact the overall returns of the fund.
Conclusion
When it comes to investing in a mutual fund, it is important to conduct thorough research and due diligence to ensure that the fund aligns with your investment goals and risk tolerance. One crucial aspect of this research is evaluating the fund's portfolio, investment objective, and the fund manager's track record. The fund's portfolio should align with its stated investment objective and the fund manager should be following the strategy and style outlined in the scheme's statement of investment objectives and policies. Additionally, investors should review the fund's performance, expense ratio, and potential risks in the portfolio before making a decision. It's important to keep in mind that past performance is not a guarantee of future returns and that the fund's suitability should be assessed in relation to your overall investment strategy and risk tolerance.
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