By Saravana Kumar
For many of us, lack of knowledge proves to be a hindrance in choosing the right investment product. Many of us invest in mutual funds based on the advice given by a mutual fund distributor. The suggestion of a distributor is normally biased and based on the commission received by them.
The end result, we end up making wrong investments. Hence doing a fundamental research in analyzing mutual fund schemes is important. Here we discuss 10 signs to know whether you have the right mutual fund schemes or not:
1. Assess your risk appetite and investment objectives
Age and current income are the key determinants when it comes to assessing your risk profile. So, if you have invested in a scheme which do not suit your risk profile and investment objectives, it is better to get rid of the investments. Equity funds are high-risk, high-return products while debt funds are at the other end of the spectrum. If you want higher returns and can take high risks, then having equity mutual fund schemes in your portfolio is a good idea. However, if you want steady and lower-risk returns, then your portfolio needs to be more focused towards debt mutual fund schemes.
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2. Performance of Mutual Fund House and Fund Manager
Choose a fund house that has strong global or domestic track record in asset management. For how long the fund has been in business – the longer the better. For, in general the more one is engaged in a particular trade the more intimately one knows that business. Also understand the investment strategy of the fund manager. A fund manager decides on instruments or securities to invest in. Being pre-emptive and not reactive is what distinguishes a good fund manager from an average one. Look at how he has managed your scheme over a medium to long period. If the fund manager has taken over the fund very recently, it would be a good idea to give him some time to prove his worth.
3. Look at the Quartile Performance of your Mutual Fund Scheme
Each mutual fund is assigned a rank based on trailing annualized returns. Mutual funds are categorized into four quartiles, namely Top Quartile, Upper Middle Quartile, Lower Middle Quartile and Bottom Quartile. Quartile rankings are a measure of how well a mutual fund has performed against all other funds in its category. Many mutual fund research websites publish the quartile performance of mutual fund schemes. The rankings range from “Top Quartile” to “Bottom Quartile” for all time periods. While you may want your scheme to be in the top quartile, what is even more important is the consistency of quartile ranking across several quarters.
4. Alpha of a Mutual Fund
There are risk return indicators available which can help you to judge the performance of a mutual fund. Alpha is one such indicator; it is a measure of a mutual fund’s performance on a risk-adjusted basis and as compared to the benchmark. Simply stated, alpha is often considered to represent the value that a portfolio manage adds or subtracts from a fund portfolio’s return. A positive alpha means the fund has outperformed its benchmark index. Correspondingly, a similar negative alpha would indicate underperformance. For investors, the more positive an alpha is, the better it is.
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5. Beta of a Mutual Fund
Beta is the measure of a fund’s volatility as against the benchmark. It measures the fund’s sensitivity to changes in the market. A mutual fund investor can use beta in planning their fund selection to determine volatility of the fund and to compare its sensitivity in movement to the overall market. Conservative investors looking to preserve capital should focus on securities and fund portfolios with low betas, whereas those investors willing to take on more risk in search of higher returns should look for high beta investments.
6. Standard Deviation of a Mutual Fund
Standard deviation measures the dispersion of returns from its mean. With mutual funds, the standard deviation tells us how much the return on a fund is deviating from the expected returns based on its historical performance. Mutual funds with a long track record of consistent returns display a low standard deviation. Growth-oriented or emerging market funds, however, are likely see more volatility and have a higher standard deviation. So asses your risk profile and have the right mutual fund in your portfolio. Ideally choose a fund which has a long track record and has shown consistence performance.
7. Sharpe Ratio of a Mutual Fund
Sharpe ratio measures risk-adjusted performance. It is calculated by subtracting the risk-free rate of return from the rate of return for a mutual fund investment and dividing the result by the fund’s standard deviation of its return performance. The greater an investment’s Sharpe ratio, the better its risk-adjusted performance. It basically tells investors whether a mutual fund’s returns are due to smart investment decisions or the result of excess risk. This measurement is very useful because although one mutual fund can reap higher returns than its peers, it is only a good investment if those higher returns do not come with too much additional risk.
8. R-Squared of a Mutual Fund
R-Squared is a statistical measure that represents the percentage of a fund portfolio’s movements that can be explained by movements in a benchmark index. R-squared values range from 0 to 100. Generally, a mutual fund with an R-squared value greater than 85 has a performance record that is closely correlated to the index. A fund rated 70 or less would not perform like the index.
Mutual fund investors should avoid actively-managed funds with high R-squared ratios, as they would give you the same returns as the index. So, why pay the higher management fees when you can get the same or better results from a passively-managed index fund?
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9. Exit Load of a Mutual Fund
Exit load is paid by the investor when he redeems the investment before a certain period. Different types of funds have different exit loads depending upon the nature of assets held by them. Exit loads are imposed to discourage premature withdrawals. Funds managers who manage schemes meant for the long run would like to their investors to stay invested for long tenures.
This is desirable because if too many investors exit, the fund manager has to sell shares—in distress—of companies that are liquid but generally well-managed, thereby robbing existing investors of their future growth potential. Hence, the fund imposes an exit load to discourage investors from moving out too so.
It is important to check the exit load of the mutual fund scheme as you might need money before investment horizon. Try to invest in schemes with minimal exit load requirement.
10. Expense Ratio of a mutual Fund
There are ratios that would further help you to eliminate some more schemes from your shortlist. Total Expense Ratio is one of the main ratios. Expense ratio states how much you pay a fund in percentage term every year to manage your money. It takes care of the fund manager’s fee, administration and other operational expenses. For example, if you invest Rs 10,000 in a fund with an expense ratio of 1.6 per cent, then you are paying the fund Rs 160 to manage your money. In other words, if a fund earns 12 per cent and has a 1.6 per cent expense ratio, it would mean a 10.4 per cent return for an investor. Different funds have different expense ratios. While calculating returns from the scheme, it is advisable to check the expense ratio as expense ratio eats into returns from the scheme.
(The author is CIO, LIC Mutual Fund)