Mutual Funds: Tips on how to choose the funds right for you

Updated: Nov 24, 2020 1:17 AM

From the risk-o-meter rating to performance indicators such as Alpha and Beta along with the Sharpe and Treynor ratios, each indicator helps identify the mutual fund ideal for you.

A risk-averse investor would prefer to have funds with lower beta.

By P Saravanan and Sumit Banerjee

Mutual funds are the most preferred vehicle of investment for investors who wish to have better returns by assuming little additional risk. Investors who have limited knowledge and time to invest in the stock market directly by themselves take the mutual fund route of investment, generally through systematic investment plans (SIPs). Let us discuss below certain key indicators that the investors must check before investing in mutual funds to get the most of their investment.

Check the type of mutual fund
Mutual funds offer a plethora of funds ranging from pure equity funds to pure debt funds and everything in between. On the equity side, the funds range from capitalisation-based funds to index funds to thematic funds. On the debt side, funds on offer are liquid funds and fixed income funds to funds that invest only in government securities. It is always recommended to diversify one’s investment by investing in different types of funds to spread the risk.

Check the risk rating
Recently, market regulator Securities and Exchange Board of India (Sebi) released a methodology to quantify the level of risk in a mutual fund scheme. Accordingly, every mutual fund is rated on a risk-o-meter that gives the risk rating of the fund on a five-point scale ranging from one to five. One means low risk whereas five means very high.Though it is mandatory from next calendar year, many fund houses are already adopting it. Based on your risk appetite, you should choose your mutual fund.

Check the performance indicators: Before choosing the mutual funds, investors should look at the following major performance indicators.

Alpha: It indicates how well the fund manager has performed over and above the benchmark index. The Alpha shows the percentage above or below the benchmark index that the fund has been able to return to the investors. Investors should always look for funds with higher positive alpha.

Beta: It indicates the volatility of funds to the benchmark index. A beta of more than one indicates that the funds were more volatile than their benchmark index, and vice-versa. An investor should know the beta of the fund to understand if the superior returns were achieved with or without taking additional risks. A risk-averse investor would prefer to have funds with lower beta.

Sharpe and Treynor ratios
Sharpe ratio shows the amount of return in excess to the risk-free rate per unit of volatility. Investors should always prefer funds with higher Sharpe ratio.Treynor ratio indicates the amount of excess returns achieved per unit of risk undertaken. But here risk is measured as beta of the portfolio. Similar to Sharpe ratio, investors should choose funds with a higher Treynor ratio.

Thus, by doing a quick analysis on the above parameters, investors stand to make a better investment call at their end. Often the above indicators are readily available, and these will immensely help investors in their long journey of investment.

Reading the signs
Invest in different types of funds to spread the risk
Risk-o-meter gives the risk rating of the fund on a five-point scale ranging from one to five
Alpha indicates how well fund manager has performed over and above benchmark index
Beta indicates volatility of funds to the benchmark index
Sharpe ratio shows amount of return in excess to risk-free rate per unit of volatility
Treynor ratio indicates amount of excess returns achieved per unit of risk undertaken

(Saravanan is a professor of finance & accounting and Banerjee is a doctoral scholar at IIM Tiruchirappalli)

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