Factors to consider before selecting the right mutual fund

A common statement I have heard from unhappy mutual fund investors is 'The market has gone up significantly, but our mutual funds have not done very well'. In this article, we will explore the factors that one needs to take into account before selecting the right fund.

1. Fund category (Debt vs Equity vs arbitrage): The investor should be in a position to determine his investment objective, investment horizon and risk appetite. If the investment horizon is low and risk appetite is low-moderate, it is best to go for debt mutual funds. If the investment objective is open ended and there is nothing specific that you save for, plus your investment horizon is long term, it is advisable to go for equity oriented funds. Financial risk has a typical characteristic: The longer the investment horizon, the higher the chances of generating excess returns.

One fund category that I want to highlight here is the Equity Savings scheme: In this scheme, minimum 65% of the total fund AUM is invested into equity and arbitrage opportunities and the remaining into debt. The arbitrage part is interesting and offers comfort to risk-averse investors who are looking for equity exposure. If the markets are overheated and the fund manager suspects that there may be a correction / crash anytime soon, he or she will start building positions in the derivatives segment. Let us take a simple example of arbitrage: Assume you have invested in a Nifty ETF. When Nifty crosses a PE ratio that the fund manager finds is not historically comfortable, he will start shorting Nifty futures. This shorting(or selling) is at a premium to the current value of ETF. Essentially what the fund manager has done is sold something at a higher rate when compared to what he currently owns. Doing this month-on-month gives him the required arbitrage.

2. Expense ratio: Just like every other business, in the mutual fund industry too, there are no free lunches. Mutual funds are managed by professional Asset Management Companies (AMCs) which are managed by professional fund managers and their research teams. The AMC has to take care of salaries of their staff and also manage the distribution costs.

Expense ratio is calculated as operating costs of mutual fund as a percentage of average assets of the fund. As per SEBI guidelines, a mutual fund's operating costs cannot exceed 2.5% of its average assets.

3. Sharpe ratio and Treynor ratio: Sharpe ratio is the ratio of excess returns a fund generates over the risk free rate per unit of standard deviation of the portfolio. Standard deviation is a measure of a portfolio's risk. The idea behind Sharpe ratio is to measure the excess returns that the fund can generate when compared to the assumed risk. Higher the Sharpe ratio, the better it is for the fund.

Treynor ratio is ratio of excess returns a fund generates over the risk free rate per unit of portfolio Beta. Higher the excess returns per unit of Beta, the better it speaks about the fund's ability to generate returns.

4. Fund PE ratio and PB ratio: These valuation ratios are not something to go by absolutely, but they give you an overall idea of the fund's philosophy. A fund with consistent high PE ratio indicates that the fund is a growth oriented fund. These ratios need to be compared with the PE ratio of benchmark indices.

5. Market capitalisation: It is important to consider the average market capitalisation of all stocks owned by the fund to ensure that you are taking only so much risk as you intend to. Small and mid-cap companies are considered risky and hence exposure needs to be limited for risk-averse investors. As against this, the blue chips are established companies and hence the associated risks are low.

I hope this article helps you in taking the critical decision of selecting the right mutual fund. Do visit out mutual funds page to make sure you invest your hard earned money in the right fund. Happy investing!


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