#2: How to select a Mutual Fund
Mutual fund selection involves a lot of thought process and understanding of several parameters. Most of us drop the idea of investing all together just because selecting the right product can become too overwhelming.
Now that you have a fair understanding of the types of funds, it will be a lot more easier to down select one fund that fits right into your investment objectives.
Goals
First, understand your Goals. Your goal could be your child’s higher education. Your goal could be world tour in 5 years’ time or a retirement. Your goal could as well be a short term one like buying a car in 2 years. This is quite the most basic ingredient that is required. We usually tend to lose out on this. When I started, my goal was to make as much money as I can. There is no deadline to this. This open-ended goal can backfire you as it did to me. We need to have a target in mind. A purpose. If the purpose is retirement, can you live without touching this fund (unless you do not have another choice).
The reason to have a set goal is that we do not end up selecting a wrong fund. When I got started the only objective that I wanted was to earn maximum returns and I had no intentions of taking it out. I invested in a high-risk fund. But just when the market showed some signs of fall, I started to panick and considered selling the fund. After a couple of years, I eventually took out the money with a significant loss for my higher education. Had I planned well and understood that I would use this money for a purpose, I would have put the fund in much stable instrument like debt fund and safeguarded my money rather than take the loss.
Having a pre-determined plan can estimate your time horizon for you to be invested. The larger the time, the larger the risk you can afford to take.
Risk
If I ask this question, a lot of you will tell that you are a high risk taker. But you are the same person who gets paranoid when your stock falls by 10%. You can not be both. We, including me want to believe that we have the appetite to take higher risks. Because internally, we want to gain highest possible returns. That makes us believe that we are high risk takers. We have spoken in length on risk tolerance previously. Ideally, you should have some sense of what kind of risk can you actually take and not worry about the ups and downs in the market.
Investing Strategy
We spoke about different types of funds. Which of those would you like to be in. First classification – Debt or Equity. Second level of classification if you have chosen equity would be the type of fund – Large, mid, small etc.
Below is the table that can help you select the type of fund you would possibly fall into in my opinion based on your goals and risks.
Once you made a decision on which style of fund you want to be in, you can find out how do we short list a few good quality funds from the plethora of funds.
Performance
Past Performance of a fund matters. Though it does not promise you similar returns in future, we get a fair idea of how the fund has fared in the last few years. Duration to compare performance of different funds should be 10 years or 5 years. This ensures that we see how the fund performed during multiple market cycles. The performance of the funds should be compared with its benchmark and its peers not with a fund that belongs to completely different group. For example, you are most likely to see a large cap fund performing much differently compared to a small cap fund while it has actually done well in its peer group and has beaten the benchmark be a large margin.
Expense Ratio
It is that fee that we have to pay to the fund house for managing our funds. With this money, the fund house pays to the fund manager, the entire team of experts, the researches they do on our behalf and all other expenses that they incur in managing the portfolio. This is usually between 0.10 to 1.5% of our investment. The lower the expense ratio, the higher the returns you get back from your investment. However, it is not something that you have to swear by. If a fund is performing really well and gives 5% higher returns than its peers, you are absolutely fine paying a little higher expense ratio. You pay higher for a better fund manager. It is like you don’t mind paying extra fee to the best doctor. But it does not mean that higher the fee, the better treatment you receive. So it is important for you to identify if the expense ratio justifies the return they have been giving.
Usually in debt and index funds, the expense ratio could be less than 0.2%. In actively managed funds, the ratio is higher. Anything between 0.5% to 1% can be considered decent. There are a few active funds that have expense ratios as low as 0.25%. Usually, it reduces over time as and when the size of fund they manage increases.
By this time, you are most likely to have short listed 2-3 funds from the ocean. You may go ahead and select one of these by looking into the portfolio of stocks or by Crisil ranking. However, below are few key ratios you may want to understand that can help you in nitpicking one fund from those 2-3 funds that you have in hand. Note that these are oversimplified version of what it actually is but it is enough for you to have a high level understanding of what they actually mean.
Standard Deviation – You are looking at a fund that has been in the market for a few years. The value of the fund has been changing on daily basis meaning there will be some degree of volatility in the fund. A mean (or average) value of the fund can be derived for the time horizon you are looking at. Standard deviation refers to the extent to which the stock has been moving to and fro from the mean. Higher the standard deviation, higher the volatility. Lower the standard deviation, the better it is for you.
Beta – Beta equal to 1 suggests that the fund is strongly corelated to the broader market. If Beta is less than 1, it suggests that the fund is less volatile than the market. Beta greater than 1 can mean that the fund can be slightly riskier than the market but has the potential to give better returns. Usually, a fund with higher exposure to utility stocks or FMCG stocks or any slow moving stocks will have lower beta while a fund with exposure to technology or upcoming sector stocks will have higher beta. Beta anywhere between 0.9 to 1.2 should be good depending on which side of the beta you want to be.
Sharpe Ratio – Sharpe ratio represents the additional return you get for every risk you take. When comparing funds, the one with higher Sharpe Ratio is expected to give you higher returns for the same risk you are taking.
Once you realize what your goal is and your risk appetite, you are in a better position to select the type of fund you could potentially invest in. Once you know your type, you can now select the fund based on few parameters discussed above. Though there is a lot more we can get into in the field of mutual funds and analyzing them, these make a good starting point for you to choose one fund from the many out there.
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