Choosing right Mutual Fund scheme holds key to high returns

Most experts opine that mutual funds are the most economical and transparent means of investment into equity markets. One finds enamored by the marketing bling about the star performers and at times the unbelievable returns they generate.

So, how could one end up picking the right fund to his advantage? I would broadly classify two parameters to evaluate a fund viz, Fundamental and Technical, very much similar to that of a stock analysis.

The fundamental parameters to focus in a fund are: 
1) History of the fund house 
2) Fund Returns 
3) Fund Size and 
4) Expense ratio.

The track record of a fund house helps one to evaluate on the consistency in launching and retaining its funds. The range and the performance across the asset classes indicate an ability of the fund house to attract the right talent pool of highly skilled research teams and experienced fund managers. This is critical especially in the long-term investment nature of equity. 

The fund performance across the market cycles needs to be checked not just for a particular period. This helps in getting insights of how it responds or reacts during a bull or bear phase of the market. Also, look beyond the performance of the fund vis-à-vis the benchmark but versus the category average to identify how it stacks up against the peer group.

Though there is inconclusive evidence linking the size of the fund to the performance, it’s always ideal to pick a moderate sized fund. This is because a smaller fund has constraints of optimal allocation leading to concentration risk and possible underperformance, while very larger funds tend to become less nimble and near-replication of the benchmarks in the long run, hindering outperformance.

Expense ratio shouldn’t be the sole parameter for deciding on a fund, though, the lesser the better. When puzzled with funds with good track record, opt for a fund with lower expenses. However, be aware that expenses are higher with actively managed funds and tend to decrease as corpus increases.

The technical parameters or statistical tools to evaluate a fund are  Standard Deviation, Beta, Alpha, Sharp Ratio and R-Squared. Standard deviation (SD) measures the degree of the fund’s volatility. It provides information about how much the fund fluctuates from its mean or average return. The larger the deviation the higher the risk; so ideally opt for a lower SD when comparing two equal performing funds of the same category.

Beta measures the volatility with respect to the market. So, it throws the sensitivity of the fund with respect to the market swings. Note that market beta is always one and any higher beta depicts higher volatility of the fund. Risk-averse investors are better off avoiding funds with higher beta. 
Alpha defines the fund’s value addition or the performance over its benchmark. A positive alpha suggests an outperformance of the index by that much percent while a negative alpha represents underperformance. So, it’s always better to avoid funds with negative alpha.

Sharp Ratio gives the measure of risk to return or risk adjusted return. It estimates the levels of risk the fund takes to achieve the returns. Higher sharp ratio indicates higher returns at lower risk and vice-versa. Opting funds of higher sharp ratio within its peer group makes sense. 

R-squared helps one to understand how much of the fund’s performance could be attributed to that of the market. It brings out the correlation between the fund and the benchmark. A ‘zero’ indicates no correlation and 1 indicates perfect correlation. Its better to opt an index fund as it has lesser expense ratio instead of higher R-squared equity fund.

One needn’t sweat it out to obtain this information, as these indicators are available for free by most of the fund houses and other research firms. Most importantly the fund objective should suit the investor’s risk profile, goals and timelines. (The author is a co-founder of “Wealocity”, a wealth management firm and could be reached at knk@wealocity.com)