Mutual Funds are one of the most popular Investment options available to park your savings. Over the years, mutual funds have become ‘sort after’ instruments, to save & grow your money through Systematic Investment Plans. The popularity of the Indian MF industry is evident from y-o-y growth in Assets under management(AUM). AUM for the industry is steadily growing from ₹7.43 trillion in 2010 to ₹24.55 trillion in 2020, a 3-fold rise in 10 years.
The major reasons for this growth are attributed towards positive campaign (Mutual Fund Sahi Hai), Increase in individual disposable income, awareness about investments in millennials & faith in the Indian economic growth story.
India has 44 registered Fund houses which together offer 2540 different schemes. Mutual fund Industry is an under-penetrated sector in India, so many companies try to capture a part of this huge available market by offering diverse kind of schemes & to attract investors to a particular scheme which will earn them the highest sale commissions.
Also on certain occasions, Mutual funds have failed to meet Investor expectations such as the recent closure of Franklin Templeton funds, Deviation from core fund objective to bet on risky assets which resulted in huge losses.
With so many funds available, it becomes a challenge to select the best mutual fund to invest your savings in, isn’t this true?
So, here are the few very important criteria that will help you decide” konsa Mutual fund sahi Hai?”
1. Investment Purpose:
Mutual funds are structured in such a way to meet different financial needs. So before selecting any fund, you need to decide the purpose of your investment like I started my mutual fund investments, so I could purchase a new house. Risk appetite is another important aspect before shortlisting mutual funds. Doing your risk analysis helps you determine whether you are Risk-averse, Risk- Neutral, or Risk taker.
Knowing your investment goals & risk appetite before actual investment help in the selection of a mutual fund according to your financial needs.
Another hurdle for many new investors is, what should be fund allocation in Equity & Debt funds? You can follow a simple rule to decide fund allocation for this you need to subtract your age from 100. Let’s say your age is 25 years then you should Invest 75% in Equity funds & 25% in debt funds & cash. So as you grow older your assets allocation shifts from a risky asset class to a risk-free asset (like debt fund).
2. Risk Indicator
Every time you see mutual fund ads, it shows “Mutual fund Investment are subject to Market Risk. Please read the offer document carefully before Investing” hearing these words create doubt in our mind & discourages from mutual fund Investment. But have you ever thought what are the different risk parameters associated with mutual funds?
Be it your life or investments, there is always some form of risk associated with it & as in our day-to-day life we overcome challenges, similarly, we can manage risk associated with Mutual fund as well.
Mutual funds have mainly 3 stages of Risk Analysis à Independent Risk parameters, Risk management & Risk-to-reward ratio. The Risk parameter helps to judge particular fund risk against the benchmark. Risk management shows us how well the fund manager able to manage risk & risk-to-reward ratio tells us how much return we make for every rupee of investment.
2.1 Risk parameters
I. Standard Deviation(SD):
It is a statistical tool that shows the deviation of individual mutual fund returns from its past average return. Standard deviations help us understand the volatility of the individual fund.
For Example, suppose HDFC small-cap mutual fund has a previous 3 years’ average return of 7% and a standard deviation of 4%, then Investors can expect the return of the fund to be between [11% (7+4) to 3%(7-4)]. Now suppose another fund has SD of 6% and the fund’s past average return is 5% than expected future return will be between [11% to -1%].
Comparing with the category average or benchmark helps determine your fund’s standard deviation is high or low. So while selecting mutual funds, look for funds with a median level of standard deviation. Funds with a modest level of standard deviation tend to lose less money on short-term high market volatility.
II. Beta of Mutual Fund:
Beta is a statistical measure that helps to predict the volatility of fund w.r.t benchmark. Beta for the market (benchmark) is assumed as 1.00, then If fund beta <1, then invested assets will be less volatile then the market. A beta of more than 1 indicates more volatility than the market for example fund with a beta of 1.10 will be 10% more volatile than the market.
If your Risk appetite is low (conservative Investor) then look for funds with low beta value (like debt funds or balanced funds) while risk-taker Investors can consider a fund with high beta value (like Mid/Small-cap funds).
Beta helps the investor in creating a portfolio of funds with a diverse beta value, which helps to get diversification benefit & also ensures selected fund match individual risk tolerance level.
2.2 Risk Management
I. Maximum Drawdown(MDD):
Maximum drawdown (MDD) is the maximum loss in funds NAV from peak to bottom value, MDD is used to gauge fund performance in a down market.
For example- suppose you Invest ₹10,000 in one of the equity funds for 1 year. 3 months after your investment, fund value Increases to ₹15,000 then afterwards, due to down market investment value went down to ₹7,000 and again when market sentiments improved investment value quickly went to ₹18000.
Then the maximum drawdown (MDD) is -53.33%.
MDD numbers are not shown by most funds as it could frighten Investors & make fund unfavourable for investors. MDD is compared with benchmark fall & If Maximum drawdown is less than benchmark fall (In %) during short-term market fall then the fund is considered a good investment option.
II. Downside capture Ratio:
Downside capture ratio, tells us how much fund moved in a downward direction during market fall relative to its benchmark.
Suppose the benchmark Index falls by 10% & the fund’s value also goes down by 10% then the downside capture ratio is 100%. If funds downside capture is 80% v/s benchmark, then it means the fund has captured 80% of downside moment which shows that it has fallen less than the benchmark & protected downside risk.
Funds are said to be good if it has a lower downside capture compared to peer fund from the same category & benchmark (like Nifty500).
Both MDD & downside ratio tells us about risk management skills of the fund manager.
2.3 Risk-to-reward ratio
I. Sharpe Ratio:
Sharpe ratio gives a risk-adjusted return of a mutual fund. Often when we Invest in mutual funds we expect returns from our investment which is above the returns of risk-free assets (like bank FD or Govt. bond).
Sharpe ratio indicates the extra return by the fund over & above the return generated by risk-free assets like fixed Deposit or government bond. Higher Sharpe ratio of portfolio indicates better risk-adjusted return while negative Sharpe ratio means that it would be better off investing in risk-free assets like fixed deposit then in Mutual fund.
Sharpe ratio helps to compare a fund to its peer funds within the same category as well as to its benchmark.
3. Fund performance & consistency:
Investing in mutual funds or purchasing a brand new car, both have a lot of similarities. When you buy a car beside colour & other specifications we keep a keen eye on car’s fuel economy (How much distance covered on per litre of fuel), while investing in a mutual fund, first thought comes in our mind is, Fund Kitna return Deta Hai? (how much return fund gives)
Isn’t It???
To track Mutual fund returns, we look at fund’s long term return, short term returns, Fund return v/s benchmark (for consistency).
i. Long term Mutual fund returns are tracked since Inception or for at least 10 years, the reason being when a fund has a long history it likely goes through a lot of ups & downs in terms of economic cycles which help us understand the return performance of a fund. Try to select funds which have gone through at least one economic cycle (like 2008 recession or 2020 corona pandemic) which helps us to know fund’s ability to recover from downward economic moments.
ii. Short term Mutual fund returns are tracked on a 3 & 5 years’ time period, which helps us to know about the fund performance on a short term basis. We also come to gauge the fund performance rank within the same category. Ideally, select the fund which is ranked within the top 3 of that particular fund category.
iii. Fund return v/s benchmark return comparison tells us how well fund performed against benchmark & also, funds’ return consistency. Suppose a large-cap fund has an annual return of 15% then we may think returns are good but what if, the benchmark let say Nifty50 has a return of 20% during the same period? Logically, it would be better off investing in the benchmark (like Nifty50) & get higher returns, than to invest in a mutual fund. Ideally, select the fund that has a consistency of at least 5 years of benchmark overperformance.
4. Portfolio turnover ratio:
The ratio indicates the number of times fund manager has bought or sold fund’s assets (like stock, bonds, etc.) within 1 year. The portfolio turnover ratio(PTR) is expressed in percentage (%) & high PTR Increases the expense ratio of the fund.
Suppose in the year 2019, Fund house purchased 500 crores of shares & sold 750 crores of shares. Average AUM for the year was 5000 crores then portfolio Turnover ratio(PTR) will be 10%(500 ÷ 5000) which means one-tenth of the AUM was churned over the one year.Turnover ratio provides a lot of Information about fund management style like low turnover ratio indicates buy & hold strategy which means the manager is less frequent in buying/selling of assets & has long term investment approach while the high ratio indicates aggressive fund actions, to take advantage of current market situations or short term market blips.
High turnover ratio means a lot of buy & sell transactions which adds to expenses for the fund house, which should be compensated through high fund return.
If a fund has a constant history of high turnover ratio & low annual returns, then it may indicate that the fund manager is churning assets with trial & error strategy, to arrive at right asset combination.
5. Expense Ratio:
Fund house which manages your money has various expenses like asset manager salary to manage the fund, administrative expenses (like customer support etc.), transaction expenses etc.
All these expenses are taken as a percentage of total assets under management in the form of Expense Ratio(ER). A fund with lower assets under management will have a high expense ratio because the fund has to manage all the above expenses within a smaller asset base. Similarly, the fund having a higher AUM will have a lower expense ratio.
High Expense Ratio Impact your returns, suppose you Invest ₹100,000 in a fund having expense ratio of 3%, then you pay ₹3000(3% of ₹1,00,000) to manage your money or in other words if fund’s NAV Increases by 10% in a year then real return for Investors will be 7%. The Net asset value (NAV) reported by the fund house is after deducting the expense ratio.
From the fund selection point of view, always remember funds should justify their expense ratio through overperformance or you can select a fund which has a low or moderate level of expense ratio (0.5% – 1%).
6. Fund Manager Tenure & Experience:
When you invest in mutual fund your money is ultimately managed by a fund manager whose job involves the critical decision making & Investment in the right type of assets accordingly, which require expertise & the right skill set. So having the right fund manager to manage your money is very important. Isn’t It?
In fact, for many investors, tenure & experience of the fund manager are important parameters while selecting a fund. It is perceived, that funds which are managed by experienced managers can pass through the phases of high market volatility.
During fund selection, look for a fund where the fund manager has managed the fund for a minimum of 5 years & try to avoid the funds, which have seen frequent manager changes.
Fund Comparison:
Here we will compare 2 large-cap Equity Mutual fund schemes based on the above parameters.
Fund selection criteria: large-cap equity orientated schemes used for comparison based on 5years’ history (Axis blue-chip large-cap fund & Taurus large-cap fund). Both funds are direct growth plan only difference being one fund is best performing fund of large-cap fund category & another fund has given below-average returns over a 5-year timeframe.
Conclusion
Rise of mutual fund over the past decade is mainly due to increasing awareness of mutual fund investments & people’s willingness to save money in the form of Mutual Fund investments due to higher liquidity and better returns.
2nd phase of evolution in mutual fund industry will be somewhat similar to Charles Darwin Theory of “Survival of the Fittest”, people should be more aware about investments & should consider the above investment criteria to select an appropriate Mutual Fund.
Funds which provide consistent returns with risk management will tend to survive.
To add here, Mutual Fund Industry’s future growth prospects will depend on deeper investor engagement & ‘thinking’ in the interest of investors.
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