There are around 1500+ mutual funds and about 15+ different types of funds available in Indian market today. And, the list keeps on increasing every day with new schemes getting launched and new players entering the market, Currently, India has about 44 different fund houses offering different types of mutual funds. With so many options, it has become increasingly difficult for retail investors to choose the right fund.
Mutual Fund Ratings: Significance
In last few years, some of the influential rating agencies have started publishing mutual fund ratings for India funds. These include Crisil, Morningstar and Valueresearchonline. Undoubtedly, all of them have a robust research methodology and provide a good starting point to understand the performance of the fund.
But, there could be certain limitations which are:
- Ratings are mostly based on 3-year risk-return framework. Since most of the investments we do in mutual funds are for a longer tenure. Hence, some of the long term consistency goodness might not be captured by these ratings.
- Ratings do not help the investors to design a right portfolio viz-a-viz his individual risk.
- Also, ratings can at best be the starting point. But, they should never be the end point for your analysis, as you go about choosing the right fund for you.
So, having established that rating is not a sufficient criterion. Now, what is the best framework to select a mutual fund? Actually, there is not one, but multiple methods you can use to find the right funds. You should primarily keep in mind the long term consistent performance of funds.
We will be taking you through a step by step guide, on how to choose the right mutual fund.
Important Note: We will be just explaining the process. The examples we have chosen does not mean we are recommending these funds, examples are purely chosen for explaining the right process. We are not endorsing any of these funds. This is for information and should not be regarded as a professional advice in any regard. Please follow due diligence before investing in any risky asset classes.
Before we go into details of the step by step process, here’s a cool infographic which will summarize the key steps.
How to Select a Mutual Fund? 5 Step Guide
- Set up an objective.
- Set up your expectations.
- Find out the Right portfolio for you.
- Shortlist the top funds.
- Analyse and Choose the winner.
Ok, let’s now dive into the detailed process. Before you select a mutual fund, the precondition is to set up your objective. Without a right goal in mind, any analysis, any suggestion you get is useless. So, let us understand how to set up an objective.
1. Setting up an Investment Objective for Mutual Fund Investment
When you set up an investment objective, you must ask yourself the following questions:
Why am I Investing?
This answers the fundamental question about goals you are chasing with the investment you are making. Some examples of legitimate goals are as follows:
- I want to save for my retirement.
- I want to park my money for one year and get decent returns.
- I am saving up to buy a new car and will need this money in 2 years.
- I want to invest this money to plan for my kids education.
Whatever be your goal, please write it down on a piece of paper. Your goal should have a financial requirement mapped to it.
When will You Need the Money?
No investment is for eternity, every investment has a time horizon. In some cases, the time horizon is very important, mutual funds is one of those asset classes. Unlike fixed deposit or post office schemes where time horizon is generally not important. Mutual funds choice and probable returns have a direct co-relation with when you want your money back. Let’s get through this with an example.
Say, if your investment horizon is less than 2 years, equity funds may not be the right choice.
Let’s look at how a legitimate goal should look like:
Remember, Without right investment objective any mutual fund investment you do is inherently flawed.
2. Setting up Right Expectations for Mutual Fund Investment
Setting up a genuine return expectation
Before you start investing, you need to have a reasonable return expectation. And, those expectations have to be realistic and tied up with your investment horizon and the goals you have set up. So, if you are expecting a 20% return on mutual funds, that have historically delivered 14% and plan your goals based on this assumption, you are bound to fail in achieving your goals.
Encounter the beast called Inflation in the room
Now that, we have set up a return expectation, next thing we need to do is provision for inflation. Basically, as a thumb rule, inflation is a factor you need to subtract from your expected rate of return to know what is the real rate of return you will get. The equation is very simple:
Real Rate of return = Nominal Rate of Return- Inflation
Now, what inflation rate you should be using in your calculations? Before we arrive at the answer, have a look at the retail inflation trends in the country. As you can see in last few years Inflation have hovered close to 8-10 % it has fallen in 2016, so to be on the safer side we can use 8 % for inflation.
3. Deciding Portfolio of Your Investment
Should you buy debt funds or equity funds? And, if you have to buy both, how much to buy of each of them? This is a central portfolio question which should be governed by your investment objectives as well as your risk profile in general.
Selecting Debt Funds :
If you are investing for a super long term, like say 15 years or more, you can add PPF or NPS to your portfolio. For shorter tenures, you may try short-term debt funds.
Selecting Equity Portfolio:
Again this depends on your risk profile and your age mainly. But, in general if you are young, and can afford to take risks, you can add equity to your portfolio. But, remember “Mutual fund are subject to market risks” and equity is a more riskier asset class.
Shortlisting of Mutual Funds
Now that we have arrived at the right portfolio, we will try to shortlist the funds for our portfolio. In this post I will be discussing selecting of equity funds. There are multiple ways or criteria to shortlist funds. We will follow a simple route.
- Remove all funds which are less than 5 years of age.
- Remove all funds which are less than 4-star rated (you can use Value Research or Morningstar rating for the same).
- Remove all unrated funds.
- Remove all funds suspended for sales.
- Remove all fixed monthly income funds (because here we are explaining to build a growth portfolio).
This is how the list looks like for a sample of large cap funds we picked up from Value Research.
Now that, we have the list. Here is what you should do next, sort all these funds by 10-year returns, which basically sorts funds in descending order of returns based on 10 year returns. Below is the snapshot of funds sorted based on 10-year return.
Next step, we do is sort all the funds based on 5-year returns, we get a chart like the one below:
And we do go ahead and do the same for 3-year returns
Now, we need to define a criteria for shortlisting funds, while all of us can have different criteria. A simple way is to select funds that have been in top 25 in all the periods under discussion i.e for 3, 5 and 10 year period. This will be our shortlist.
Making the Final choice
Now that we have the short-list , we want make a final choice of the mutual fund we want to invest in. There are different methods to do this. We will be using a standard risk-return framework to identify the winners. For now, we will only focus on risk-return framework which is based on MPT or Modern Portfolio theory.
Firstly, let’s get some terminologies and definitions straight.
Alpha measures funds out performance with respect to to benchmark. In simple terms, the excess return of a fund over the benchmark is fund’s alpha.
Beta measures the volatility of a fund. A Beta of 1 means your fund is as volatile as the benchmark index. So, if the index goes up, your fund also goes up in the same proportion. While a beta of 1.2 means your fund is 20% more volatile than the benchmark index. If you are risk averse investor, you would want a lower beta.
3. Standard Deviation:
SD measures dispersion from mean for funds and measures the volatility. Higher the standard deviation, higher the volatility.
4. Sharpe Ratio:
Sharpe ratio is a measure of risk adjusted return. It measures the amount of risk that fund has to take to deliver a particular return.
5. Sortino Ratio:
The Sortino ratio is a variation of the Sharpe ratio that differentiates harmful volatility from total overall volatility by using the asset’s standard deviation of negative asset returns, called downside deviation.
Now, that we read about the ratios. Let us see, how we use them to arrive at the fund we want to invest in.
First of all, look for funds with lower beta. Once you have sorted them by lower beta, look for higher alpha and higher sharpe ratio and sortino ratios. This will help you find the right fund, if you look at the data below you can easily pick up 2-3 funds from the top.
A limitation of this approach is that, we have not looked at some of the funds which have performed really well in last a few years but were not available in past 10 years. One way we can take care of that is do analysis for 1/3/5 year return, to do shortlisting.
There are various other approaches you can use to pick up the funds. Most of them build on top of the long term value and risk-return approach. This could help starters to find the right mutual fund. Although, nothing is guaranteed here! Do act wisely while investing in your hard earned money at different places.