John C. Bogle, one of the most acclaimed investment gurus wrote in his 1999 bestseller ‘Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor’ that “Intelligent investing turns out to be little more than common sense and sound reason. The sooner investors realize that elemental principle, the better will be their ability to accumulate the maximum possible amount of capital for their financial security.”
Not that what Bogle observed in plain words well past a decade ago was something many investors are unaware of — almost all of us do apply our grey matter in whatever way we believe as apt. However, what many of us rarely do is to understand our investment in a perspective.
Take for instance, picking a mutual fund belonging to the same category and tracking the same benchmark that is offered by different fund houses under different names. There are many funds by different names but belonging to the same category sold by different fund houses. If you take large-cap or debt fund category for instance, almost all AMCs sell differently-named funds under this category. Many of us when putting in money in a large-cap fund randomly pick a fund or, at the most, pick the one that has given a higher return that its peers over a certain period. Sadly, but this is not the right way to select a mutual fund, reckon experts.
One Size Doesn’t Fit All
Believe it or not but there is no best mutual fund available in the market that’s suitable for all classes of investors, irrespective of their risk profile and goals. This is the first parameter of picking a fund of the same category that you should remember. In other words, any fund will work for you, but only if you pick it up after duly considering your risk profile and investment goals. Don’t go on buying a fund just because your friend has bought one or because it has given good returns in a short term.
“It is important that investors select funds that are suited for them i.e. funds whose risk/reward profile matches that of the investor. To identify such funds, investors need to go beyond just the name, objective or asset allocation strategy,” maintains Vicky Mehta, Senior Research Analyst, Morningstar India.
Apart from checking the fund’s suitability, other factors that you should consider to differentiate between funds are the fund manager of each fund, his experience and skills, the investment strategy that is being followed and the practices of the fund company.
Go For Risk-adjusted Return
Apart from these factors there is something more that needs to be looked into. Almost all mutual fund investors track the historical returns of the fund. However, instead of judging a fund of the same category on the basis of its past performance and returns, the more appropriate way is to compare them on the risk-adjusted return parameter too, maintain experts.
Here come the technical indicators of a fund that give you an idea of how much risk-adjusted return the fund has given over a period of time (See How Equity Large…).
“Don’t go for returns but risk-adjusted returns of a fund. First, filter down the funds on the basis of their benchmark. Thereafter see how much risk-adjusted return they have yielded over a period of time,” advises Pankaj Mathpal, Managing Director, Optima Money Manager, Mumbai.
Here you’ve to be a little bit technical and do some bit of ratio analysis as there are many indicators or ratios that measure this very risk-adjusted return of a fund over a period of time. One of the indicators is the standard deviation that measures the historical volatility of a fund and risks that it carries. Generally, a mutual fund with a low standard deviation is believed to carry lower risk and is a more stable performer than the one having a high deviation.
Another indicator of risk-adjusted return is the Sharpe ratio that compares the return of a fund against the return of a risk-free instrument such as the government bond. This parameter measures the relationship between investment risk and return and is used to find out whether a fund’s return is a result of good investment decisions or due to high risk taken. If the Sharpe Ratio is higher, it means the fund has performed better vis-à-vis the risk it has taken.
Another parameter for judging a fund of the same category is to compare alpha of funds. Alpha is another measure of risk-adjusted return. It measures the volatility of a fund by comparing its risk-adjusted return against a benchmark index. Take for instance, a fund that takes as much risk as its benchmark, BSE 100. While the BSE 100 gives return of 10% in 1 year, the fund yields 11%. In this case the fund has an alpha of 1.0. However, if the fund has given only 9% returns, it means it has an alpha of -1.0. In other words, a positive alpha of 1.0 means the fund has outperformed its benchmark index by 1% while a negative alpha of 1.0 means it has underperformed its benchmark by 1%.
Let’s understand it with an example. In the given Table take two funds viz., Canara Robeco Large Cap+ Regular and JM Equity, both equity large cap funds. While the former has given a one year return of 8.20% the latter has given 5.36%. However, if you compare the two funds on technical parameters the difference becomes clearer. While the standard deviation of JM Equity is 21.28 that of Canara Robeco Large Cap+ Regular is just 14.18. There is s stark difference in the alpha too. While the alpha of JM Equity is -3.98 that of Canara Robeco is 1.64.
However, while evaluating a fund on these mathematical ratios, keep in mind these indicators are not static and keep changing. So, just don’t go by what the numbers tell you. Check the fund’s fundamentals too.
Checking a fund’s expense ratio would also help you pick funds from the same category. There are various costs, fixed and variable, associated with a fund that includes, but not limited to, fund administration charge, management fee, etc. Expense ratio of equity funds could vary from 1.25% to 2.5%. The higher the expense ratio, the lower would be the overall return on the fund. So even though the expense ratio has been capped by the SEBI, check each one’s expense ratio if you are comparing two funds from the same category.
“Other things being equal, go for an AMC that gives better value through lower costs,” advises Prem Khatri, Founder & CEO, Cafemutual.
Adds Mehta of Morningstar India, “A lower cost is certainly beneficial for the investor. If two funds are identical on all parameters then it would certainly make sense to invest in the one with lower costs. The importance of lower costs is accentuated in segments such as debt funds.”