Mutual funds offer a convenient way to invest in a diversified portfolio of stocks, bonds, or other securities. An investor must analyse parameters of not only performance history, but also risk adjusted ratios, expense ratios, downside risk or sortino ratio, and investment objectives to maximize returns and minimize risk. Understanding these fundamental considerations aids in making an informed decision to build a successful investment strategy.
Factors to consider
When selecting mutual funds, it’s crucial to consider several key factors. Performance history is a primary consideration; look for consistent performance over several years, particularly during different market cycles or downturns that need to be evaluated.
It is important to compare the fund’s returns to its benchmark index to gauge the alpha the fund manager can generate. Emphasize the importance of long-term performance over short-term gains. Fees and expenses also play a significant role. Understand the different types of fees, including management fees and expense ratios, and be aware of hidden fees like transaction costs and load fees, as lower fees generally lead to higher net returns.
Risk assessment involves examining the fund’s volatility and standard deviation, with beta being a useful measure of a fund’s volatility relative to the market. A beta greater than 1 indicates higher volatility than the market. Sharpe ratio measures a funds risk adjusted returns and shows how much risk a fund manager takes to deliver a return. A higher sharpe ratio means a fund manager is able to deliver better risk-adjust return. But compare these ratios with other funds in the same category to ensure the comparison is like-to-like.
Fund manager expertise is another critical factor; consider the manager’s background, including the number of years in the industry and previous performance. Longer manager tenure indicates stability and consistent strategy. The promoter background is also essential. Understanding the reputation and history of the fund’s promoter can provide additional confidence, especially if the fund house has a strong track record of managing funds effectively.
Risk factors
To mitigate risks associated with fund selection, investors should diversify their portfolios by investing in multiple funds across various asset classes, and consider geographical and sector diversification to spread risk further. This strategy helps spread risk and can lead to more stable returns over time. For example, diversifying across equity, debt, and hybrid funds can balance risk and return.
The information ratio, recently introduced by the Securities and Exchange Board of India (Sebi), assesses a fund’s performance relative to a benchmark while considering the consistency of that performance, with a higher ratio suggesting consistent outperformance.
The information ratio measures and compares the active return of an investment compared to a benchmark index relative to the volatility of the active return. If the fund manager beats the benchmark for a given level of standard deviation or risk, he has done his job well.
The sortino ratio is a variation of the sharpe ratio that focuses only on downside risk, making it useful for conservative investors. Additionally, alpha measures a fund’s performance relative to its benchmark, adjusted for risk, with a positive alpha indicating outperformance.
Conclusion
Selecting the right mutual fund involves a comprehensive evaluation of performance, fees, risk, and management expertise. By considering these factors and utilizing various ratios, investors can make informed decisions that enhance their chances of achieving their financial goals. A financial advisor will be able to not only suggest the best investment options suitable to ones needs and risk profile but also continually monitor and review the filtered list of the funds, while making tactical asset allocation changes.
Dilshad Billimoria is founder, managing director and chief financial planner at Dilzer Consultants
