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Chapter 8 Selection of Mutual Funds

Determine time horizon for investment and risk profile

An investor should match her investment objective to her investment horizon and risk profile. Simply put, a risk aversive investor should select a debt fund if she has a shorter investment horizon and a large cap equity fund if she has a long investment horizon. An investor who is willing to bear more risk and has a longer term horizon could select a mid or small cap fund.

One could Allocate Funds across Investment Objectives

One could invest in balance / debt / equity funds, based on one’s risk profile. It is always a good idea to take an advisor’s help in picking the right Mutual Fund.

Things to Consider before Investing in Equity Funds

Risks increase, as we move from large to small-cap funds. Similarly, risks are higher in sector or theme specific funds compared to well-diversified funds. Risks are higher in growth funds compared to value funds.

Shortlist funds

Once the category of fund has been identified, the investor should find funds that have beaten the benchmark returns with higher consistency than other funds over a large period, say 10 years. One then needs to find the Sharpe Ratio of the fund. The Sharpe ratio gives the amount of return generated for each unit of risk. So, higher the Sharpe ratio, more attractive the risk-adjusted return.

Evaluate Fund Managers (FM)

Some Fund Managers beat the benchmark in a bull market, while others do better in a bear market. Consistency of fund performance matters more than short-lived highs and lows. An investor should compare performance of all the funds managed by the Fund Manager with their respective benchmarks across market cycles. If the funds have consistently returned more than the benchmarks, then the Fund Manager is worth relying on.

Beta

Beta is a measure that is used to find out the sensitivity of equity funds to market movements. A beta of 1.25 means that fund’s return on an average is 1.25 times the benchmark returns. In bull market, this is a reason to cheer, while in falling markets, your fund will fall more than the benchmark.

Things to Consider before Investing in Debt Funds

Risk increases as duration of the fund increases. Risk increases at funds invest in lower rated bonds. Risk is lowest in government bonds but increases in corporate bonds.

Interest Rate Direction & Returns

Due to inverse relationship between bond prices (fund’s NAV) and interest rates, the performance of debt funds typically will depend on the fund manager’s ability to take accurate calls on interest rates. Past track record over a long period, say 10 years should be considered in determining the quality of the fund manager.

Choosing a Debt Fund

As interest rates and NAVs of income funds move in opposite direction, in a falling interest rate scenario, medium to longer maturity funds can be considered. Conversely, if interest rates are on the rise, shorter maturity income funds and FMPs can be considered.

Check the Expense Ratio

Expenses make a difference in net returns between two similar products. This is because expenses are knocked down from the market value of the investments. Let’s consider two funds, A and B, with exactly same portfolios, but the first charges 1.25% expense while the second charges 0.5% expense. The second fund will generate an extra 0.75% return over the first one.

Key Takeaways

  • Funds with similar investment objective could deliver different returns.

  • Lower NAV does not mean the fund is cheap.

  • Determine Time Horizon for Investment and Risk Profile.

  • Once the category of fund has been identified, the investor should find funds that have beaten the benchmark returns with higher consistency than other funds over a large period.

  • An investor should compare performance of all the funds managed by the Fund Manager with their respective benchmarks across market cycles.

  • Due to inverse relationship between bond prices (fund’s NAV) and interest rates, the performance of debt funds typically will depend on the fund manager’s ability to take accurate calls on interest rates.

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