5 Things to consider before you buy a Mutual Fund scheme!

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In the last write – up we discussed about A Basic Guide to Mutual Funds. Hope now you have a clear idea of what a mutual fund is and how it works. In this article we are going to get an idea on how to pick the best scheme out of thousands of MF schemes available in the market.

MF as we know is a vast subject, hence here we will only focus on key points which are essential to know as an investor.

The first few things you see while picking a fund are your investment objective, time horizon and risk profile. Once you have decided upon these things and decide upon a fund category (for example you have decided to invest in a large cap equity growth fund), then the decisions of picking the right one for you becomes due.

Five important measures to help you with that decision are listed here:

Trailing Returns The first thing which comes to anybody’s mind before investing his / her hard earned money is that how much return can be expected from that investment. In the world of mutual funds you can never be sure of the return you would earn unless you opt for a Gilt Fund (secure government bonds).

However, by looking at the scheme’s trailing returns you can get a fair idea of its performance. Trailing return is the return of a MF scheme over a given period of time. For instance trailing 3 year return would show the return over the previous three years.

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Here you can see the trailing return of Tata Infrastructure Fund for last few months and years. By comparing them with index returns and with return generated by funds of same category, for the same period, you can get a fair idea of the fund’s performance.

 

Alpha Alpha states you that how much additional return the fund has generated against its minimum required return. The minimum required return is calculated using CAPM (Capital Asset Pricing Model). This model uses risk free return and risk premium to calculate how much minimum return an investor expects against the risk he / she has taken.

For example:  If a CAPM analysis estimates that a fund should generate 10% return based on the risk of the portfolio but the portfolio actually earns 15%, the portfolio’s alpha would be 5%. This 5% is the excess return over what was predicted in the CAPM model.

Investment in a fund which has a high alpha is recommended. On the other hand, you should stay away from the fund with negative alpha.

I would let you decide whether you would invest in the fund mentioned above based on Alpha!

Standard Deviation By looking at standard deviation, you can estimate the consistency of fund’s returns. SD gives you a picture of how much volatility is there in the fund’s returns from its own historical returns. For example, a volatile fund will have a high standard deviation while the deviation of a stable fund will be lower. A large dispersion tells us how much the return on the fund is deviating from the expected normal returns.

Beta Beta is a measure of systematic risk, in simple words beta measures how much the fund return respond to the changes in the market.

Beta of 1 means that if the market goes up by 5%, the fund returns will also go up by same percentage. A beta of less than 1 means, that the security will be less volatile than the market. A beta of greater than 1 indicates that the security’s price will be more volatile than the market. For example, if a stock’s beta is 1.2, it’s theoretically 20% more volatile than the market.

Sharpe Ratio Risk and return go hand in hand. You expect return on your money in line with the risk you have taken. Sharpe ratio tells you the risk adjusted return of the fund.

When interpreting the Sharpe ratio, the higher the value, the more excess return investors can expect to receive for the extra volatility they are exposed to by holding a riskier asset. Similarly, a risk-free asset or a portfolio with no excess return would have a Sharpe ratio of zero.

A variation of the Sharpe ratio is the Sortino ratio, which removes the effects of upward price movements on standard deviation to measure only return against downward price volatility.

Keep in mind that, all these measures are used in conjunction, no measure on its own will give you the whole picture.

Hope next time you invest in any mutual fund, you will make a wise and informed choice.

Image source: Morningstar.in, Image courtesy of posterize at FreeDigitalPhotos.net

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