How to choose a mutual fund for long term investments
Every now and then people tend to discuss about mutual funds and their benefits, but very few know, what all to look for before selecting a mutual fund. There are various aspects which need to be studied before selecting a mutual fund. Following is the list of points which needs to be highlighted while selecting a mutual fund.
Performance: Just like any other investment instrument, past performances plays a very vital role in estimating its future earning similarly while studying the past performance of a particular mutual fund can give you a brief idea about its future earnings. But remember past performance may provide you with some estimates only, this may not be completely true. If the fund is stable and had a great track record it may follow suit in the future as well.
The table given below gives the past performance of some oldest and some of the best mutual funds in the industry on the basis of absolute returns:
3 Yr Return Last 5 Yr Last 10 Yr
HDFC Top 200 Fund 33% 60% 1248%
HDFC Equity Fund 34% 61% 1229%
Reliance Growth Fund 18% 31% 1547%
SBI Magnum Contra Fund 11% 19% 1383%
DSPBR Opportunities Fund 25% 24% 994%
(Updated as on 24 Jan,2013)
Following are some of the parameters which may be taken into consideration while choosing a mutual fund
- Comparison: While comparing the performance of a fund over the years, find out the stability level and the fluctuations of the fund if any over the past years. Now after studying the table, Reliance Growth has given best returns considering 10 year period, but the recent performance is not that good considering 3 years and 5 year period. If you want to find out its competitiveness then it is important to compare it with other funds which are in the market. While comparing it with other funds, do compare it with mutual funds of the same category. E.g. If you want to study a small cap fund then it is advisable to compare it with a small cap fund only.
- Duration: If an investor wants to invest in a fund for a longer duration then it is advisable to evaluate its long term performance rather than boil down conclusions from its short term performance. From the above table, Reliance Growth Fund seems to be best bet considering long term duration. In many funds it has been witnessed that a fund may not perform that well in the short term but it has done well in the long term.
- Return on Investment: People invest in financial instruments for return, hence in case of mutual funds selection criteria, past return plays a very important part in deciding a mutual fund. If you are investing in mutual funds for more than 1 year, there is no long term capital gains tax. While investing in mutual fund one must look into return as well as risk. The best mutual fund is that which guarantees a maximum return with minimum risk which can be measured by various factors like beta, standard deviation and sharpe ratio and treynor ratio
- Risk: Risk and return are two parameters which go hand in hand. It is often observed, a financial instrument which guarantees the maximum return is the one which comes with maximum risk. While calculating risk factors, one must calculate the standard deviation of risk. This is also known as the mean of the multiple risks, which gives the general intensity of risk. Mutual funds are less risky than other vanilla instrument. However there is some amount of risk in every financial instrument hence if you are looking for a stable income then you must go in for a fund which is exposed to lesser risk.
- Portfolio Concentration: Mutual fund is a bundle of stocks which may be risky or safe. Therefore a portfolio which consists of safe and risk averts stocks may be less volatile and may lead to lesser returns and vice versa.
- Fund Management: Mutual funds are driven by a fund manager or fund management. A fund manager or management plays a very vital role in deciding the return of the portfolio. Since it’s a pool of investment hence it is very important to have a professional or an expert who has a complete knowledge of the investment and market turmoil. It has been seen that many funds suffer because of the inappropriate fund manager. The manger many is being great but he may leave in the middle of the tenure will lead to a downfall of the fund. In these cases it has been seen that funds which are regulated by fund houses tend to perform better.
- Costs: Cost of the fund plays an important role in deciding on investing in a mutual fund. Following are few things which must be kept in mind.
- Expense Ratio: expenses involved in running a mutual fund are administrative costs, management salary, overheads etc. “Expense Ratio is the percentage of assets that go towards these expenses.”
- Exit Load: initially there were exit load and entry Load but now SEBI has removed Entry load and there is only Exit Load in a Mutual fund.. Exit Load an extra expense which has to be borne by investors who tend to sell their funds before the existing tenure.
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This is a guest post from Mayank Gupta of Ninemilliondollars.com.
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Hi Suresh,
Quite an informative article. Request you explain the following terms and how they matter in the performance of a MF:
Beta, standard deviation and sharpe ratio and treynor ratio
Hi Vivek, Beta is the amount of volatility the mutual fund should undergo based on market fall. e.g. if market has fallen 1%, your mutual fund NAV may reduce to 0.5% only. In such situation, the beta is lower than 1. similarly if market has fallen by 1%, buy the mutual fund NAV has fallen 1.5%, it means the beta is higher than 1. These concepts are generally used more for a stock.
Standard Deviation: Simply measures the volatility of returns of mutual funds. e.g. SBI Magnum Emerging Business Fund and Reliance Equity Opportunities performed well, but did they performed well in the past. Are they consistent enough. Debt Funds should have low standard deviation. Short term funds have lower s.d against high risk mfs like Media and entertainment mutual funds which are highly volatile
Treynor Ratio: Tells you the returns per unit of market risk. It is a reward to volatility ratio. It measures returns in excess of that which you should have earned without taking any risk like fixed deposit.
Hi Suresh,
Nice information and statistics.I have one query to you the CRISIL ranking you have mentioned at your various articles which is a important attribute to choose a mutual fund sometimes diviates for instance I have invested some amounts at RELIANCE REGULAR SAVING fund at that time it was at Ranking 1 but now I see the Ranking has down to 3/4.Can you please let us know why this happen and in these cases how should we select the Mutual fund to invest….Thanks again for your ariticles…..
Suman, Crisil ranks the mutual funds based on certain guidelines and when they change, Crisil revises the ranking. You would see an article next week on this subject on how credit ratings are determined and how they would get changed over a period of time.
Very nice ariticle. Thanks:)
Hi Suresh, Very useful info…I like reading your blog…