5 easy steps to select a diversified equity mutual fund   Aug 30, 2012

You must have read a lot of material on how to evaluate a mutual fund scheme as well as on how not to evaluate a mutual fund scheme. And to make things difficult there a plethora of mutual fund schemes available in the market to choose from. With 44 asset management companies (AMC) currently in the mutual fund industry offering more than 450 schemes (under diversified equity category) the choice is not that easy. So it can be a challenge for you when it comes down to identifying a handful of mutual fund schemes from this rather large universe. The good news for you is that based on performance, most of these schemes fall short of making the grade. But then the real challenge lies in finding those few schemes that do make the grade and are worthy enough to be a part of a well performing mutual fund portfolio.

But when it comes to investment decisions many of you appear confused due to similar looking schemes in terms of investment objective, risks and returns. The simplest of decisions prove elusive to you. Moreover, this confusion is further enhanced by misrepresentation or false sales pitch made by some self-centric mutual fund agents.

Thus, to make things easy for you, we provide you with a 5-step strategy to select a diversified equity mutual fund for your portfolio.

  1. Compare returns across funds within the same category

    One of the most basic forms of benchmarking involves comparing funds within a category. For instance, if you are evaluating a large cap for investment, you should compare its returns with other predominantly large cap diversified equity funds. Comparing it with mid cap funds for example, will deliver erroneous results, because the risk-reward relationship between mid cap and large cap funds are not comparable.

    As equities are best equipped to deliver returns over longer time frames (3-5 years), investments in diversified equity funds should be made with a long-term perspective. Hence, while comparing returns, investors must consider longer time frames (of 3-5 years) before taking a conclusive decision about investing in a fund. Comparing a fund over a longer time frame will also give investors a good idea about how the fund has fared over a stock market cycle (boom and bust). Performance of the fund across different market phases compared with the category average will help in gauging the consistency of the returns generated by the fund.
  2. Compare returns against those of the benchmark index

    Regulations demand that every fund mentions a benchmark index in its Offer Document. The benchmark index serves the dual purpose of being a guidepost for both the fund manager and the investor community. All eyes must be on the benchmark index and how the fund has fared against it. Again with a diversified equity fund, investors should consider the performance of the fund over the longer time frame, while comparing it to its benchmark index. In the Indian context, most equity funds outperform their benchmark indices over the long-term (3-5 years). However, during market turbulence, like the one witnessed over November 2010 till date, investors will find many equity funds trailing their benchmark indices. This is something we have observed on more than one occasion. The funds that can outperform their benchmark indices during stock market volatility must be marked closely.
  3. Compare against the fund's own performance

    Besides comparing a fund with its peers and benchmark index, investors should evaluate its historical performance as well. Not all funds show stability in performance over the years. Many of them plunge during the market downturn, sometimes even more than their benchmarks or the category average; only a few manage to sustain their performance year after year, market cycle after market cycle. By evaluating a fund against its own historical performance, you ensure that you get the most consistent performers in your mutual fund portfolio. The inconsistent performers (the one rally wonders) are available a dime a dozen and must be filtered effectively.
  4. Check the costs associated with the mutual fund scheme

    Apart from analysing the performance of the mutual fund scheme, you should also pay attention to the costs associated with investing in that particular scheme as this has a direct bearing on the net returns you earn from the mutual fund scheme. Expense ratio should be checked before making the final decision of investing in a mutual fund scheme. Also, beware of the exit load (charges levied by a mutual fund scheme in case of redemption within the stipulated period) while requesting for redemption from a mutual fund scheme. However, if you hold on to your investments from a long term point of view, you need not bother about the exit load whatsoever.
  5. Risk-related parameters

    While NAV returns are important, one area, which should never be ignored by investors is the risk undertaken by the fund to generate returns. Mutual funds being market-linked are prime candidates for stock market related risks. The two aspects that investors should take into account are volatility of the fund as indicated by the Standard Deviation (SD) and risk-adjusted returns as calculated by the Sharpe Ratio (SR).

    While SD shows the degree of risk taken on by the fund, SR shows the return generated by the fund per unit of risk taken. The SD (volatility) of a fund should be lower than its peers; on the other hand, the SR should be higher. The best fund is the one with the lowest SD and the highest SR within its peer group. Again, it is advisable for investors to evaluate the SD and SR of the fund on a historical basis so as to identify the most consistent performers.

    Hence, the next time you come across a situation where you need to select a diversified equity mutual fund for your portfolio please ensure that you undertake the 5 easy steps mentioned above.

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Dec 04, 2013

Very we informed article. Thanks and keep up the good work..