Authored by Saumya Shah
Even though mutual funds are a popular investment vehicle, people still hesitate to invest in them. While mutual funds have gained popularity in recent times, investors are unaware of how to analyze mutual funds. Whether you are investing for capital preservation or wealth creation, choosing the right mutual fund is essential in order to achieve your investment objective.
In this blog, we will walk you through 8 simple steps that will help you with mutual fund analysis.
Regular Plans vs Direct Plans
Before you start analyzing a fund, we recommend checking whether the mutual fund is a Regular Plan fund or a Direct Plan fund. A Regular Plan mutual fund pays out commissions to brokers or distributors, thereby giving you lower returns on your investment. In fact, with time, as your investment cost increases, your returns decrease.
Here’s a real-world comparison between a Direct Plan and a Regular Plan (Mirae Asset Tax Saver Fund):
Particulars Direct Plan Regular Plan SIP Amounts
₹5,000
₹5,000
Time
20 Years
25 Years
Returns (Since Inception)
20.45%
18.69%
Expense Ratio
0.30%
1.75%
Amount at Maturity ₹ 1,66,40,498 ₹ 1,27,83,529
As you can see, what appears to be a minuscule amount in the short term, ends up being a huge expense in the long run. If your entire mutual fund portfolio contains Regular Plans, imagine how much money you’re wasting away over the years. By choosing Direct Plans, you save yourself a huge opportunity cost.
Bear in mind, it is important to get investment advice from a SEBI Registered Investment Advisor when you invest in Direct Plan funds.
Returns
As investors, the first thing we look into is the returns on our investment. The right way to go about this would be to benchmark the returns against the appropriate category average. Every mutual fund has a benchmark against which you can measure its performance. For instance, a large-cap mutual fund’s benchmark could be NIFTY 50, NIFTY 100, or Sensex. It is imperative for the fund to always beat its benchmark. Also, always remember to check rolling returns instead of just trailing returns; trailing returns may be biased based on a single year’s performance.
Note: if a fund is beating its benchmark and peers drastically, this could be a red flag, indicating that the fund might not be following the fund objectives.
Assets Under Management (AUM)
AUM indicates the market value of all the investments that a mutual fund holds on behalf of its clients. When you analyze a debt fund, a higher AUM is usually a good sign. It suggests that the fund has a better investment inflow and investors enjoy economies of scale. Also, when investors want to withdraw their money, it doesn’t create a redemption pressure on the fund because of its larger size.
Recently, Franklin Templeton had to wind up 6 of its schemes due to massive redemption pressure from investors.
On the other hand, when you analyze an equity mutual fund, especially a mid-cap or small-cap mutual fund, a relatively smaller AUM would be preferable; with a larger AUM, a fund manager may find it difficult to make entries and exits, as small and mid-cap companies don’t have the large free floats that larger mutual funds would need. That said, you shouldn’t always target mutual funds with the lowest AUMs because smaller funds can have higher operational costs per unit. A good strategy is to go for funds that have an average AUM; these funds can enjoy economies of scale, without losing out on investment opportunities.
Expense Ratio
The expense ratio represents the percentage of the fund’s total asset value that is charged as an expense to investors. This amount is charged to cover the expenses incurred by a fund and for its professional management. The lower the expense ratio, the higher your real returns are. As an investor, it is practical to invest in funds that provide good returns while charging a lower expense ratio. Do compare the fund’s expense ratio with the category average (expense ratio).
Tip: If you are investing in an actively managed large-cap fund, switch to an index fund and earn potentially higher returns by paying a lower expense ratio.
Fund Manager
‘Bet on the jockey, not on the horse’; Check if the fund manager of the mutual fund you’re considering has adequate experience and a good track record. Look for the fund manager’s years of experience in the field, and the performance of the funds he has managed or co-managed. You want to entrust your funds to someone who understands the market well, and can help you earn a higher return on your investment.
Quantitative Measures
Quantitative measures give you a brief idea of the risk taken by the fund and the volatility you can expect in your returns.
Standard Deviation: This is a measure of how volatile the returns are. A higher standard deviation indicates higher volatility, which makes it hard to predict the returns. When you are comparing two funds from the same category, a fund with a lower standard deviation will provide more consistent returns. It is important to note that equity funds have a higher standard deviation than debt funds because the equity market is more volatile; they should not be compared with each other. Two equity funds sharing the same benchmark can be compared, as these funds will have the same inherent risks and properties.
Beta: Beta denotes how sensitive the fund is to market movements. For example, a beta of 1 indicates that the performance of the fund will mirror the performance of the market. A beta lower than 1 suggests lower volatility than the market. For instance, a beta of 0.8 means that if the market goes down by 100 points, the fund’s returns might only go down by 80 points. So, a beta should be less than or close to 1. You should opt for funds with a higher beta only if you have a high-risk appetite.
Risk-Adjusted Returns (Sharpe’s ratio and Treynor’s ratio): It is important for investors to look at the risk that funds have taken to generate returns. If fund A has historically taken enormous amounts of risk to generate returns that fund B has been able to generate with a lower level of risk, an investor should opt for fund B. A higher Sharpe’s or Treynor’s ratio suggests that a fund has taken a lower level of risk to generate high returns, which is a good sign. You can also compare a fund’s returns with the category average.
Alpha: Alpha is the additional return that a fund can generate compared to its benchmark. A higher alpha is desirable.
Portfolio Turnover Ratio: This shows you how frequently the fund manager buys/sells securities. Every time the fund manager buys/sells security, transaction costs apply, and your investment cost increases. A lower portfolio turnover ratio is preferable; it also signals that the fund managers have faith in the stocks that they pick.
Portfolio
The next step is to look at the portfolio of the fund, the securities the fund has invested in and the sectors it has more exposure to. If you are investing in debt for capital preservation, you should see whether or not the securities that the fund has invested in, have a good credit rating (AAA). If you are investing in an equity mutual fund, the securities mentioned in the portfolio should be in line with the investment objective of the fund.
Objective
Before investing, it is vital to decide your investment objective, your investment horizon, and your risk appetite. This requires you to ask yourself three questions: i) Why am I investing? ii) When will I need my funds back? iii) What is my risk appetite? Once you have these answers, you should ensure that your objective, investment horizon, and risk appetite align with those of the fund. To ascertain the risk profile of a fund, you can look at the ‘riskometer’ of the fund. For example, if you want to invest for a longer time frame, and you have a high-risk appetite, it would make sense to invest in mid-cap or small cap funds.
This article has provided you a brief idea of how to analyze a mutual fund. However, it can get overwhelming for the best of minds to choose from numerous funds and evaluate them individually. This is where it is extremely helpful to take investment advice from a SEBI registered investment advisor. A good investment advisor can help you evaluate your risk profile and recommend investment products that suit your needs and profile The Tarrakki app provides expert investment advice, making mutual fund investment commission-free, easy, fun, and convenient.
Saumya Shah is the Founder of Tarrakki.com, providing comprehensive wealth management solutions. Views are personal
