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5 parameters of selecting best mutual fund scheme

Manikaran Singal discusses five parameters of selecting the best mutual funds scheme.

January 21, 2014 / 03:30 PM IST

Manikaran SingalCertified financial planner

At the onset let me clarify that best mutual fund scheme does not mean the best in returns, but the one best suited to your risk profile and goals and the one that is good in its peer group. The biggest mistake that mutual fund investors make is selecting mutual funds only on the basis of performance and that too just the recent performance.

There are some investors who consider only the star ratings given by various research agencies. These star ratings can be one of the factors to look at, but there are many other parameters that one should look into before finalising a mutual fund portfolio. 

Also read: Mutual Funds soar high as markets end higher

The aim of this article is to apprise you with some of those parameters.

1. Performance Ranking

More than the recent or long term performance of any scheme its ranking among peers should be looked at. To find out the ranking you need to check out the quartile ranking which will show how the fund has performed quarter on quarter among its peer group. In quartile ranking each quartile comprises of 25 percent of peer group schemes.

So one may select the scheme which has remained in top quartile most of the time. If at all you find your scheme going below 3rd quartile in a couple of consecutive quarters it hints that time has come to exit the scheme. You can find these rankings from the factsheets of various AMCs and also on some mutual funds research websites.

2. Ratio analysis

Risk and return ratios like standard deviation, Sharpe ratio etc. I have discussed in my earlier article on Measuring Mutual funds risk. Along with those ratios, one also should check out the ALPHA of the fund.  Alpha tells us what extra or less the fund manager has generated out of a given portfolio in comparison to benchmark.

In other words alpha is the performance ranking of the fund manager. You may check how often the fund manager has generated positive alpha in last few quarters and also keep a watch on its consistency going forward.

3. Total expense ratio

Expense ratio is very important parameter to be looked at while selecting any mutual fund scheme. All fund management and distribution related expenses are borne by the scheme. This means high expense ratio will affect the fund’s returns.

Though mutual fund’s total expense ratio has been capped by SEBI, still lower the better unless we get some extraordinary return by paying higher expenses for fund management.

4. Fund manager tenure and experience

Fund manager plays a very important role in the fund’s performance. Though it is a process oriented approach but still fund manager is the ultimate decision maker and his experience and view point counts a lot. You should know who is the fund manager of the scheme and what is his past track record.

You should also look at the performance of other funds which he is managing. If the fund manager of the scheme has recently been changed, don’t panic.  Just keep a watch on his performance by looking at alpha and quarter to quarter performance.

If you find that due to change in the fund manager there is considerable effect on the fund’s performance which does not suit your risk appetite then you may make a decision to exit.

5. Scheme asset size

This parameter is different for debt and equity schemes. In equity the comfortable asset size in hundreds of crores, in debt it should be in thousands of crores as the investment value per investor is higher in debt funds. 90 percent of total assets under management (AUM) of the mutual fund industry are invested in debt funds, so your selected scheme assets should also have a considerable AUM.

Less AUM in any scheme is very risky as you don’t know who the investors are and what quantum of investments they have in this particular scheme.

Exit of any big investor out of any mutual fund may impact its overall performance very badly and the remaining investors in a scheme will have to bear the impact.  In schemes with larger AUMs this risk gets minimised.   

You must have observed that all the above mentioned parameters are overlapping each other in some way or the other. A good fund manager will automatically result in better performance and thus improve the quartile ranking and would also generate good alpha.

High scheme assets will help in reducing the total expense ratio of the scheme.  But, as the popular saying goes- ‘There is no scientific way to choose tomorrow’s best funds today’, so one should review the current selection every quarter or half yearly.

The author is Certified Financial Planner and a member of The Financial Planners’ Guild, India (FPGI). FPGI is an association of Practicing Certified Financial Planners to create awareness about Financial Planning among the public, promote professional excellence and ensure high quality practice standards.