How to Select the Best Mutual Funds for Higher Returns?

Investing in Mutual Funds are an efficient and effective way of getting more bang for the buck. Today, the number of mutual fund folios in India has crossed 12.3 crore while the number of SIP folios has crossed 5.3 crore. For any investor, the big challenge is about selecting the right mutual fund which is among the top performers in the category. For that it is essential to understand some of the key factors in mutual fund performance analysis.

Broadly, selecting a mutual fund is about taking decisions on returns, risk, tax efficiency and liquidity needs. Above all, the most important factor to note is that these mutual fund investments must match with your goals. Let us look at some of these specific parameters to check before selecting a mutual fund for your portfolio.

1.Spending some time on understanding the history of the fund

It always makes sense to understand the character of the fund so that you know what you are getting into. One way out is by looking at the past performance history of the fund and its background. Let us understand this better. For instance, it is quite simple for a fund to generate good returns when the market is rising. However, the true character of the fund is only visible when you see how the fund performed in falling markets. Look at a longer period of 8-10 years to get the best ring side view.

2.Assess the monthly performance of the fund

This does sound confusing, You always thought that mutual funds are long term instruments. Then how is it relevant looking at 1-month returns. They show consistency over a period of time. You don’t just want a fund that has done well over 5 years. You need a fund that consistently does well or predominantly does well over smaller time capsules. What you can actually do here is compare its monthly performance to a benchmark. That way, you will get to know which month the fund performed better and in which month it went down. The underperformance or outperformance is best explained on a monthly basis.

3.Fund expense ratio matters a lot

What do we understand by fund expense ratios? When you invest in a mutual fund scheme, have to pay for their services. expense ratio is total the cost that is charged by the company to manage your investment. Expense ratio can vary from 2% to 2.5% in the case of equity funds and is lower for other category of funds. The average expense ratio is expensed on a daily basis and the NAV is adjusted accordingly. Invest in a fund that has a low expense ratio, or you will be giving away too much of your profits. That is where index funds make a lot more sense if you find that active fund managers are not generating anything extra. Accordingly, you can decide on Direct Plans versus Regular Plans and Active funds versus Passive funds.

4.What is the risk-adjusted returns of the fund

The shortcoming with most measures of mutual fund returns is that they are too return oriented and not sufficiently oriented towards risk. More than the weekly, monthly or yearly returns, it is also important to look at risk-adjusted returns. These risk adjusted return ratios measure if the returns are sufficient for the risk taken. Here is a pointer. Is a fund giving 16% returns better than a similar fund giving 15% returns. You must then look at risk adjustment.

Let us say, you are comparing two mutual funds before a buy decision. One of them has a Sharpe ratio of 0.45 and another has 0.55 (Sharpe Ratio is excess returns divided by standard deviation). The standard deviation of the first one is 11% and the second one is 16%. You should opt for the second mutual funds as the risk is adjusted better.

In addition to the above 4 factors, an investor in mutual funds can also look at additional factors like investment goals, mutual fund fit, macroeconomic attractiveness, exit loads etc.

Checklist of qualitative factors for mutual fund selection

The selection of a fund is not just about quantitative factors like returns and risk adjusted returns, but also about certain important qualitative factors. Here is a quick overview of some of the qualitative factors relevant to mutual fund selection.

Does the fund fit into my investment objective?

This is the most critical factor to consider. The fund that you select must fit into your overall investment objective. For example, are you trying to adopt a conservative or aggressive approach to investing? Are the objectives of the fund consistent with your goals. For example, if you are invested in a debt fund for stability and income stream, then there is no point in buying a debt fund that adopts a more dynamic approach. Similarly, if you are looking at index level returns, then better focus on index funds or index ETF . You don’t need to take the active risk of equities and the higher expense ratios.

Experience and longevity of the fund management team

Why does longevity of the fund management team matter? It brings consistency in investment strategy and a better sync between the dealers, traders, researchers, the CIO and the CEO. Fund management team tends to stick on if they are happy and if the fund is performing well. Otherwise, fund managers keep looking for options. Normally, funds that perform better over a longer term are funds that have had stable fund management teams. This ensures continuity and consistency in fund decision making.

How much is the fund loading on to you

There are costs beyond the expense ratio in mutual funds. For example, exit loads are still charged to you at the time of exit before the stipulated period. Fund managements have to explicitly disclose the expense ratio and the break-down in a transparent manner. Equity funds have an expense ratio of 1.5-2.25% while index funds have much lower expense ratios. Make this comparison before investing.

Understand tax implications of fund entry and exit

These are applicable to all funds you choose. For example, if you sell equity funds before a period of 1 year they attract STCG tax at 15% while debt funds sold before 3 years will attract STCG tax at your peak rate. Similarly, equity funds LTCG gains used to be tax-free but from April 01st 2018 gains above Rs.1 lakh are taxed at a flat rate of 10% without benefit of indexation. Also look at the exit loads applicable which may range from 0.5% for larger funds to 1% for smaller funds. All these aspects impact your eventual returns.

Is the fund staying ahead of the curve?

This is a qualitative judgement, yet important. Did the equity fund manager move into winners early or move out of losers early? Fund managers cannot catch every trend in the market but did they catch key trends? Has the debt fund manager effectively tweaked maturity of portfolio on interest rate expectations. The bottom-line is that the fund management should be ahead of the curve if your fund has to perform well. That is what differentiates a good fund manager from an average fund manager.