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Indicators for efficient Mutual Funds selection ~ Simplified.

Mutual Funds- Mysterious Investment instruments about which some people are very happy (gainers) and some people are very terrified (losers). Depending upon the side, people have a broad perception of good/bad upon this instrument. Both of which are dangerous as it might lead to overconfidence about selection of funds or fear acting as de-motivator to invest in MF at all (losing out on opportunities).

Just to be clear: Mutual Funds are financial instruments where a large corpus (collected by a large group of people including retail, trust, companies, partnerships etc. depending upon the objectives) is managed by a professional team working for an AMC (Asset Management Company). The benefit of large corpus is of diversification. Instruments need not necessarily be of equity, it is often times in debt too. (Note: Companies usually park their excess cash in liquid debt MFs to get better return for their idle cash at very low risk).

I have brought out few indicators/criteria which have been my instruments for choosing efficient funds:

  1. Fund Vs Benchmark Performance: Many times you will see that a fund claims to have 50% returns. But, what if that year happened to have a bull market and the benchmark index rallied by 60%. It marks a straight opportunity cost of 10%. A potential 10% gain on the passive fund (click here to know more about passive fund). So, always have a comparative analysis with benchmark performance to save yourself from irresponsible advertisings.
  2. Historical Performance Analysis: Always check for past performance of the data (Fund Vs Benchmark and Fund Vs Competitors). Always try to latch upon those funds who have a track record of outperforming the benchmark.
  3. Expense Ratio: It is a very important component of charges that you will pay out of your funds. These expenses are higher for actively managed funds and lower for passive funds. Check your desired performance level from your money and then go for active or passive selection. If you want returns to the tune of average market returns, it is more sensible to go for passive funds. If you want to go more aggressive, go for active funds (but the, beware to check if it reflects this in its performance or if it is “active” for namesake.)
  4. Select your category: MF is very versatile investment instrument. It has many options under which you can park your investments. You can have investments in Equity (Large Cap, Mid Cap, Small Cap, Sectoral, Arbitrage), Debt (Sovereign, Corporate, Long-Term, Short-Term, Ultra-Short Term, Dynamic), Hybrid (Balanced), Gold Funds,  International equity etc. Ask yourself what type of risk profile suits you, what type of pay-out plans you want (one-time or staggered, you want to get the dividend from investments in cash or reinvested in your fund etc.) There is immense flexibility!!
  5. Mean and Standard Deviation: It just indicates what is average return of the fund (mean) and how much its returns deviate from the mean (standard deviation). Here, Standard Deviation>Mean is a high risk business!
  6. Judge Fund Manager’s Efficiency: Alpha (click here to know more on alpha from my previous post), Treynor ratio, Sharpe’s Ratio (I will explain these in my posts later). For the time being, for all these 3 ratios, Higher the better is the key.
  7. Risk -Return Matrix: This is a widely used tool to show the risk-return trade off in a square matrix. It is easier to analyse risk-return trade-off this way.
  8. Lock- In Periods: They might severely impact your investment decisions if this is in conflict with your expectations. Never forget to check this aspect.
  9. Taxability: It has its higher impact for higher tax-bracket individuals. You must check the applicabilities of tax liability exemptions on the proceeds (when you receive/withdraw funds). In India, Equity Funds (>65% assets invested in equity) has tax exemption policy on its proceeds given that the investments are made  for at least above 1 year.
  10. Portfolio of the fund: This is THE most important thing. I am mentioning it at last because, I didn’t want non-finance people to feel out of the world. So, I have mentioned all mathematical indicators at the top. This part is quite subjective, it depends upon the analyst’s / person’s view on the growth of various sectors of the market. If person is bullish on banking sector, he might go for a fund which has major investments in that sector. For a debt MF, one might want to see the credit-worthiness of the assets the Fund holds. This is highly significant factor which will propel its future performance. So, mover ignore this section.

Useful Tips: Always go for SIP (Systematic Investment Plans) and NEVER try to time markets when you have a long-term investment horizon. Or for that matter- for any investment matters. After you started your investment, trust on the Fund Manager and have a review after every 3-6 months to have periodic check. If you see regular underperformance, then switch your fund.

Stay tuned for more on finconomics issues. 🙂

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