There are around 1500+ mutual funds and about 15+ different types of funds available in Indian market today and the list keeps on increasing every day with new schemes getting launched and new players entering the market, Currently, India has about 44 different fund houses offering different types of mutual funds. With so many options it has become increasingly difficult for retail investors to chose the right fund.
In last few years,some of the influential rating agencies have started publishing mutual fund ratings for India funds these include Crisil, Morningstar and Valueresearchonline all of them have a robust research methodology and provide a good starting point to understand the performance of the fund,but they have certain limitations which i have summarized below.
- Ratings are mostly based on 3-year risk-return framework, most of the investments we do in mutual funds are for a longer tenure, hence some of the long term consistency goodness might not be captured by these ratings
- Ratings do not help the investors to design a right portfolio vis-a-vis his individual risk
- Ratings can at best be starting point but should never be the end point for your analysis as you go about choosing the right fund for you.
So having established that rating is not a sufficient criterion so what is the best framework to select a mutual fund. Actually,there is not one but multiple methods you can use to find the right funds my recommended method is to look at a long term consistent performance of funds, I will be explaining this approach in detail in this post.
I will be taking you through a step by step guide on how to chose the right mutual fund, please note I will be just explaining the process and examples I have chosen does not mean we are recommending these funds, examples are purely chosen for explaining the right process.
Before we go into details of the step by step process, I put together a small infographic which will summarize the key steps.
5 Step guide on how to select a mutual fund
- Set up objective
- Set up expectations
- Find out the right portfolio for you
- Shortlist top funds
- Chose the winner.
Ok, let’s now dive into the detailed process.Like with anything else we do in life before you chose a mutual fund precondition is to set up the objective,without a right objective any analysis,any advice you get is useless, so let us understand how to set up an objective.
1. Setting up an Investment objective for Mutual fund Investment
When you set up an investment objective, i would like you to answer the following questions
Why am I Investing
Why am I investing answers the fundamental question about goals you are chasing with the investment you are making. Some examples of legitimate goals are as follow
- I want to save for my retirement
- I want to park my money for one year get decent returns
- I am saving up to buy a new car and will need this money in 2 years
- I want to invest this money to plan for my kids education
whatever be your goal, please write it down on a piece of paper your goal should have a financial requirement mapped to it.
When will you need the money
No investment is for eternity, every investment has a time horizon, and in some cases time horizon is very important, mutual funds is one of those asset classes, unlike asset classes like fixed deposit or post office schemes where time horizon is generally not important, Mutual funds choice and probable returns have a direct co-relation with when you want your money back, let me try to give you an example
” If your investment horizon is less than 2 years, than i will never recommend equity funds to you”
Let’s look at how a legitimate goal should look like
2. Setting up right expectations for mutual fund investment
Setting up a genuine return expectation
Before you start investing you need to have reasonable return expectation, and those expectations have to be realistic and tie up with your investment horizon and the goals you have set up. So if you are expecting 20% return on mutual funds,who have historically delivered 14% and plan your goals based on this assumption, you are bound to fail in achieving your goals.
Encounter the beast called Inflation in the room
Now that we have set up a return expectation, next thing we need to do is provision for inflation, and if you want to know the reason why go ahead read my post on How inflation impacts your money.
Basically, as a thumb rule, inflation is a factor you need to subtract from your expected rate of return to know what is the real rate of return you will get , equation is very simple
Real Rate of return = Nominal rate of return- Inflation
So now what inflation rate you should be using in your calculations, before we arrive at the answer have a look at the retail inflation trends in the country , as you can in last few years have hovered close to 8-10 % it has fallen in 2016, so to be on the safer side i would recommend you use 8 % for inflation
3. Deciding Portfolio of your investment
Should you buy an equity fund or a debt fund, and if you have to buy both how much to buy of each of them is a central portfolio question which should be governed by your investment objectives as well as your risk profile in general for long-term investments greater than 5 year time horizon for investors under the age of 40 years, I recommend 80/20 equity to debt split.
Selecting debt funds :
If you are investing for super long term like say 15 years or more, I would suggest you go with PPF or NPS, For shorter tenures, I recommend short-term debt funds.
Selecting equity Portfolio:
Again this depends on your risk profile and your age, but in general if you are young, i am going to suggest a portfolio of Large cap: 40 %/Diversified : 40 /Small-Mid Cap: 20 % , we have created a nifty tool as part of investment advisory service at bodhik, you can use it to find the right portfolio for yourself
ok before we go ahead let’s summarize what we have done till now :
Shortlisting of Funds
Now that we have arrived at the right portfolio, we will try to shortlist the funds for our portfolio In this post I will be discussing selecting of equity funds ,now there are multiple ways or criteria to shortlist funds but I am going to select a very simple criteria.
- Remove all funds which are less than 5 years of age
- Remove all funds which are less than 4-star rated (you can use valueresearchonline or Morningstar rating for the same)
- Remove all unrated funds
- Remove all funds suspended for sales
- Remove all fixed monthly income funds ( because we are trying to build a growth portfolio
Below is how the list looks like for a sample of large cap funds I picked up from valueresearch.
Now that we have the list here is what you should do next sort all these funds by 10-year returns, which basically sorts funds in descending order of returns based on 10 year returns,below is the snapshot of funds sorted based on 10-year return.
Next step we do is sort all the funds based on 5-year returns, we get a chart like the one below
And we do go ahead and do the same for 3-year returns
Now we need to define a criteria for shortlisting funds, while all of us can have different criteria,I am suggesting a simple criteria select funds who have been in top 25 all the periods under discussion i.e for 3, 5 and 10 year period, this will be our shortlist
Making the final choice
Now that we have the short-list , we want to go for the kill and make a final choice of the fund we want to invest in, there are multiple methods to do this, I will be using a standard risk-return framework to identify the winners, I will write about other methods in a different post but for now we will only focus on risk-return framework which is based on MPT( Modern Portfolio theory). Before we start analyzing our funds, lets get some terminologies and definitions straight.
1. Alpha : Alpha measures funds out performance wrt to benchmark, in simple terms excess return of a fund over the benchmark is fund’s alpha.
2. Beta :Beta measures the volatility of a fund ,beta of 1 means your fund is as volatile as the benchmark index so if the index goes up , your fund also goes up in the same proportion, while a beta of 1.2 means your fund is 20% more volatile than the benchmark index, if you are risk averse investor you would want a lower beta
3. Standard Deviation: SD measures dispersion from mean for funds it measures volatility, higher the standard deviation,higher the volatility
4. Sharpe Ratio: Sharpe ratio is a measure of risk adjusted return It measures amount of risk that fund has to take to deliver a particular return
5. Sortino Ratio : The Sortino ratio is a variation of the Sharpe ratio that differentiates harmful volatility from total overall volatility by using the asset’s standard deviation of negative asset returns, called downside deviation.
Ok now that we understand the ratios let us see how we use them to arrive at the fund we want to invest in
First of look for funds with lower beta,now once you have sorted them by lower beta look for higher alpha and higher sharpe ratio and sortino ratios, this will help you find the right fund, if you look at the data below you can easily pick up 2-3 funds from top
Limitation of this approach we have not looked at some of the funds which have performed really well in last few years but were not available in past 10 years, one way we can take care of that is do analysis for 1/3/5 year return, to do shortlisting though I always recommend picking up the horses
There are other approaches you can use to pick up the funds, most of them build on top of the long term value and risk-return approach I discussed above, for starteres I beleive this approach will be good enough to find the right fund for you.
If you have specific questions leave a comment and I will try to answer as fast as I can