How to analyze mutual funds

How to analyze mutual funds?

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How to analyze mutual funds?

Every financial instrument has to be analysed objectively before investing. Mutual funds are no different. Mutual funds are financial vehicles wherein a set of investors pool their money with similar return expectations and risk profile. The units of a mutual fund are distributed proportionately to investors. Profits and losses too are shared equally between investors. The structure of mutual funds offers an efficient way to diversify a portfolio. There are various mutual fund schemes available in the market based on their structure, the asset class and investment objective. Even though mutual fund investments are safer compared to some other financial instruments, they have inherent risks. Just like other financial products, mutual funds have a set of parameters to analyse them. 

Compare to appropriate benchmarks

The objective of investment should be clear while investing in mutual funds. Everyone invests to earn returns, no one intentionally wants to lose money. The first criteria to consider should be the returns generated by the scheme. But you should always be careful and do a like-to-like comparison. Just as equity returns cannot be compared to the returns generated by bonds, different types of mutual funds scheme should not be compared. You should compare a mutual fund scheme with the average returns from a similar scheme. Another way is to use an index as a benchmark. For instance, if the mutual fund is a large-cap equity fund, compare it to the performance of a broad-based index like Nifty 500. If the fund has consistently outperformed the index, you can consider investing in the fund.

Compare fund history

When planning to invest in any market-linked instrument it is pertinent to take into consideration its performance for a long enough time. In the case of mutual funds, fund history reveals the real picture. When you look at a fund’s performance of the last 5-10 years, it shows both good and bad business cycles. An ideal fund would generate returns in line with expectations during market rallies, while limiting erosion of value during market slumps. For instance, if a fund has a history of just two years and has performed extremely well in those years, it may have benefited from market rallies. It could lose substantial value in the following years when the market hits an air pocket. Therefore, it is important to compare performance across different time intervals.

Compare Fund Expense Ratio

Mutual fund managers charge a fee or a commission for managing the corpus on behalf of the investors. Market regulator Securities and Exchange Board of India has capped this fee at 2.5 percent of the fund’s average assets under management. You should look for mutual fund schemes that offer similar returns but have a relatively lower expense ratio. The expense ratio is deducted from the returns generated by the fund and so a lower expense ratio helps in getting higher returns. One way to reduce the expense ratio is to invest in direct mutual funds. You can invest in mutual funds either through an agent or directly. Agents charge a commission for their services, which automatically increases the expense ratio. You can directly invest in mutual fund schemes of your choice through Finserv MARKETS. Just four simple steps have to be followed to start investing in mutual funds.

  1. Choose the mutual fund scheme
  2. Provide the amount that has to be invested
  3. Complete the Know Your Customer process with relevant documents
  4. Complete the payment

Understand economic cycles

Understanding economic and business cycles can be a potent tool against entering the markets at the wrong time. Taking into consideration market cycles gives you a better perspective of the returns a mutual fund can generate. Knowing about business cycles is an extension of comparing fund history. For instance, markets can rally for a short interval supported by economic stimulus but will decline as soon as the effect washes away. It also helps when investing in sector funds. Many sectors are cyclical and investing during the highs of the sector could lead to loss of value when sector witnesses a downturn. Business cycles are the reason why most financial experts advise against considering short-term performance.

Compare average maturity

Debt funds are a preferred choice for risk-averse investors who want stable returns. The average maturity is used to evaluate debt funds. Debt funds invest in fixed-income instruments like government bonds, but the prices of these instruments are inversely proportional to interest rates. Average maturity period is the duration after which the instruments held by a fund mature. With an increase in duration, the sensitivity to interest rate movements rises. The chances of a decline in the NAV of a fund rises with an increase in interest rates. The average maturity should match your investment horizon.

Track record of the fund manager

The fund manager is one of the most important figures in the mutual fund industry. Professional money managers have a wide range of experience and are adept at managing risks in adverse business cycles. Fund managers make investment decisions based on risk profile and return expectations of the investors. It is important to understand the competence and track record of the fund manager. His/her track record or past performance could be an efficient parameter to predict the future performance of the fund.

Compare Turnover ratio

The portfolio turnover ratio is a reflection of the number of times the fund manager buys or sells underlying securities. It shows how frequently the fund manager is trading in securities. Frequent trading can have a bearing on your take-home returns as whenever securities are bought or sold it attracts transaction charges. The transaction charges are deducted as expenses from the returns of the fund, thus reducing the final returns for investors. However, it should be kept in mind that most fund managers would trade frequently to improve the returns. Turnover ratio is an important metric for mutual funds and you should choose a fund with a lower turnover ratio. A high turnover ratio should be justified by better returns when compared to similar funds. 

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