How to select a mutual fund
Welcome to Indian Share Market
Your Desire to Earn
In case of equity funds:
Performance - In case of an equity fund, you can begin by looking at its performance as measured in absolute returns from the fund. The Securities and Exchange Board of India (SEBI) has standardised returns declarations on the fact sheet. A declaration is on a compounded annualised basis for a period of more than a year and on absolute basis for less than a year.
Returns against benchmark - You should look at an equity fund's returns for various periods vis-a-vis its benchmarks. The benchmarks may be varied - the interest rates, Sensex level, or some other index. The performance should be seen over a long term - say two to three years. You should compare the latest NAV with the unit value during the time of purchase. Absolute returns are the first yardsticks an investor should look at.
Portfolio of fund - You should also examine the portfolio of the fund to gauge its quality of investments. Ultimately, it is the portfolio that will yield the returns. A portfolio should be in line with the mandate of the fund.
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For an individual investor, sometimes it is difficult to judge which mutual fund is good and which one is not. The parameters for evaluation differ depending on the fund type. There are different parameters for an equity fund and different ones for a debt fund.
For example, a pharma fund should have pharma stocks and a gilt fund should have investments in gilt securities. In case of a diversified equity fund, you should check whether the fund is adequately diversified across sectors and companies rather than limiting its investment sphere to a narrow gauge. Funds are supposed to give sector-wise break-up along with details of company holdings.
Portfolio turnover ratio - Another tool to evaluate a fund is the portfolio turnover ratio. This gives an understanding of the extent of portfolio movements. A ratio of 100 percent indicates that the fund changes its complete portfolio each year. A ratio of 50 percent indicates that the fund changes its complete portfolio every two years. Frequent churning increases the risk profile of the fund. Also, it means the fund is incurring additional transaction costs.
In case of a debt fund
In case of a debt fund, apart from the two parameters of absolute returns and portfolio turnover ratios, you should also look at the ratings break-up for the fund's corporate bond holdings . This indicates the quality of the portfolio. Investing in company bonds has an element of risk. You should check the ratings of the bonds in which the fund has invested. The credit rating gives a good indication of the security profile of the fund.
Portfolio maturity - In addition, you should also look at the portfolio maturity. This is the average tenure of the bond portfolio of the debt fund. It indicates the susceptibility of the fund to changes in interest rates. Bond prices and interest rates move in opposite directions.
As such, any rise in interest rates may lead to a fall in bond prices and hence the NAV of the debt funds, and vice versa. If the fund expects interest rates to fall, it might increase the maturity of the debt portfolio to gain from a probable rise in bond prices. Increasing maturity to very high levels might be construed as too high for a debt fund, because in case the interest rates rise instead of falling, the losses would also be relatively more.
(Posted date - 04 July 2010)
