11 Jan 2019 19:31 IST

How to pick equity mutual funds

One must look at the fund’s performance, rolling returns and expense ratio

Investors with a reasonable appetite for risk and long-term financial goals can consider investing in equity mutual funds. In this article, we look at four broad parameters to consider when selecting equity mutual funds.

Diversification

The equity diversified funds category is further classified based on its investments across market capitalisation and sectors. It is important to choose a fund that fits your risk appetite.

For instance, Axis Blue Chip is a large-cap oriented fund, which helps mitigate risk in a volatile market. If you have a slightly higher risk appetite you can choose a mid-cap or small-cap fund such as Invesco India Midcap or HDFC Small Cap Fund. But remember, in a volatile market such as now, it is better to stick with large-cap funds. Hence, diversifying your portfolio across various fund categories is prudent. Also, go for a well-balanced portfolio that invests across sectors. This helps off-set the under-performance in certain sectors at any given point.

Sector funds that invest in one or a few specific sectors run a big risk of under-performance if the tide turns against the sector. If you have a low-risk appetite, it is best to avoid such funds. A good blend of funds across market caps and strategies will help mitigate volatility in returns.

Consistency in returns

Though past performance may not be indicative of future returns, analysing how a fund has fared in the past will give you a fair idea about its ability to outperform its benchmark and peers. It is wise to look at the performance over the long run — whether the fund has performed consistently in the past five to seven years, as well as during the various market scenarios such as bull, bear and volatile phases.

The best way to capture the consistency of funds during these periods is through the rolling return. Rolling return is an average point-to-point return calculated for a given period. Comparisons with respective benchmarks can give a clue on how consistently a fund has outperformed its benchmark over a given period.

Risk return trade-off

Higher risk is usually associated with greater probability of higher return and vice-versa. So, the investment that gives you a return in same/higher proportion for the risk you take is ideal. A fund that gives better returns than others for the same kind of risk can be considered as a good bet. This is measured with the help of Sharpe ratio.

When comparing funds, go for funds with higher Sharpe ratio. This ratio is disclosed by all fund houses for each of their schemes in the monthly factsheet.

Expense ratio

Mutual fund companies charge a certain per cent of the corpus to manage the fund. This is called the expense ratio. Since NAVs are calculated after deducting the expense ratio, a higher expense ratio will lower your NAV and, hence, returns. Over the long run, higher expense in a fund may eat into returns significantly when compared to peers with lower expense ratios. So, the fund with a lower expense ratio is preferable, provided it also fares well on the other parameters mentioned above.

For instance, under the large-cap fund category, while good performing funds such as ICICI Pru Blue Chip, HDFC Top 100, and Reliance Large Cap Fund have expense ratio of 2-2.2 per cent, some of the others such as L&T India Large Cap Fund and Tata Large Cap have a higher expense ratio of 2.6-2.9 per cent, which eat into returns. Some funds within the category carry as high as 3.1 per cent expense ratio.

If you have a fair deal of knowledge about funds, go for direct plans that come with lower expense ratio as they exclude commission paid to the intermediaries.

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