Choosing a mutual fund seems to have become a very complex
affair lately.
There are no dearth of funds in the market and they all claimer
for attention.
The most crucial factor in determining which one is better than
the rest is to look at returns. Returns are the easiest to measure and compare
across funds.
At the most trivial level, the return that a fund gives over a
given period is just the percentage difference between the starting Net Asset
Value (price of unit of a fund) and the ending Net Asset Value.
Returns by themselves don't serve much purpose. The purpose of
calculating returns is to make a comparison. Either between different funds or
time periods. And, you must be careful not to make a mistake here. Or else, you
could end up investing in the wrong funds.
Invest in various funds, not one
Absolute returns
Absolute returns measure how much a fund has gained over a
certain period. So you look at the NAV on one day and look at it, say, six
months or one year or two years later. The percentage difference will tell you
the return over this time frame.
But when using this parameter to compare one fund with another,
make sure that you compare the right fund. To use the age-old analogy, don't
compare apples with oranges.
So if you are looking at the returns of a diversified equity
fund (one that invests in different companies of various sectors), compare it
with other diversified equity funds. Don't compare it with a sector fund which
invests only in companies of a particular sector.
Don't even compare it with a balanced fund (one that invests in equity
and fixed return instruments).
Why has my fund not declared a dividend?
Benchmark returns
This will give you a standard by which to make the comparison.
It basically indicates what the fund has earned as against what it should have
earned.
A fund's benchmark is an index that is chosen by a fund company
to serve as a standard for its returns. The market watchdog, the Securities and
Exchange Board of India, has made it mandatory for funds to declare a benchmark
index.
In effect, the fund is saying that the benchmark's returns are
its target and a fund should be deemed to have done well if it manages to beat
the benchmark.
Let's say the fund is a diversified equity fund that has
benchmarked itself against the Sensex.
So the returns of this fund will be compared vis-a-viz the
Sensex.
Now if the markets are doing fabulously well and the Sensex
keeps climbing upwards steadily, then anything less than fabulous returns from
the fund would actually be a disappointment.
If the Sensex rises by 10% over two months and the fund's NAV
rises by 12%, it is said to have outperformed its benchmark. If the NAV rose by
just 8%, it is said to have underperformed the benchmark.
But if the Sensex drops by 10% over a period of two months and
during that time, the fund's NAV drops by only 6%, then the fund is said to
have outperformed the benchmark.
A fund's returns compared to its benchmark are called its
benchmark returns.
At the current high point in the stock market, almost every
equity fund has done extremely well but many of them have negative benchmark
returns, indicating that their performance is just a side-effect of the
markets' rise rather than some brilliant work by the fund manager.
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Time period
The most important thing while measuring or comparing returns is
to choose an appropriate time period.
The time period over which returns should be compared and
evaluated has to be the same over which that fund type is meant to be invested
in.
If you are comparing equity funds then you must use three to
five year returns. But this is not the case of every other fund.
For instance, cash funds are known as ultra short-term bond
funds or liquid funds that invest in fixed return instruments of very short
maturities. Their main aim is to preserve the principal and earn a modest
return. So the money you invest will eventually be returned to you with a
little something added.
Investors invest in these funds for a very short time frame of
around a few months. So it is alright to compare these funds on the basis of
their six month returns.
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Market conditions
It is also important to see whether a fund's return history is
long enough for it to have seen all kinds of market conditions.
For example, at this point of time, there are equity funds that
were launched one to two years ago and have done very well. However, such funds
have never seen a sustained declining market (bear market). So it is a little
misleading to look at their rate of return since launch and compare that to
other funds that have had to face bad markets.
If a fund has proved its mettle in a bear market and has not
dipped as much as its benchmark, then the fund manager deserves a pat on the
back.
Why you should watch over your mutual fund
Final checklist
Here are some quick pointers when comparing
funds.
-Compare funds that are similar. For instance, compare Alliance
Equity with Franklin India Prima. Both are diversified equity funds. Similarly,
compare UTI Auto with J M Auto, both being auto sector funds. Or Birla Midcap
with Magnum Midcap, both being funds that invest in mid-cap companies.
Don't compare the performance of Alliance Equity with UTI Auto
or even Alliance Equity with Birla Midcap.
- When returns are compared, make sure that the time period is
identical. Or else, you may be looking at the one-year returns for one fund and
the three-year returns for another.
For instance, if you were told that the return of HDFC Equity
was 59.72% and that of Franklin India Prima was 61.74%, it would be misleading.
Because the return stated of HDFC Equity is a one year return
while that of Franklin India Prima is the three-year return.
- Compare a fund with it's own stated benchmark, not another. For
instance, Fidelity Equity, Escorts Growth and BoB Growth are all diversified
equity funds with different benchmarks.
Fidelity Equity - BSE 200
Escorts Growth - S&P CNX Nifty
BoB Growth – Sensex
While there are other factors that have to be considered when
investing in a mutual fund, returns is the most important. So make sure you do
your homework right on this count.
Links for Top Rated Funds
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