Choosing the Best Mutual Funds: A Detailed Comparison Guide

A Detailed Comparison Guide

When investors are faced with multiple mutual fund options, it can be challenging to make a decision. 

The three main categories of mutual funds: Equity, Debt, and Hybrid Funds - provide a starting point, but within each of these categories, there are numerous sub-categories. For example, Equity Funds can include Large Cap, Mid Cap, Small Cap, Sectoral Funds, and so on. Debt Funds can range from Liquid Funds to Long-Term Bond Funds. Hybrid Funds combine elements of both equity and debt. Each mutual fund scheme has its own investment strategy, risk profile, and track record.

Comparing Equity Mutual Fund schemes

Equity, as an asset class, represents growth investment. An investor's returns are primarily from appreciation in the value of the asset. The risk to the investor arises from the absence of defined and fixed returns from these investments, which can be volatile from period to period. The returns from equity are linked to the earnings of the business. Not all businesses are successful and manage to earn returns for their returns for their equity investors. 

When comparing Mutual Funds, there are several parameters available for evaluation. 

Returns: 

Returns are one of the primary indicators of a Mutual Fund's performance. Investors typically look at the returns over different periods, such as 1 year, 3 years, and 5 years, to assess how well a fund has performed historically.  The Performance advertisement of mutual fund schemes shall be provided in terms of CAGR for the past 1 year, 3 years, 5 years, and since inception. However, it's essential to remember that past performance is not indicative of future results. 

Returns Relative to Benchmark: Comparing a fund's returns to its benchmark index provides insight into how effectively the fund manager has managed the portfolio. If a fund consistently outperforms its benchmark, it indicates skilled management and may be more attractive to investors. 

 Expense Ratio: The expense ratio represents the annual fees charged by the fund house for managing the fund. This percentage is deducted from the fund's assets and impacts the overall returns to investors. Lower expense ratios are generally preferred as they can significantly impact long-term returns. 

 Risk Metrics: Various risk metrics need to be evaluated for comparing an equity mutual fund scheme. These are explained below:

Standard Deviation: 

Standard deviation is a measure of total risk in an investment. As a measure of risk, it is relevant for both debt and equity schemes. A high standard deviation indicates greater volatility in the returns and greater risk. Comparing the standard deviation of a scheme with that of the benchmark and peer group funds gives the investor a perspective of the risk in the scheme. Standard deviation, along with the average return, can be used to estimate the range of returns that the investment will take. Since standard deviation is calculated using historical numbers, it is limited in predicting future performance. This metric measures the volatility of a fund's returns. A higher standard deviation indicates greater volatility, while a lower one suggests more stable returns. 

Sharpe Ratio: The Sharpe Ratio evaluates a fund's risk-adjusted returns by comparing its returns to its volatility. A higher Sharpe Ratio indicates better risk-adjusted performance. 

Sortino Ratio: This ratio is similar to the Sharpe Ratio, but it only considers downside volatility, focusing on the risk of negative returns. A higher Sortino Ratio suggests better risk-adjusted returns with less downside risk. 

Alpha: Alpha measures a fund manager's ability to generate excess returns compared to its benchmark index. Positive alpha indicates outperformance, while negative alpha suggests

underperformance. 

Beta: Beta measures the fluctuation in periodic returns in a scheme as compared to the fluctuation in periodic returns of a diversified stock index (representing the market) over the same period. It measures a fund's sensitivity to market movements. A beta greater than 1 indicates higher volatility compared to the market, while a beta less than 1 suggests lower volatility. 

Portfolio-Level Information: 

Allocation Across Market Caps: This indicates how the fund is diversified across different market capitalizations, such as large, mid, and Small-cap stocks. It gives insight into the fund's risk profile and growth potential. 

Number of Securities: The total number of securities held by the fund provides an understanding of its diversification strategy. A higher number of securities may indicate better diversification, reducing specific risk. 

What are the additional criteria for comparing debt mutual fund schemes or Hybrid mutual fund schemes?

Weighted Average Maturity

Relevant to debt mutual funds, average maturity measures the weighted average time until the bonds in the portfolio mature. It helps assess interest rate sensitivity and potential impact on returns. 

The extent of fluctuation in the value of the fixed-rate debt security is a function of its time to maturity (balance tenor). The longer the balance tenor, the higher would be the fluctuation in the value of the fixed-rate debt security arising out of the exact change in interest rates in the market.

This has led to the concept of weighted average maturity in debt schemes. If a scheme has 70 percent of its portfolio in a 4-year security and the balance of 30 percent in a 1-year security, the weighted average maturity can be calculated to be (70 percent X 4 years) + (30 percent X 1 year), i.e., 3.1 years. The NAV of such a scheme can be expected to fluctuate more than that of another debt scheme with a weighted average maturity closer to 1.5 years.

Modified Duration: Modified duration measures the sensitivity of a debt security's value to changes in interest rates. The higher the modified duration, the more interest-sensitive the risk in a debt portfolio.

A professional investor would rely on modified duration as a better measure of sensitivity to interest rate changes.

Yield to Maturity (YTM): YTM indicates the expected annualized return if the bond is held until maturity. It provides insights into the overall quality and potential returns of the bonds held in the fund's portfolio.

Portfolio Holdings: Understanding the sectors and individual companies in which the fund is invested helps investors assess the fund's investment strategy, sectoral concentration, and alignment with their investment objectives.

Credit Rating

The credit rating profile indicates the credit or default risk in a scheme. Government securities do not have a credit risk. Similarly, cash and cash equivalents do not have a credit risk. Investments in corporate issuances carry credit risk. The higher the credit rating, the lower the default risk. The better an issuer's credit rating, the lower the spread. Issuers with a poor credit rating need to offer higher yields to attract investors. Therefore, the spread of such securities is higher.

Credit rating, too, changes over time. A security that was rated ‘AAA’ can get downgraded to, say, ‘AA’. In that case, the yield expectations from the security would go up, leading to a decline in its market value. Thus, a wise investor who anticipates an improvement in an instrument's credit rating can benefit from the increase in its value that would follow.