How to compare mutual funds: Beyond just looking at returns

Returns are not the whole picture

When most investors are shopping for mutual funds, the first number they consider is the prior return percentage. While this is an important metric, it’s misleading if considered in isolation. Top prior returns are often a result of a one-time market bounce, sector bubble, or short-term strategy that is not likely to repeat. Instead of looking at past winners, investors should look for consistency and congruence with their risk tolerance and investment time frame.

Calculate the risk and volatility

All mutual funds carry some degree of risk, and two funds yielding the same returns can exhibit extremely disparate volatility profiles. Key measures of risk such as standard deviation, beta, and Sharpe ratio can provide investors with an estimate of the extent of risk a fund takes to offer returns. For example, a fund that offers 12% returns on a yearly basis and lower volatility is generally preferred to one offering 14% returns with extreme fluctuations.

Look at fund manager and AMC track record

A quality and consistent fund manager can actually make a real difference to a mutual fund’s performance. Think about how long the current fund manager has been managing the scheme and his/her track record over different market cycles. Also, see the stability and reputation of the Asset Management Company (AMC), as a strong AMC platform ensures disciplined investment processes and better investor servicing.

Analyse expense ratio and costs

The expense ratio represents the annual fee charged by the mutual fund for managing your investment. Over the long term, even a 0.5% difference in expense ratio can meaningfully impact your final corpus. Compare expense ratios within the same category of funds and opt for direct plans if you’re confident in making investment decisions without a distributor.

Diversification and portfolio quality

The underlying structure of a fund’s portfolio says a lot about its stability and approach. Consider sector diversification, stock concentration, and the quality of firms represented. A diversified fund spreads risk across sectors and is not overly concentrated in a single stock or theme and thus is less prone to suffering from declines in the market.

FAQs

Q1: Do I need to always pick the highest returning fund within its category?

Not necessarily. More return often accompanies more risk, and the past is not the future.

Q2: How often should I review my mutual fund portfolio?

At least once a year, or more often if market conditions or your goals suddenly shift.

Q3: Is direct plan investment a good thing?

Direct plans will have fewer cost ratios that are effective in the long term, but you will have to do research and trade on your own.