How to pick a good mutual fund

We always advise our readers never to go by tips but to do their own analysis. Here, we tell you what to keep in mind in order to pick a good mutual fund.  

The way to do it is by comparing it rightly with other benchmarks and parameters.

Absolute returns

Absolute returns measure how much a fund has gained over a certain period. So, you look at the Net Asset Value 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.

Compare the returns of various funds. 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, compare it with other diversified equity funds. Don't compare it with a sector fund.

Don't even compare it with a balanced fund (one that invests in equity and debt).

For instance, compare HDFC 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.

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. This is because it dropped less than the benchmark.

A fund's returns compared to its benchmark are called its benchmark returns.

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 as the one 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 debt funds or liquid funds that invest in money market instruments. These are fixed return instruments of very short maturities. Their main aim is to preserve the principal and earn a modest return. 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. It is alright to compare these funds on the basis of their six month returns.

When returns are compared between funds, make sure the time period is identical. Else, you may be looking at the one-year returns for one fund and the three-year returns for another.

For instance, let's assume you are told the return of Fund A was 60% and that of Fund B was 70%. But, if Fund A's return is a one-year return while Fund B's return is a three-year return, the answer you would get would be very misleading.

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. 

Value Research is a mutual fund research outfit.