How to Compare Mutual Funds

March 1, 2023 Mutual Fund

Just like you compare products before purchasing them, it is vital to compare mutual funds before you deploy your hard-earned money to meet your financial goals.

Why should you compare mutual funds before investing in them?

Selecting the right schemes for your portfolio is an important aspect of successful mutual fund investment. However, with hundreds of mutual fund schemes floating in the market, picking the right one that aligns with your financial goals, risk profile, and investment horizon becomes a difficult task.

As an investor, you do not need more than 7-8 schemes in your mutual fund portfolio to achieve the set financial goals. Thus, it is crucial to compare mutual fund schemes and shortlist the ones that will help you reach your target while maintaining the optimal risk-reward balance.

[Read: Are You Setting Your Risk-Return Expectations Right While Investing in Mutual Funds?]

How to compare mutual funds?

There are various quantitative and qualitative parameters that can be used to compare mutual funds. Here are a few important criteria that you can use:

1) Historical returns

This is the most commonly used parameter to compare mutual fund schemes. To do this, analyse the performance of the schemes over different time periods such as 1 year, 3 years, 5 years, and 7 years relative to the category peers and the benchmark index. This will help you determine the returns potential of different schemes and also assess its track record.

2) Performance across market cycles

Comparing mutual fund performance over different bull and bear phases and market cycles will help you determine how consistently an equity-oriented mutual fund has performed. In the case of debt mutual funds, compare the performance of schemes across various interest rate cycles.

3) Risk ratios

Every mutual fund scheme is susceptible to different types of risks. Therefore, it makes sense to compare mutual fund schemes on the degree of risk it has exposed the investors to and whether they were well-compensated for the underlying risk. You can use the below metrics to compare mutual funds on the basis of their risk:

a) Standard Deviation – The standard deviation is a determinant of volatility. A higher standard deviation means that a scheme is more volatile than its benchmark and peers.

b) Sharpe ratio – The Sharpe ratio denotes the risk-adjusted returns of a scheme; the higher the Sharpe ratio, the better is the scheme’s risk-adjusted returns.

c) Sortino ratio – The Sortino ratio signifies a fund’s ability to limit downside risk. A higher Sortino ratio indicates a higher return per unit of downside risk.

[Read: 3 Important Ratios to Consider Before Investing in Mutual Funds]

4) Portfolio quality

Compare mutual fund schemes on their portfolio qualities to ensure that it is well-diversified within their stated investment objective. To assess the portfolio’s quality, analyse the fund’s top holdings (stock and sector-wise), market cap bias, portfolio churning rate, etc.

In the case of debt mutual funds, assess the portfolio’s credit profile, average maturity, and yield-to-maturity (YTM).

5) Track record of the fund house

Mutual fund schemes and fund houses that have a reliable long-term track record are likely to offer stability in performance. Thus, it makes sense to compare mutual fund schemes based on the number of years it has been in existence, and the track record of the fund house and the management team.

Things to remember when you compare mutual funds

i) Avoid comparing schemes on a single criterion

Often investors base investment decisions by depending on a single criterion, such as past returns. This can be risky because a top-performing scheme of a particular period may not continue to be a top performer year after year. Furthermore, it is possible that the scheme generated superior returns by undertaking high risk and, as such, may prove to be unsuitable to your risk profile. Therefore, you need to adopt a holistic approach to compare mutual fund schemes.

ii) Ensure fair comparison

The comparison of mutual fund schemes should be a fair one (not akin to comparing apples to oranges). Ensure that you compare a scheme only with other schemes within the same category as well as with comparable indices. For instance, the performance of a Large Cap Fund should not be compared to that of a Mid Cap Fund, as both categories offer different risk-return profiles.

iii) Avoid comparison based on NAV

The NAV of a mutual fund scheme does not in any way indicate its future potential. Generally, schemes that are newly launched have low NAVs, while those that have been in existence for several years have higher NAVs. Thus, NAV is one parameter that can be overlooked when comparing mutual funds.

This article first appeared on PersonalFN here