How to pick an equity fund

Investors with a reasonable appetite for risk and who have a longer-term investment horizon in which to meet their financial goals are best placed to invest in equity mutual funds. Here, we look at four broad parameters that investors ought to consider while choosing the equity funds that best match their profile.

Diversification The diversified equity funds category can be further stratified based on the investments that a fund makes across sectors and on the basis of the market capitalisation of the companies it invests in. It is important to choose a fund that matches your risk appetite.

Typically, these funds follow a value/growth/blended strategy when choosing their stocks and the sectors they invest in. For instance, Quantum Long-Term Equity is focussed on large-cap stocks. But it follows a value strategy, fishing for beaten-down stocks that may take time to recover. This means that in the short term, the fund may be an underperformer when compared to its peers that invest in growth stocks.

Go for a well-balanced portfolio with investments across sectors. This can help offset the underperformance in certain sectors at any given point in time.

Sector funds, which invest in one particular sector or a few sectors, run a big risk of underperformance if the tide turns against that particular sector(s). If you have a low risk appetite, such funds are best avoided. A good blend of funds across market capitalisatin and across strategies will help mitigate volatility in the returns you make.

Consistency in returns Breathless announcers in those television advertisements for mutual funds rattle through the fine print, which offers the disclaimer that past performance may not be indicative of future returns. Even so, analysing how a fund has fared in the past will give you a fair idea of its ability to outperform its benchmark and its peers. It is wise to look at the performance over the long run: how the fund has performed consistently during the past five to seven years, as well as during various market cycles, such as during bullish, bearish and volatile phases.

The best way to get a sense of the consistency of funds during these periods is through the rolling returns that they offer. Rolling returns are the average point-to-point returns calculated for a given period.

For instance, the one-year point-to-point return (between August 17, 2016 and August 17, 2017) of Birla Sun Life Frontline Equity fund and Axis Focused 25 fund are 17 and 23 per cent, respectively, while their one-year rolling returns calculated for the past five years are 20 and 17 per cent, respectively. Birla Sun Life Frontline Equity fund thus scores over Axis Focused 25 fund on consistency of returns.

Similar comparisons with the respective benchmarks will offer a definitive measure of how consistently a fund has outperformed its benchmark over a given period.

Risk-return trade-off In the world of investing, there is no such thing as a free lunch – or a low-risk, high-reward option. The prospect of higher returns typically comes with greater risk. The inverse, however, is not always true: the mere embrace of greater risk does not automatically translate into higher returns, although that is typically how the correlation works.

As an investor in a mutual fund, you should ideally look for investments that gives you returns of the same or a higher proportion for the measure of risk that you take. A fund that gives better returns than others for the same kind of risk can thus be considered a good bet. And how is this measured? Welcome to the Sharpe ratio, which is an index of the risk-adjusted returns from an investment.

When comparing funds, opt for those that have a higher Sharpe ratio. This ratio, which has become an industry standard, is routinely disclosed by all fund houses for each of their schemes in the monthly factsheet.

Expense ratio Mutual fund companies charge a certain per cent of their corpus to manage the fund. This is called the expense ratio. Since the fund’s Net Asset Values (NAVs) are calculated after deducting the expense ratio, a higher expense ratio will automatically lower your NAV, and hence your returns. Over the long run, higher expense ratios of a fund may significantly eat into your returns, particularly in comparison with peers with lower expense ratios. So, funds with lower expense ratios are generally preferable, although this is also a function of how well the fund fares on the other parameters mentioned above.

If you have a fair degree of knowledge about funds, you could even consider going in for direct plans, which come with lower expense ratios as they exclude the commission that funds pay to the intermediaries.