How to Choose the Right Mutual Fund

3 ratios to check before starting your SIP →

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Today in less than 5 minutes:

1) How do you pick the right mutual fund?
2) Stock in Spotlight: A non-PSU railway stock that’s only going up
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Choosing the Right Mutual Fund

Mutual funds sahi hai.

Says every mutual fund investor ever.

AUM of the Indian Mutual Fund Industry as of January 31, 2024 stood at ₹52,74,001 crore. The AUM of the Indian MF Industry has grown from ₹9.03 trillion as of January 31, 2014 to ₹52.74 trillion as of January 31, 2024, marking around a 6-fold increase in 10 years. And the speed with which the industry has grown is commendable as well:

There are 15 crore+ mutual fund investors in India, and many new players are entering the game looking at this opportunity. With new fund houses flooding the market, it’s more important than ever to pick the right mutual fund. And picking the right fund is not only about looking at the CAGR returns…

Here are the top 3 ratios you should consider before you decide to invest in any mutual fund:

1) Alpha Returns

The returns generated by a fund don’t say much if looked at them alone. Saying that a fund generated 15% returns in the past year means nothing.

To evaluate the performance of a fund, it needs to be compared with something. Comparing a fund’s returns to the benchmark is a good starting point. And ‘alpha’ helps us calculate that.

Alpha Returns = Fund’s Returns - Benchmark’s Returns

If a fund generated 14% while the benchmark returned 8%, it’s alpha is 6%, which indicates benchmark overperformance.

The higher the alpha, the better. At the least, the alpha of a fund should be greater than 0.

2) XIRR > CAGR

We all know that the compound annual growth rate (CAGR) of a fund will help us understand the multi-year performance of a fund.

CAGR formula = [(Final Investment Value / Initial Investment Value) ^ (1 / No. of Years Invested)] - 1

However, it has a pitfall. Since the CAGR formula takes into consideration only the starting and ending investment values, it is biased towards recent performance. This means that the CAGR of a fund appears good when the markets are doing well, and subdued during volatile periods.

A solution to this is using the extended internal rate of return (XIRR).

The XIRR takes into account all the money inflows and outflows and shows the overall returns over a specific time. You can calculate the XIRR using its function in Microsoft Excel. It’s particularly useful if you’re an SIP investor.

But looking purely at returns is not a good practice either…

3) Risk-Adjusted Returns

Stock markets are risky. You wouldn’t mind taking the risk if you get a higher return. The higher the risk, the higher the expected return. But what if we told you that a fund is generating lower returns year after year, even after being risky? No one would want such a fund.

To ensure that a fund is generating decent risk-adjusted rewards, we would use the Sharpe ratio to evaluate it.

Sharpe Ratio is calculated as:
(Fund Returns - Risk-free Returns) / Standard Deviation

If fund A & B both made 15% while the risk-free rate is 5%, and their standard deviations (volatiltiy) is 10% and 7% respectively, here are their Sharpe ratios:
Fund A: (15% - 5%) / 10% = 1.0
Fund B: (15% - 5%) / 7% = 1.4

Fund B has a better Sharpe ratio since it delivered the same returns as Fund A but with lesser volatiltiy.

Learn all about picking the right mutual funds and investing in the most profitable way in our How to Pick the Best Mutual Fund Course by CA Twinkle Jain. Use “STOCK10” for a 10% discount & get the course for just ₹359.

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