Mutual Fund Performance: Invest Or Avoid?

Investing in mutual funds is a popular choice for many, as it provides access to a broad swath of investments without having to purchase stocks or bonds individually. However, with thousands of mutual funds available, choosing the right one can be challenging. When deciding whether to invest in the top-performing mutual funds, it's essential to consider factors such as your financial goals, risk tolerance, investment horizon, and the fund's history, expense ratio, and management. Here's an overview to help you make an informed decision.

First, define your financial goals and risk tolerance. Are you investing for the long term or seeking short-term gains? Do you prefer consistent growth or are you willing to take on more risk for higher returns? Knowing your goals and risk appetite will help you determine the right type of mutual fund, such as equity funds for long-term capital appreciation or debt funds for regular income with lower risk.

Next, research the fund's history and performance. Look for funds with a proven track record of outperforming the market and their peers over several years. Examine how the fund has performed during market corrections and downturns, as this indicates its resilience. Also, consider the fund's expense ratio, which represents the fees charged by the fund house. Lower expense ratios mean higher returns for investors, so look for funds with ratios lower than their peers.

Additionally, evaluate the fund manager's track record and performance. Assess how well they have navigated market conditions and the returns generated from their investment strategies. You can also compare the fund manager's performance across different schemes they manage.

Remember, past performance does not guarantee future results, so it's crucial to consider a combination of factors when deciding whether to invest in the top-performing mutual funds. By assessing your financial goals, risk tolerance, investment horizon, and the fund's history, expense ratio, and management, you can make a more informed decision that aligns with your investment strategy.

How to pick the best-performing mutual funds

Investment objectives

Firstly, you should only undertake an investment after a thorough examination of your life goals. You need to compare your needs to the objectives of a mutual fund scheme to see if investing in them would help you achieve your financial goals. Mutual funds, like individuals, have specific investment objectives, and it is up to the investors to determine whether their goals align with the mutual fund scheme in which they will invest. For example, one of the objectives of equity mutual funds is wealth creation, so they are best for investors looking at long-term wealth creation to achieve long-term goals like building a retirement corpus. In this case, investing predominantly in equity funds would be a better option than investing in debt funds, as equities have the potential to generate higher returns than debt funds. So, if you invest chiefly in debt funds to build a retirement corpus, you won't accumulate the same retirement corpus as you could with equity funds. As a result, to make a meaningful selection, the fund’s investment objective must align with an investor’s goals and risk tolerance.

Fund's history

The fund's history provides a record of the fund's performance over time, including times of rising and corrections in markets. This shows the fund's resilience during volatile market conditions. Recently launched mutual funds and funds that are open for subscription don't have a track record so it becomes difficult to predict their returns and their performance across the different market cycles. The best MF to invest in is a fund with a long track record of delivering consistent returns over different market cycles. It also demonstrates the proof of well-researched investment strategies.

Expense ratio

The fund house charges fund management fees along with other charges for managing the assets of a fund, which is the expense ratio and is represented as a percentage of the fund’s asset. The mutual fund returns generated minus the expense ratio will be the net return earned by the investor. An investor’s returns will be lower if the expense ratio is high. As a result, an investor should look for a scheme with a lower expense ratio than its peers in the category while choosing a fund.

Fund manager's performance

The fund manager is in charge of managing the fund. It's crucial to look at the fund manager's track record. An investor should monitor the fund's performance during times of rise and corrections in the market. They can also look at the performance of the different schemes managed by the fund manager.

Check the consistency of the fund

Top-performing mutual funds in India have a proven track record of outperforming the market over the long term, typically three to five years. These funds would have outperformed their benchmark and peer funds in terms of performance. You must examine the fund’s performance across the previous several business cycles. Examine the fund's performance during market downturns, in particular. Market fluctuations have a lower-than-average impact on the performance of a top-performing fund. However, that past performance does not guarantee future results.

Check the financial ratios

You can evaluate financial ratios such as alpha and beta to identify India's top-performing mutual funds. Mutual fund returns and risk are inextricably linked. The increase in the overall value of the capital invested is referred to as a return. Risk is defined as the uncertainty surrounding an investment, and it refers to the possibility of obtaining no or negative returns for a variety of causes. As a result, any investor must evaluate the risk-return potential, and financial ratios have made this risk-return analysis possible. The Sharpe and Alpha ratios provide crucial data. The Sharpe ratio measures the fund's excess return on every unit of risk it has taken. As a result, funds with a higher Sharpe ratio are seen as superior to funds with a lower Sharpe ratio. The additional mutual fund returns earned by the fund manager over the benchmark is called alpha. Funds having a higher Alpha are seen to be superior.

Other factors to consider

• Risk and return: Returns and risks are related. While some assets have higher risks, some have lower risks. To balance return and risks while meeting your financial goals, opt for asset allocation. Consider your risk appetite and investment horizons while selecting the right mutual funds for your individual goals.
• Investment horizon and investment objective: If you want to invest for a long-term goal, opt for equity funds. If your investment horizon is short- or medium-term and your investment objective is to get regular income, select debt mutual funds.
• Track record of the fund house and its fund manager: Before making investments in a scheme, check its long-term performance record and also the track record of its fund manager and the fund house.
• Taxation: You should know the tax impact on your investments before you start your investments.

The pros and cons of mutual funds vs. exchange-traded funds (ETFs)

Mutual funds and exchange-traded funds (ETFs) are two popular investment options that provide diversification benefits and are managed by professionals. However, there are several differences between the two that investors should consider when making investment decisions. Here are the pros and cons of mutual funds and ETFs:

Mutual Funds Pros:

• Actively managed: Mutual funds are typically actively managed, which means fund managers aim to outperform the market by making strategic investment decisions. This active management approach may lead to higher returns over time.
• More diversification options: Mutual funds offer investors a broader range of securities and investment options, providing exposure to various sectors, regions, and asset classes.
• Potential for higher returns: Actively managed mutual funds have the potential to generate higher returns by investing in riskier assets or employing complex investment strategies.
• Suitability for hands-on management: Mutual funds are suitable for investors who prefer professional fund management and a more hands-on approach to investing.

Mutual Funds Cons:

• Higher fees and expenses: Mutual funds often have higher management fees and expense ratios due to their active management nature. These higher costs can eat into investment returns.
• Less tax-efficient: Mutual funds may be less tax-efficient than ETFs because they distribute realised capital gains to investors at the end of the year, resulting in potential tax liabilities.
• Limited trading flexibility: Mutual funds can only be bought or sold at the end of each trading day, based on the calculated Net Asset Value (NAV), which may not suit investors who want more flexibility.
• Higher minimum investment: Mutual funds typically require a higher minimum investment amount compared to ETFs, making them less accessible to some investors.

ETFs Pros:

• Lower fees and expenses: ETFs usually have lower expense ratios than mutual funds due to their passive investment strategy, resulting in cost savings for investors.
• Passive investment strategy: ETFs are typically passively managed, tracking specific market indices or sector sub-indices. This passive approach can lead to lower costs and better long-term returns.
• Trading flexibility: ETFs can be traded throughout the day on stock exchanges, just like stocks, providing investors with greater flexibility and control over their investments.
• Tax efficiency: ETFs are generally more tax-efficient than mutual funds because they do not distribute realised capital gains, and their unique creation/redemption process reduces the likelihood of triggering capital gains tax liabilities.
• Lower minimum investment: ETFs often have no minimum investment requirement, making them more accessible to a wider range of investors.

ETFs Cons:

• Limited active management: ETFs are usually passively managed, so they may not be suitable for investors seeking active management strategies to potentially outperform the market.
• Potential for higher risk: The ability to trade ETFs throughout the day can expose investors to market volatility and potentially higher risk.
• May not be suitable for frequent trading: ETFs may incur brokerage fees, bid-ask spreads, and tracking errors, making them less ideal for frequent trading.

In summary, the choice between mutual funds and ETFs depends on an investor's financial goals, risk tolerance, and investment preferences. Mutual funds offer active management and broader diversification, while ETFs provide liquidity, lower fees, and tax efficiency. Both investment options cater to different objectives and risk tolerances, making them suitable for various financial strategies.

How to assess a mutual fund's track record

When assessing a mutual fund's track record, there are several key factors to consider:

Investment Objectives

Firstly, determine your investment objectives and risk tolerance. Mutual funds have specific goals, such as wealth creation, and it's crucial to align your financial goals and risk appetite with the fund's objectives. For instance, equity mutual funds are typically suitable for long-term goals due to their potential for higher returns, whereas debt mutual funds may be more appropriate for shorter-term goals as they are less volatile.

Fund's History

Examine the fund's historical performance, including its resilience during market fluctuations. Avoid recently launched funds or those without a track record, as it's challenging to predict their performance. Opt for funds with a long history of consistent returns across different market cycles.

Expense Ratio

The expense ratio represents the fund management fees and other charges levied by the fund house. A higher expense ratio reduces your net returns, so look for funds with lower expense ratios compared to their peers.

Fund Manager's Performance and Consistency

Evaluate the track record of the fund manager, especially during market highs and lows. Check the consistency of the fund's performance over the long term (at least three to five years). Top-performing funds should consistently outperform their benchmarks and peers, with minimal impact from market fluctuations.

Financial Ratios

Analyse financial ratios such as alpha and beta to assess the fund's risk-return potential. The Sharpe ratio measures the fund's excess return per unit of risk, with higher ratios indicating superior performance. Alpha represents the fund manager's additional returns over the benchmark, and higher alpha values are favourable.

Additionally, consider the fund's tax implications, as capital gains and dividends are taxed differently depending on the type of mutual fund and investment period.

The importance of a fund's expense ratio

When deciding whether to invest in a mutual fund, it is important to consider the fund's expense ratio. This is because the expense ratio directly impacts the net return on investment. The expense ratio is the percentage of a fund's assets that are used for administrative, management, and other expenses. It is influenced by the fund's size, strategy, operational efficiency, the type of assets it holds, and regulations.

A higher expense ratio means a larger part of the fund's assets is used for costs, directly reducing the fund's net return to investors. Over time, even small differences in expense ratios can lead to significant changes in an investment portfolio due to the mathematics of compounding. Therefore, a lower expense ratio is generally preferable for investors as it means less of the fund's assets are being used for operational expenses, potentially leading to higher net returns.

When evaluating mutual funds, it is important to compare expense ratios among similar funds and consider them alongside other factors such as fund performance history, management quality, and investment strategy. While a lower expense ratio is generally favourable, it should not be the sole criterion when selecting a mutual fund. Other costs, such as sales loads or redemption fees, should also be considered to understand the total cost of ownership.

In summary, the importance of a fund's expense ratio lies in its direct impact on investment returns. By carefully considering and comparing expense ratios, investors can make more informed decisions and select funds that offer competitive returns while keeping costs low.

How to select a mutual fund based on your risk profile and time horizon

When selecting a mutual fund, it's important to consider your risk profile and time horizon. Here are some key factors to keep in mind:

• Goals and Risk Tolerance: Before investing, identify your goals for the investment. Are you seeking long-term capital gains or current income? Are you saving for retirement or for college expenses? Your risk tolerance is also crucial. Can you tolerate dramatic swings in portfolio value, or do you prefer a more conservative approach? Remember, risk and return are directly proportional.
• Time Horizon: Consider how long you plan to hold the investment. Mutual funds have sales charges, so an investment horizon of at least five years is ideal to mitigate the impact of these charges. If your goal is less than three years away, consider investing in a debt-oriented fund. For medium-term goals (3-5 years), explore hybrid equity funds. For long-term goals, equity mutual funds are often a good option.
• Investment Strategy and Objectives: Understand the investment objectives of the mutual fund and evaluate if they align with your risk profile and goals. Mutual funds offer diversification across stocks, sectors, and asset classes. When choosing equity schemes, look for top-performing diversified equity schemes with a good spread of large-cap and mid-cap stocks. For debt funds, consider your investment horizon and the fund manager's view on interest rate direction and sensitivity.
• Fund Performance and Management: While past performance doesn't guarantee future results, look for funds that have consistently outperformed their benchmarks over 3, 5, or 10 years. Evaluate the fund manager's experience and track record. A stable and experienced management team can add value.
• Fees and Expenses: Mutual funds have various fees, including expense ratios, sales loads, and management fees. These fees can eat into your returns, so it's important to understand them before investing. Compare the expense ratios of different funds and target those with lower ratios. Also, consider the fund's investment approach and ensure it aligns with your investment philosophy.

Frequently asked questions