How to cherry pick the right equity funds

Lower volatility in returns and gains that are commensurate with risks are key metrics

Investors with a reasonable appetite for risk and having long-term financial goals can consider investing in equity mutual funds. Here, we look at four broad parameters to consider while selecting equity mutual funds:

Diversification

The equity diversified funds category is further classified based on its investments across market capitalisation and sectors. It is important to choose a fund that fits your risk appetite.

Besides, these funds can follow a value/growth/blended strategy when choosing their stocks and sectors. For instance, Quantum Long-Term Equity is focused 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 peers that invest in growth stocks. Go for a well-balanced portfolio which invests across sectors. This can help offset the underperformance in certain sectors at any given point in time.

Sector funds that invest in one or a few specific sectors run a big risk of underperformance if the tide turns against the sector. If you have a low risk appetite, such funds are best avoided.

A good blend of funds across market caps and strategies will help mitigate volatility in returns.

Consistency in returns

Though the past performance may not be indicative of future returns, analysing how a fund has fared in the past will give you a fair idea about its ability to outperform its benchmark and peers. It is wise to look at the performance over the long run — how the fund has performed consistently during the last five to seven years as well as during the various market scenarios such as bull, bear and volatile phases.

The best way to capture the consistency of funds during these periods is through the rolling return. Rolling return is an average point-to-point return calculated for a given period.

For instance, the one-year point-to-point return (between August 17, 2017 and August 17, 2016) of Birla Sun Life Frontline Equity fund and Axis Focused 25 fund are 17 and 23 per cent respectively, while their one-year rolling return calculated for the last 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 respective benchmarks can give a clue on how consistently a fund has outperformed its benchmark over a given period.

Risk return trade-off

Higher risk is usually associated with greater probability of higher return and vice-versa. So, the investment that gives you a return in same/higher proportion for the risk you take would be ideal. In mutual funds, a fund which give better returns than others for the same kind of risk can be considered as a good bet. This is measured with the help of Sharpe ratio.

When comparing funds, go for funds with higher Sharpe ratio. This ratio is 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 the corpus to manage the fund. This is called the expense ratio. Since NAVs are calculated after deducting the expense ratio, a higher expense ratio will lower your NAV and hence returns. Over the long run, higher expense in a fund may eat into returns significantly when compared to peers with lower expense ratios. So, the fund with lower expense ratio is preferable, provided it also fares well on the other parameters mentioned above.

If you have a fair deal of knowledge about funds, go for direct plans that come with lower expense ratio as they exclude commission paid to the intermediaries.

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