How to Compare Different Mutual Fund Schemes?

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  • 28 Dec 2023
How to Compare Different Mutual Fund Schemes?

You can use these parameters to compare different mutual funds:

1. Benchmark Index

A benchmark index measures fund performance, showing how much returns the fund has earned compared to its expected performance. According to SEBI’s rules, each fund declares its benchmark and treats it as a target for performance analysis. If the index goes up by 10% and the fund's NAV goes up by 14%, the fund has outperformed the index.

On the flip side, if the index drops by 10%, and the fund's value decreases by 12%, then the fund is considered to have underperformed the index. The comparison helps find a fund that gains more during a market upswing and loses less during a downturn.

2. Investment Horizon

Your investment horizon guides your choice and comparison of funds. The investment horizon refers to how long you plan to stay invested in a particular fund. Choose a fund type that aligns with your investment horizon.

Equity funds are apt for a long-term horizon, like seven years or more. The fund aims to accumulate wealth with a higher risk tolerance during this time.

Conversely, liquid funds are a better choice if you're parking surplus funds for the short term. In this scenario, the fund aims to safeguard capital while providing moderate returns. Ensure that the fund returns you compare match your investment horizon.

In practical terms, when comparing two equity funds, look at their returns over the past 5 to 10 years. Similarly, when comparing two liquid funds, focus on their returns over the past six months to one year. Opt for the fund that has consistently performed well across different time intervals.

3. Expense Ratio

Another parameter to consider when comparing two mutual funds is the expense ratio. The expense ratio is a small fee that the asset management company (AMC) charges for taking care of your money. It is expressed as a percentage of the total amount you invest. So, if you invest Rs. 1,000 in a fund that has a 1% expense ratio, you pay Rs. 10 each year for the fund's management.

A lower expense ratio is usually better for you because it means you get to keep more of your investment returns. Imagine you have two funds with similar performance – if one has a lower expense ratio, you could end up with more money in your pocket over time.

So, when you're comparing mutual funds, it's a good idea to check and compare their expense ratios. It's like comparing prices when you shop – you want the best value for your money. Note that direct plans have a lower expense ratio compared to regular plans.

4. Risk-adjusted Returns

Investing in any mutual fund involves assuming some level of risk, which correlates with the fluctuation of the fund's NAV in response to overall market movements. The investment thumb rule suggests that higher risk should be met with higher returns. However, conventional returns might not adequately capture this facet of a mutual fund.

To address this, a more effective measure for comparing two funds based on risk-adjusted returns is necessary. The use of alpha and beta serves this purpose. These financial ratios provide insights into the rewarding potential of a mutual fund. Beta indicates the level of risk associated with investing in a particular fund, while alpha reveals the additional return the fund is poised to generate beyond the underlying benchmark.

The objective is to surpass the benchmark rather than replicate it. For instance, consider two funds with the same beta level, say 1.5. Fund A and Fund B possess alphas of 2 and 2.5, respectively. In this scenario, Fund B outperforms Fund A because it yields higher risk-adjusted returns. The key is to focus on generating returns that exceed the benchmark, emphasizing the importance of both alpha and beta in the fund comparison process.

5. Sector Allocation

A mutual fund scheme allocates your invested capital based on its investment objective. SEBI mandates asset allocation for each fund in a specific category. For instance, in a multi-cap equity fund, the fund must allocate at least 65% of the capital to equity shares of various companies. This allocation significantly influences the fund's risk profile. However, funds in the same category may not necessarily have identical sector allocations.

Fund A may invest more in technology services, while Fund B may allocate more to FMCG companies, both complying with SEBI's mandate. This difference affects the risk levels, making Fund A less risky than Fund B.

Additionally, some funds may take concentrated bets to pursue higher returns. When comparing two funds, it is crucial to assess their sector allocations. Align the fund's risk profile with your risk appetite to make an informed investment decision.

6. Returns Generated

When evaluating the performance of two mutual funds based on their generated returns, a crucial aspect to consider is the long-term perspective. Long-term returns provide a comprehensive view of how well a fund has performed over extended periods, smoothing out short-term market fluctuations. To compare two mutual funds effectively, investors should examine their historical returns over various time horizons, such as five, ten, or even fifteen years.

The first step in this comparison is to assess the average annual returns of each fund over the chosen time frames. A higher average return is generally favourable, but consistency is equally important. Investors should focus not only on funds with occasional spikes in returns but also on those that have demonstrated stability and steady growth over the long term.

Examining the consistency of returns helps investors gauge the fund's ability to deliver sustained performance, reinforcing confidence in its ability to meet long-term financial goals.

Moreover, analyzing the funds' performance during economic downturns or market volatility is essential. Funds that exhibit resilience during challenging times and manage to limit losses demonstrate a robust investment strategy.

By comparing the long-term returns and evaluating the consistency of these returns, investors can make informed decisions about which mutual fund aligns more closely with their risk tolerance and financial objectives.

In Conclusion

Comparing different mutual fund schemes requires a thorough understanding of your financial goals, the types of funds available, and careful analysis of factors such as performance, expenses, and risk. Following these steps, you can make informed investment decisions aligning with your financial objectives.

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