How do I shortlist those 3-4 Mutual Funds for my portfolio

I must say that today's investment environment has become more conducive for naive or first-time investors to actually think about investing in mutual funds. However, there is always an element that remains unanswered - Out of the 700+ mutual fund schemes in the market, which one should I go for.

I thought that it would be interesting to actually analyze some of the publicly available data on mutual funds to make it easy for a naive investor also to make a choice.

Here is a list of the performance metrics I used to compare mutual fund schemes.(some of these are standard in the industry while a couple of them have been derived by me).

1. Volatility: In lay-man terms, volatility is the degree of movement in the returns of the mutual fund scheme when compared to that of its benchmark index. In Capital markets, this is usually referred to by a fancy name called 'Beta'! 

2. Benchmark Comparison: Simply put, this metric aims to measure the degree by which the mutual fund scheme outperforms or under-performs when compared to its expected performance, measured by using its benchmark index's returns and its volatility. Again, you may call this as 'Alpha' if you like it!

3. Peer Comparison: Every mutual fund scheme has a peer group with which its comparison would be fair. The ratio by which the mutual fund's returns outweigh that of its topmost peer fund is referred as the 'Peer Index'.

4. Risk-adjusted returns: This accounts for the standard deviation in the returns and is nothing but a ratio of the risk-free return to the standard deviation. In the parlance of financial markets, they call it the 'Sharpe Ratio'.

5. Skewness Quotient: It measures the degree to which the mutual fund's money allocation is skewed towards the topmost or the top-2 sectors.

6. Age of the fund : The age identifies the newness of the mutual fund into the market on the basis of the time for which it has operated since its launch date.

Some other factors viz. Expense Ratios(% operating costs for fund managers from the total assets), Exit Loads(redemption charges for investors), min SIP investment, etc. have not been looked at here, as they are fairly the same across funds due to the competitive spirit between the mutual fund houses!

Data Used : Publicly available Mutual Fund Data of the Growth type, as of 31st Mar'15 & Benchmark Index performance available publicly on BSE and NIFTY websites.

Some interesting insights that came out of this exercise-

1. Age of the fund does matter!

       The mutual fund schemes which have been in the market for over 6 years and not more than 15 years offer excellent risk-adjusted returns(with a Sharpe ratio greater than 1.5)

2. Skewness towards particular sectors might not be that bad!

      Those funds which offer excellent risk-adjusted returns(Sharpe ratio > 1.5) have generally been found to have an extremely high Skewness Quotient, i.e. they allocate > 70% of their funds into the top 2 sectors. 

    To add to this, those funds which are 'Hedgers'(having negative betas) having a diverse portfolio(~30% allocation to top 2 sectors) perform poorly on their Sharpe Ratios(< 0.67). Thus, a mutual fund scheme which is too diverse like the ones mentioned above could also be a potential problem for investors.

3. High volatility(having Betas > 1.2) mutual fund schemes are not necessarily the ones with very skewed fund allocation

4. Sharpe Ratio is the one to look out for while looking at a fund's returns and not its 3-year/ 5-year returns plainly

     Interestingly, ~70% of the mutual fund schemes which are poor performers as per their Sharpe ratios(< 0.65) were Excellent/Good performers as per their Benchmark returns. Thus, the standard deviation in a fund's returns plays a key role in determining whether you would invest in it or not.

 There are plenty of other interesting things to be discussed about the performance of a fund house, impact of Mergers & Acquisitions of funds on its returns, profile of the fund manager, correlation  between upfront commissions and recommendations of investing platforms, etc.  I would be happy to discuss these with those who are interested further on this topic. Feel free to mail me at harsh.107@gmail.com .

(Remember that I am just another investor like you and have no stakes whatsoever in any of the Fund houses, Investment platforms and other advisory services, etc.)

 Happy Investing!