Six factors to look for before Investing in a Mutual Fund
Before investing in a mutual fund, here are six metrics that investors should consider and analyse.
Investing in a mutual fund can be pretty confusing. What should you be looking for in a mutual fund apart from its outstanding performance record?
Investors should consider qualitative factors before investing in a mutual fund. These factors may make a big difference in your return potential from a mutual fund. While one can easily evaluate some of these qualitative factors, others might require more research.
Qualitative factors that investors consider before investing in a mutual fund
The standard deviation of a fund shows how volatile it has been. Simply put, the standard deviation is a metric that quantifies how far a fund’s returns deviate from its average.
It represents the risk associated with a particular mutual fund scheme. The higher the standard deviation, the more volatile the returns will be, and vice versa.
If you are a conservative investor, look for schemes with a low standard deviation. However, if the fund manager is overly cautious, the result could be over-diversification or underperformance.
Examine how standard deviation changes overtime to get a better idea of how volatile the fund can be during different market cycles.
Therefore, if you are looking for a diversified equity scheme with less volatility, look at its standard deviation before investing in it.
The fundamental disadvantage of standard deviation is that it does not differentiate between good and bad volatility because it takes both negative and positive returns from the average return into account.
The Sharpe ratio is another measure of risk and returns that Nobel Laureate William F. Sharpe developed. It is defined as the difference between the rate of return of a fund and the risk-free rate of return divided by the fund’s standard deviation.
The Sharpe ratio of a fund can determine how well a fund has fared in relation to the risk it has taken. For the volatility of the fund, this ratio looks at the additional returns a fund has achieved over a risk-free return from an investment such as a Government Treasury Bill.
A positive Sharpe ratio shows excess returns for the amount of risk an investor takes. A negative Sharpe ratio indicates that an investor would have been better off taking no risk than investing in this fund.
Look at the Beta ratio if you only want to know how much riskier your fund is than its own benchmark index.
The beta coefficient measures how well a fund correlates with the market index.
A beta greater than one
indicates that the fund is more volatile than the market, while a beta lower than one means it is less volatile.
Your fund is as risky as the benchmark index if it’s only one. The Beta of all passively managed funds, such as index funds and exchange-traded funds, is one.
When the fund’s portfolio closely resembles the index’s, the Beta is also closer to one. That’s bad news, because despite charging expenses for active fund management, your fund would only generate returns that are close to index returns.
A negative beta means an inverse relationship between fund and market price movements, i.e., if the market moves up, the fund moves down and vice versa.
Generally, investors should prefer funds with low beta coefficient, reducing their risk of losing money to market fluctuations.
The portfolio turnover
ratio is a metric that determines how frequently your fund manager churns the portfolio to generate higher returns. Typically, it is calculated during the previous 12-month period.
A high turnover ratio translates to higher expenses that will eat into returns.
A low turnover ratio indicates that the fund manager’s strategy is to buy and hold. However, a high turnover ratio isn’t always a bad thing; it could indicate a predisposition for taking regular returns from investments.
Fund manager experience
As the fund manager manages the fund, you might not want an inexperienced fund manager in charge of your hard-earned money. Invest in a mutual fund scheme run by a seasoned fund manager.
Experience alone is not enough. While looking at the fund manager’s experience profile, be sure to look at their track record and the current performance of all other schemes they manage.
Similarly, relying on the fund manager’s historical performance to make investment decisions isn’t a good idea. They may have done well for investors in the past, but if all of their schemes haven’t performed well for a long time, it’s advisable to focus on current performance and avoid such schemes.
However, blaming a fund manager is unreasonable because there could be other legitimate reasons for the scheme’s poor performance. This brings us to the last qualitative factor.
Pressure on the fund manager to do well
Sometimes, the success of fund managers can have adverse implications. Fund houses and investors put greater trust in them as they frequently outperform other funds.
If money continues to flow into a few schemes and their Asset Under Management (AUM) grows, this directly impacts their investments. Because sitting on cash isn’t an attractive alternative, the fund manager is forced to invest even when there aren’t enough investment opportunities.
This article has tried to show the qualitative factors that you need to consider while choosing a mutual fund. Standard deviation, Sharpe ratio, Beta, portfolio turnover, fund manager’s experience, and the performance pressure on the fund manager are the top six qualitative factors you need to look at while looking at mutual funds.