How to select good Mutual Funds for long term wealth creation?

Last week, I was in a coaching centre with my 15 year old daughter for her admission into the engineering entrance coaching. The course which will run for the next 2 years along with her +1 and +2 studies cost me a cool 2.6 Lakhs. While coming back after her admission, I have done a back calculation and was surprised by the findings. I was interested in knowing, the amount, I should have saved monthly by way of SIPs for accumulation of this 2.6lakhs.  I was surprised to see that a monthly SIP of Rs.200/- in Franklin India Bluchip Fund for the last 15 years would have created this amount!

My business partner was interested in hearing this data because he is having a new born son and is interested in knowing, how much he should save for his son.

Let us assume an inflation of 8% in educational expenses. The present cost of 2.6 Lakhs will become 8 lakhs after 15 years. Assuming a return of 15% from diversified equity fund for the next 15 years, he has to invest 1200/- per month for the next 15 years.

This is the power of compounding. If you start early, you can achieve your financial goals by saving small amounts.

In the last article, we have discussed the concept of mutual funds. In this article, we will discuss, how, to select good mutual funds for long term wealth creation.

As we discussed in the previous article, the fund manager pools the amount received from various investors and invest in shares of select companies/debt schemes as per the mandate of the scheme. In this case of professional fund management, why there is huge difference between the performances of different schemes? From these large number of mutual fund schemes in the market, how we can identify the winner for long term investment?

There are some ratios you must know, if you want to analyse a mutual fund.

Sharpe Ratio: Generally we judge mutual funds performance by the returns only. But the better parameter is return with respect to the risk taken. The Sharpe Ratio of a fund measures whether the returns that a fund delivered were commensurate with the kind of volatility it exhibited. This ratio looks at both, returns and risk, and delivers a single measure that is proportional to the risk adjusted returns.

Sharpe ratio is nothing but risk adjusted returns. So a mutual fund with higher Sharpe Ratio is better.

Alpha: This is very important ratio in mutual funds. Alpha is a measure of an investment’s performance on a risk-adjusted basis. It takes the volatility (price risk) of a fund portfolio and compares its risk-adjusted performance to a benchmark index. The excess return of the investment relative to the return of the benchmark index is its alpha.

Simply stated, alpha is often considered to represent the value that a fund manager adds to the fund return. A positive alpha of 1 means the fund has outperformed its benchmark index by 1%. Correspondingly, a similar negative alpha would indicate an underperformance of 1%. For investors, the more positive the alpha is, the better it is.

You can see from the above list that the first 5 funds which have delivered good returns in the last 5 years have higher Sharpe Ratio and higher Alpha compared to the next 5 funds, which were bad performers in the same period.

If you cannot, analyse these ratios, the following points can be evaluated while selecting mutual funds.

1.  Invest in funds with atleast 5 year track record. Avoid new fund offering (NFO) unless, it is coming out with a new theme. The Rs.10/- NAV concept is a marketing technique and it will not help you in getting better returns.

2.   Long term performance of the fund: It should figure out in top 10-15 at least over 5 yrs returns criteria.

3.  They should have a track record of consistently outperforming its Bench mark (this shows that they did better than what they were tracking).

4.   Study the quality of the management. Don’t just buy MF just because it returns 40% last year, but you have never heard of its parent name.

5.   Once you shortlist some mutual funds , then look for its portfolio allocation see how it has put its money for large , Medium and small cap companies . If its concentration is high on mid and small cap funds, it means that it has more than average risk, but potential for very great returns also, choose it if it fits your risk appetite.

Most mutual funds on an average invest in around 50-60 companies. If you buy 3-4 diversified equity mutual funds, you are going to invest in close to 100 companies overall (considering there will be some overlaps). Now when you buy another diversified equity mutual fund, most probably, the money is going to be invested in almost same set of companies.  So what you have to understand is that after a certain point adding more mutual funds of the same category is of no much value for the portfolio.

Ideally, you can have a core portfolio of 2- 3 large cap funds, one mid cap fund and one thematic fund, one index fund and one gold ETF. Also review the performance of these funds annually and take corrective action if required.

Also ensure that, you maintain the overall asset allocation between different asset classes like equity, debt, real estate and gold as per your risk profile.

In the next article, we will recommend you some good funds for wealth creation based on the above criteria.