How to Compare Mutual Funds? Tips & Strategies

How to Compare Mutual Funds?

Comparing mutual funds is not limited to comparing their absolute returns. Learn how to compare mutual funds comprehensively in this article.

The demand for mutual fund (MF) investing is rising, and simultaneously, there is an increase in the number of mutual fund schemes. Comparing multiple mutual funds before investing will help you find the best-performing funds according to your needs. This process is not restricted to tallying the absolute returns. You should know how and where to use financial ratios and other tools to research the best MF option.

Why Should You Compare Mutual Funds?

Mutual funds are usually medium to long-term investments, meaning the final yield will significantly affect your future financial goals. There are now a plethora of mutual funds that allow you to start investing with a nominal amount. Unless you take a deep dive, you might fail to differentiate between them. If you keep looking only at the absolute returns from the fund, you may miss other critical aspects, like the consistency in generating returns etc. Unless you do a mutual fund performance comparison, you may miss important details about the fund.

Method for Comparing Mutual Funds

A mutual fund is a financial product that allows you to take exposure to different asset classes through a managed risk method. They let you invest through lumpsum or SIPs, which makes them suitable for different investor personas based on their financial conditions. To learn about the right mutual fund that will earn returns in your expected range, you must weigh up all the options available. When you know how to compare mutual fund investment options, you can easily choose the one that matches your expectations. Here are the parameters that will help you compare mutual funds online

Market Benchmark:

The benchmark is an index like the NIFTY50, against which you can measure the performance of a mutual fund. You can use the benchmark as a yardstick to compare the performance of the MF against the market. Benchmark-related information is available in the Scheme Information Document, or SID. On February 1, 2018, SEBI mandated all mutual funds to declare their benchmark and fix it as a target for performance analysis. Hence, if a fund’s NAV rises more than the benchmark index, we can say that the fund has outperformed the benchmark. The opposite situation will play out if the fund’s loss is higher than the benchmark it follows during a slump. So ideally, you should search for funds that have higher gains during a market rally and drop less during a downturn. Comparing against benchmarks has several advantages. The first is being able to gauge a fund’s performance against the market average. Secondly, you can use the parameter to compare similar funds. You can also use it to understand the expected returns of a new fund without a previous performance record.

Investment horizon:

The investment horizon determines how long you plan to stay invested in the plan. It helps in finding the right MFs for comparison. For example, equity funds are more suitable for long-term investments and have longer investment horizons than liquid funds. Hence, while comparing equity funds, you should look at atleast 5 to 10 years of returns. For liquid funds, the time horizon will be fixed at 6 months to 1 year. The rule of thumb is to select whichever fund has consistently given superior returns.

Riskiness:

The fund’s riskiness determines its ability to generate additional returns for an extra unit of risk. It can’t be decided only by looking at the changing values of NAV. For a better measure, you must consider the alpha and beta ratios of the fund. The beta ratio denotes the riskiness of investing in a fund, whereas alpha measures the returns generated by the fund against the benchmark. Beta denotes relative volatility and is measured based on the past performance of the fund. The baseline of beta is considered to be 1, which implies that the stock's or fund’s volatility is aligned to that of the benchmark. While interpreting the ratios, a higher beta indicates higher volatility in the fund. A growth equity fund can have a higher beta value compared to a debt fund because of the volatile nature of the underlying securities. So, conservative investors might get discouraged by high-beta growth funds. On the other hand, a high alpha is always preferred. Alpha measures the risk adjusted return of the fund and helps investors guess how much extra return to expect from the investment. So, if a fund’s alpha is 5.0, it might mean that the fund has outperformed the benchmark by 5%. Suppose there are two funds with the same beta value; investors will invest in the fund with higher alpha. Fund managers determine alpha following the Capital Asset Pricing Model (CAPM) to project the potential return of the fund. The baseline is set at zero, which indicates that the fund is perfectly aligned with the tracking benchmark.

Sector allocation:

A MF spreads your capital among different assets according to the investment objective of the fund. To qualify for a category, a mutual fund has to follow the minimum asset allocation instructions given by the Securities and Exchange Board of India. While that is one parameter of the selection process, the other is to analyse the capital allocation pattern of each fund. Two funds in the same category can have different risk quotients when they invest in different segments or sectors.

Expense ratio:

Mutual fund investments involve costs, called the expense ratio, which the fund house charges from the unitholder for offering fund management services. It is important because it helps in deciding the cost of your investment and its eventual returns. A higher expense ratio means fewer units will be allocated. It will eventually result in lower returns. It is because the expense ratio is a percentage of the money invested. It is important to note that an actively managed fund has a higher expense ratio than a passively managed or index fund. Therefore, one must avoid comparing the expense ratios of index funds with those of actively managed funds.

Understand This With An Example

Let us compare two mutual funds, ABC Equity Fund and XYZ Diversified Fund, and understand which is good. ABC Equity Fund primarily focuses on large-cap stocks in established sectors such as IT and finance. It has a historical annualised return of 15% over the past 5 years. The expense ratio is 1.5%, indicating the annual fee charged to investors. The fund manager has been consistent, and the fund has outperformed its benchmark index. On the other hand, XYZ Diversified Fund follows a more balanced approach by investing across large, mid, and small-cap stocks in diverse sectors like healthcare and consumer goods. It has shown a slightly higher annualised return of 16% over the same period. The expense ratio is lower at 1.2%, enhancing cost efficiency. The fund manager's strategy involves adapting to market conditions and ensuring flexibility. Now, both these funds are offering similar returns. However, the sectors are different, and the expense ratio of ABC Equity Fund is a bit higher than that of the XYZ Diversified Fund. If you are a conservative investor who doesn’t prefer taking high risk can go with ABC Equity Fund, which invests in large-cap funds. While XYZ Diversified Fund provides exposure to different market segments, it might carry slightly higher risk but could appeal to those comfortable with a moderate risk level.

Quick Pointers for Mutual Funds Comparison

Comparing Returns: When comparing the returns of two funds, ensure the time period is the same. You can compare the five-year returns of one fund with another. Avoid comparing different time frames, such as the five-year return of one fund against the three-year return of another, to ensure a fair assessment.
Index Relevance: Make comparisons against the relevant broad-based index. Like large-cap funds can be compared with BSE Large-cap. Avoid using indices such as BSE Mid-cap to evaluate large-cap fund performance.
Plan-Specific Assessment: Specifically assess one fund's growth plan against another's growth plan when making comparisons. Avoid comparing growth plans with dividend plans, as they serve different financial objectives, ensuring a meaningful evaluation.
Fund History Consideration: Opt for funds with a substantial fund history, preferably spanning at least five years, when comparing. This duration provides insights into the fund's resilience and stability over a significant period in the financial domain.
Invest Wisely: Lastly, do not invest based on incomplete information or tips. The mutual fund investment should match your financial goals and expected returns. Ask a financial advisor or expert like Angel One when you aren’t sure.

Common errors to avoid while comparing mutual funds

• Always compare results for the same period or duration. If you are evaluating the 3-year CAGR of one fund, you must compare it with the 3-year CAGR of another and not with the 5-year CAGR. Keeping the time frame in mind will help you understand how the two funds have fared under similar market conditions. • Similarly, you should choose the benchmark wisely during performance analysis. For instance, you must compare the returns of a large-cap fund with a broad-based index such as the BSE SENSEX and those of mid-cap funds with the BSE Mid-cap index. • Investors should avoid comparing funds from different categories, such as growth and dividend funds. Since the objectives of these funds are different, comparing them will not give you the correct idea. • Lastly, do not invest based on incomplete information or tips. The mutual fund investment should match your financial goals and expected returns. Ask a financial advisor or expert like Angel One when you aren’t sure. Check Out the Mutual Fund Return Calculator

Wrapping Up

Mutual funds are one of the most popular ways to invest money in the market. If you too want to invest, open demat account with Angel One and start your journey. Angel One, with its huge repository of financial data and knowledge base, helps you ace the game of investing. We believe that any investment can turn out well when the investor knows the ins and outs of it. Disclaimer: This article has been written for educational purposes only. The securities quoted are only examples and not recommendations.