This post is by guest contributor, Mayank Malik. Mayank writes about money, cars, sports and all things dad-related.
It was not until 2005 that we, as a household, started investing in mutual funds. Ever since then mutual funds have become a regular part of our investment portfolio and have given us great returns. Even in times of the 2008 credit crisis, we were confident of this investment tool and held on to most of our funds only to see them appreciate in the last twelve to eighteen months.
Today, let’s look at how you, too, can add this to your investment portfolio.
What Are Mutual Funds?
A mutual fund is an investment tool made up of a collection of funds from a range of investors. This sum of money is used to invest in stocks, bonds, money market instruments and similar assets.
Fund Managers or Investment managers operate mutual funds and invest the fund’s capital in order to generate income for the fund’s investors. A mutual fund’s portfolio is structured and maintained to match the investment objectives stated in its prospectus.
History of Mutual Funds
Mutual funds go back to the times of the Egyptians and Phoenicians when they sold shares in caravans and vessels to spread the risk of these ventures. The foreign and colonial government Trust of London of 1868 is considered the forerunner of the modern concept of mutual funds.
The USA, however, is considered the Mecca of modern mutual funds. By the early 1930s quite a large number of close – ended mutual funds were in operation in the U.S.A. Later in 1954, the committee on finance for the private sector recommended mobilization of savings of the middle class investors through unit trusts. Finally, in 1964, the concept took root in India .
Mutual funds are among the most popular investment tools for a household investor today.
In this post, I will focus on some of the key things to keep in mind while picking up a mutual fund for your investment portfolio.
1. Track record of the Fund
You should compare a fund’s performance with that of its peers over various periods, as well as against relevant benchmarks. Look at the fund’s performance over a longer period (2 years or more).
You should choose a fund, which looks at ample diversification across companies, and sectors, which ensures that when one sector does poorly, your scheme’s NAV (Net Asset Value) does not sink. For instance, a mutual fund that invests a percentage of it’s assets in real estate, pharmaceutical companies, FMCG companies/products, futures and options, banks and the like is a better option than a fund that invests solely in any one of these sectors.
There is an asset management fee and also some other operational expenses for the fund that the mutual fund company will charge you. The fund’s Net asset value that you finally get is after the fund house has deducted all these expenses. This amount is known as ‘expense ratio’. Therefore, in a given year, if your scheme returns 20 per cent and shows an expense ratio of 2 per cent, it means that it earned 18 per cent, but used up 2 percentage points of that to meet its expenses.
Obviously, the lower the expense ratio, the better it is. An expense ratio in the range of 2 per cent -2.5 per cent or less is what you should be looking for.
4. Mutual Fund Fact Sheet
This document (can be downloaded from the fund website) gives you all the information you might require about your fund.
Decoding a fact sheet is the easiest and the best way to ensure that you have all the relevant information on your fund. Some of the key technical terms repeatedly used in a mutual fund fact sheet are:
a. Standard Deviation
Standard deviation is a statistical tool for measuring the variation in NAV and helps us in identifying the consistency in performance of a fund. The return posted by the fund on a daily basis is considered for this purpose. The deviation is a sign that the fund is performing consistently. The lower the standard deviation, the more consistent and fundamentally strong the fund is.
b. Sharpe Ratio
Sharpe ratio measures returns delivered per unit of risk borne. The Sharpe ratio tells us whether a portfolio’s returns are due to smart investment decisions or a result of a risk overload. This measurement is very useful because although one portfolio or fund can reap higher returns than its peers, it is only a good investment if those higher returns do not come with too much additional risk. The higher the Sharpe ratio, the better the fund.
This statistical measure compares your fund’s volatility in relation to that of its benchmark. It gives you an idea of how far you can expect a fund to go up/down when the market gains/falls. A fund with a beta greater than 1 is seen as more volatile than the market. Similarly, a fund with a beta less than 1 is seen as less volatile than the market. Therefore, if your fund gets a beta of 1.08 then it has fluctuated in the past and is likely to fluctuate 8 per cent more than the benchmark. If the market gains, the fund should better the market performance by 8 per cent. If the market falls, the fund should be poorer in its performance by 8 per cent.
d. Portfolio Turnover Ratio
The percentage of a mutual fund or other investment vehicle’s holdings that have been “turned over” or replaced with other holdings in a given year. Each transaction has some cost involved. This means the higher the portfolio turnover ratio, the greater will be the cost associated, affecting your returns. The lower this ratio is, the more conviction your fund manager has in his purchase decision.
Keep these things in mind when deciding on your next mutual fund purchase. Remember, even if you have a financial advisor or an investment manager to take care of your mutual fund requirements, knowing these simple tips can help you make an informed decision and be more involved in your investments.
Have you invested in Mutual Funds? What tips do you have for others? Questions? Ask away!
Photo Credit: Satish Krishnamurthy