Published on: October 16, 2024
When it comes to mutual fund investments, many investors fall prey to a common misconception: selecting schemes based solely on performance rankings.
You might read a few articles on Google, check out one-year, three-year, or five-year returns, and invest in the top-performing schemes. But here is the truth: this is one of the biggest mistakes you can make in mutual fund investing.
The Trap of Chasing Past Winners
Let us discuss the numbers. We have compiled a table showing mutual fund schemes rankings over the last 15 years. Identifying schemes that were top performers in a particular year is easy.
Source: FundsIndia
For instance, a scheme ranked first in 2017 might seem like a rock-solid investment, but by 2020, that same scheme may have slipped to the 165th rank. That’s right—the once top-ranked scheme underperformed 164 other funds over just three years.
This shows a clear trend – chasing the winners of the past does not guarantee future success. In fact, history tells us that many top-performing schemes struggle to maintain their position. So, if you had invested in the highest-ranked scheme in 2017, you would have earned far lower returns than if you had chosen one of the 164 schemes that outperformed it by 2020.
Isn’t it an Eye Opener? So, what is the solution?
A Better Approach to Mutual Fund Selection
How do you identify good mutual fund schemes without falling into the trap of chasing past winners?
At Definedge, we have developed an in-house mutual fund analysis platform called MFZone, which is equipped with a powerful mutual fund scanner. This tool allows you to filter mutual fund schemes based on key parameters so you can make an informed decision instead of relying on past performance alone.
Let me explain how to use our Mutual Fund Scanner effectively. Since most of our readers are equity investors, let us begin by selecting “Equity Funds” as the scanner’s fund category.
Filtering with The Turnover Ratio
Next, look at the Turnover Ratio, which is an essential metric. The turnover ratio indicates how frequently a fund manager buys and sells stocks within the fund. For instance, if a fund started the year with 50 stocks and replaced 40 of them throughout the year, the turnover ratio would be 80%.
A high turnover ratio could suggest that the fund manager is constantly churning the portfolio, which can increase costs due to transaction fees and taxes.
We generally look for funds with a turnover ratio of less than 70%. This signifies that the fund manager has a stable investment approach and reduces unnecessary costs.
Based on Turnover Ratio criteria, the scanner shortlisted 346 schemes.
Ah, 346 Schemes! Isn’t it too much? 😉
Let us refine the selection further by applying additional criteria.
Applying Alpha and Beta Filters
We might have too many options once we have filtered equity schemes with a low turnover ratio. For example, our filter has yielded over 300 schemes, which is overwhelming.
To refine the selection further, let us introduce two additional metrics: Alpha and Beta.
Alpha measures the excess return a fund generates compared to its benchmark. For instance, if a large-cap equity fund returns 20%, and the Nifty 50 (its benchmark) returns 18%, the alpha would be 2%.
We look for funds with positive alpha, which indicates they outperform their benchmarks.
Beta measures a fund’s sensitivity to market movements. If a fund’s beta is 1, it moves in tandem with the market.
A beta greater than 1 suggests the fund is more volatile than the market, while a beta less than 1 indicates it is less volatile.
Ideally, we look for funds with a beta lower than 1, as these tend to be less risky in volatile markets.
We will further refine the selection of mutual fund schemes using the Alpha and Beta criteria. We will filter for schemes with an Alpha greater than 1, which indicates that the scheme has outperformed its benchmark, such as the Nifty index. Additionally, we will focus on schemes with a Beta of less than 1, providing a margin of safety in case the markets decline, as these schemes tend to be less volatile than the market.
Adding the Alpha and Beta filters has reduced the number of schemes to 250.
But are you ready to invest in 250 schemes? Probably not, right?
To narrow it further, we can apply the next filter: Standard Deviation and Risk Parameters.
Standard Deviation and Risk-Adjusted Ratios
Standard Deviation measures a fund’s return volatility. A lower standard deviation indicates more stable returns. To ensure stability in our portfolio, let us aim for low-volatility funds.
For investors seeking long-term mutual fund schemes, the standard deviation should ideally be less than 10% to ensure lower volatility and more stable returns.
But we don’t stop there. We can also apply three critical Risk-Adjusted Return Ratios: the Sharpe Ratio, the Sortino Ratio, and the Treynor Ratio. These ratios help us compare a fund’s return to the risk it takes.
Let us understand this ratio.
The Sharpe Ratio compares the fund’s return to the risk-free rate, adjusted by the fund’s volatility (standard deviation). A Sharpe Ratio of greater than 1.5 is considered good.
The Sortino Ratio is similar to the Sharpe Ratio but only considers downside volatility (negative returns), which makes it more precise for risk-averse investors. Again, we look for a ratio of more than 1.5.
The Treynor Ratio takes beta into account, measuring the fund’s return compared to market risk. Like the others, a Treynor Ratio greater than 1.5 is desirable.
We have significantly narrowed down our options by filtering schemes with a Standard Deviation of less than 10% and Sharpe, Sortino, and Treynor Ratios greater than 1.5.
Here is the result:
Starting with 346 schemes, we have narrowed it down to just 57 schemes.
Tailoring to Your Risk Appetite: Small, Mid, and Large-Cap Allocations
At this point, you may still have around 57 schemes, which is more manageable but still a broad list. Now, it’s time to consider your risk tolerance and investment goals.
For example, if you have a higher risk appetite and want exposure to small-cap or mid-cap stocks, you can adjust the scanner to show funds with at least 15% allocated to small-cap stocks and 10% to mid-cap stocks.
For more conservative investors who prefer large-cap stability, you can filter for schemes with over 50% allocation to large-cap stocks.
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