To choose an equity mutual fund, investors need to bear in mind the cost that they are willing to pay to own a fund, its performance over a considerable period of time, its risk-adjusted returns and the volatility of the fund. When choosing an equity mutual fund, investors need to shortlist peers to compare the mutual fund performance on key metrics that need to be analyzed before choosing a fund:
This is the annual fee paid to cover the operating expense of a mutual fund or an exchange-traded fund (ETF). This expense included the management cost, administrative cost as well as marketing and advertising cost borne by the asset management company to maintain the mutual fund.
When choosing a mutual fund scheme, you must select mutual funds that charge a reasonable expense ratio to ensure the majority of your investment is used to generate returns. When you buy a mutual fund, you don’t pay an expense ratio over and above your investment as the expense ratio is directly deducted from your returns.
What is a Benchmark Index?
A benchmark index is used to evaluate the performance of an investment in the stock market. A benchmark index covers different market capitalizations, sectors and themes. When making an investment, a portfolio manager evaluates the returns of an investment based on the performance of a set or a group of securities called the benchmark index.
When choosing a mutual fund, investors need to evaluate how the fund has performed in comparison to its benchmark index to evaluate if investing in the fund will garner returns. A mutual fund that has outperformed the benchmark index is preferred over a fund that has underperformed the benchmark index.
What is Alpha?
The alpha is the excess returns over the benchmark index that a fund generates. Alpha is generated by portfolio managers by diversifying their investments and can be positive or negative. An alpha at zero indicates the fund manager has not generated more or less returns compared to the broad markets and the fund’s performance is in line with that of the benchmark index.
When choosing a mutual fund, you must consider the alpha of the fund compared to its peers. This alpha must be higher than that of other mutual funds as well as higher than the expense ratio of the fund. Higher the alpha, higher is the excess returns the fund has generated.
What is Beta?
The beta is a measure of the volatility of the mutual fund when compared to the broader market. Beta indicates the risk that a stock or a portfolio carries and it changes as the market swings.
When choosing a mutual fund, beta of less than one is considered less volatile when compared with funds that have beta higher than one. When a mutual fund’s beta is compared with its peers, it is important to evaluate other factors as well before deciding if the fund will increase or decrease the risk associated with the fund.
What is Standard Deviation?
The standard deviation is a measure that indicates the volatility of a fund; the higher the standard deviation, the higher is the volatility of the fund and vice versa.
When choosing a mutual fund, lower standard deviation of the fund compared to peers’ implies lower risk. It is, however, not necessary for a fund to have lower standard deviation for it to generate higher returns.
What is Sharpe Ratio?
The Sharpe ratio indicates the return of an investment when compared to its risk. It shows the extra returns you make for the additional risk that you have taken.
When choosing a mutual fund, a high Sharpe ratio is preferred when compared with peers’ performance and implies better risk-adjusted returns of the fund.