Mutual fund enthusiasts have a special inclination towards equity funds. These help them in getting wider exposure at a nominal initial investment of as low as Rs 500. In spite of so much enthusiasm, many investors are unable to achieve the gains they initially dreamt of. There is a strong reason behind it. This relates to improper choice of funds. On the face, all equity funds might look alike. However, not every equity fund is made for every investor.
You have to make a wise choice based upon subjective and objective parameters. Often, there is a tendency to choose funds based on annualised returns given in the factsheet of the fund. Some of them might rely on star ratings assigned to the fund. But ratings change every now and then. The top performers of today will slid to the bottom tomorrow. As an investor, you need to know that this is a highly inadequate criteria to select equity funds. You should understand that equity funds are sophisticated products which need to be analysed in-depth before shortlisting any one. You need to have a robust criteria to select funds and maximize returns.
How to maximise returns on equity funds?
1. Objective selection
Don’t confine yourself to annualised returns. Go for a fund which rewards you in a better manner for the risk taken. By looking at the financial ratios of a fund, you can measure its risk-adjusted return generating capacity. You can find Sharpe Ratio in every mutual fund factsheet. It is a financial ratio which tells you how much returns your fund is going to deliver for every extra unit of risk assumed. A Sharpe Ratio of say 2 means for the fund generates 2% extra return for every additional unit of risk taken. Ideally, the fund with the highest Sharpe Ratio, in a particular category like small-cap, is superior to funds with a lower Sharpe Ratio.
2. Cost of Investment
There might be possibility that you are investing in costly funds which is taking a toll on your profitability. Analyse the funds based on the expense ratio and loads involved. The expense ratio of competitive funds reflect how much cost does it take to manage the fund. It is charged from the unitholders as an annual fee. Suppose your fund has an expense ratio of 1.5%, then this becomes its hurdle rate which it has to outperform in any manner. Higher the expense ratio, higher would be difficulties for a fund to beat it to generate positive returns. Invest in funds with a lower expense ratio as compared to other funds.
3. Alpha of the fund
Investors who have invested in actively-managed funds need to be concerned about fund’s alpha. It is the extra return which the fund generates over and above the underlying benchmark. A higher alpha results from the efforts of the fund manager. It is good way to judge whether the fund justifies its expense ratio or not. Suppose the underlying benchmark - say Nifty - gives average returns of around 12%. Then, in order to maximise returns, your fund needs to generate returns above 12%. Else you are better off in going for low-cost index funds.
4. Target rate of return
You may find annualised returns indicated on the factsheet of every mutual fund. Standalone these figures convey no sense. You need to draw a comparison with a benchmark to analyse whether these are useful for you or not. For this, the benchmark can be a rate of return which you would need to achieve your goal. Compare this target rate of return with the fund returns. If the fund returns are on the expected lines, then go ahead and invest.
Archit Gupta is Founder & CEO, ClearTax