How to Choose the Best Equity Mutual Fund

You must have heard a lot about investing in mutual funds. But before jumping on this trend you need to assess a mutual fund scheme according to your goals, investment horizon, risk profile, liquidity needs and many other factors to find a suitable match. This is exactly what we will cover in this article on How to choose the best equity mutual fund.

What is an Equity Mutual Fund?

Equity mutual funds make investments in the shares of different companies as per pre-defined mandate. Since their performance hinges on market conditions, the risk associated with equity funds is comparatively higher than debt funds or hybrid funds. As they happen to be riskier, they also hold the potential to yield higher returns than their counterparts.

The main objective of the equity fund is to invest in a right set of companies to generate better returns for the investors.

Factors to Consider While Choosing an Equity Mutual Fund

The 3 most crucial factors which should preferably be central to your decisions are your investment objective, your time horizon and your risk tolerance. 

1. Investment Objective: The investment goal can be short term or long term or anything, but you should preferably have a goal so that you can make congruent choices while selecting an equity fund to invest in
2. Time Horizon: The time period for which you are willing to keep your money invested in an equity fund is an important factor to select the top performing equity funds. Historically, equity mutual funds have generated better returns when invested over a long time-frame. 
3. Risk Appetite: This essentially is the amount of risk you can tolerate with your investments in equity funds.  As a general rule, higher risks should translate to higher returns, equity funds are relatively riskier and hold the potential to provide higher returns.

Performance Metrics to Consider While Investing in an Equity Fund

1. Compare the equity fund's performance amongst its active peer group to get a holistic view of the fund’s performance

2. Choose a scheme which performs consistently. The fund’s performance needs to be assessed not only over the past few years, but over multiple market cycles so as to select a fund that has consistently beaten its benchmark 

3. The expense ratio also needs to be considered in order to choose funds which have a comparatively lower expense ratio, but this could not be the deciding factor.

Useful Ratios for Measuring Equity Mutual Fund’s Performance

1. Standard Deviation: It conveys how volatile a fund is by measuring the deviation in the fund’s returns as compared to its average returns spread over a period of time. Funds having higher standard deviation are inherently riskier than their counterparts having lower standard deviation, so risk-averse investors should prefer funds having lower standard deviation.

2. Sharpe Ratio: It conveys whether an equity fund generates the returns in comparison with the total risk it carries. A higher sharpe ratio indicates better returns from an investment in comparison to the total risk taken. Therefore, assessing the Sharpe ratio for similar funds is useful for investors in identifying good funds.

3. Beta:  It measures the volatility of the equity fund in response to market fluctuations as compared to the index. A beta of 1 implies an equivalent shift in the prices compared to the index movement, a positive beta of more than 1 indicates a greater shift in the fund’s prices as compared to the index and a negative beta implies the opposite movement in the prices. Risk-averse investors should consider a fund with positive beta less than 1 as it conveys that the funds prices aren’t that severely impacted by volatility. Investors with a higher risk appetite can consider funds with a beta of greater than 1.

4. Treynor Ratio: It measures the risk-adjusted returns delivered by a fund, similar to the Sharpe ratio but considers only market risk instead of total risk. 

5. Sortino Ratio: It measures the performance of the investment in accordance with the downside risk. It is different from Sharpe ratio which considers both upside and downside risk. The Sortino ratio is thought to provide a better view of the fund’s risk-adjusted performance as positive volatility is beneficial

6. Alpha: It represents the fund manager's performance as being able to bring additional profits compared to the risk taken. An alpha of zero conveys that the fund manager did not add value to the fund. Investors should consider selecting equity funds with a positive alpha, as this ratio tells the investor whether the fund manager will be able to pull off profits. Investors should consider alpha after taking an average of the past returns and not only on the presently available data.

It is paramount that investors use all these ratios in combination with each other and not in isolation in order to make holistic decisions.

Conclusion

To conclude, let’s summarize everything we have discussed:

1. The 3 most important factors which need to be considered while selecting an equity fund are investment objectives, time-horizon and risk appetite.
2. Before choosing an equity fund, compare its performance with other funds in the same category to get a holistic view of the performance.
3. Ensure that the equity fund has consistently beaten its benchmark in both the bullish and bearish phases of the stock market.
4. Carry out the required ratio analysis by comparing funds across the ratios which we discussed like alpha, beta, Sharpe ratio, Treynor ratio and others to better judge the fund’s performance and the risk involved.