Everyone wants to become rich and wealthy. But if you are smart enough then you can make your money to work for you. One of the best ways to make money work for you is by investing it smartly. Mutual funds are good investment vehicles and could help retail investors to create a decent amount of wealth. But many of us do not know how to select mutual funds. Today we will understand what are the key aspects we should look before investing in a mutual fund.
There are certain terms that an investor should understand before investing in any Mutual Fund.
How to view ratios of any fund?
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NAV (Net Asset Value):
It is the sum of the market capitalization which includes shares, cash minus liabilities for the mutual fund divided by total units outstanding. Therefore NAV represents the net worth of a unit of the mutual funds. There is no correlation between higher NAV giving higher returns, therefore, an investor should refrain checking NAV during the selection of Mutual Funds. Read more here.
You can calculate your current invested value using NAV.
Investment worth = (Current NAV)* (Units allotted to you)
Expense ratio:
It is the annual expenditure or fee of the Mutual fund. It is represented as the percentage of the total assets held by the fund.
Expense Ratio = (Management Fee + Operating Expenses) / (Assets under Management)
Different kinds of mutual funds have a different expense ratio but SEBI has established a maximum limit as 2.5% for equity funds and 2.25% for debt funds.
Annual Returns:
These are the returns offered by the mutual fund to their investors. Note that actual returns are calculated by subtracting expense ratios from annual returns.
Note: The expense ratio is never deducted from the fund performance, therefore in order to calculate net returns, you should deduct expense ration from it.
Net returns by MF= Gross returns – Expense ratio
For Eg, Let us take an example of a Mutual Fund
In the second photo, the actual return which will be realized by the investors will be performance minus expense ratio. Therefore for 1 year, the returns will translate to 7.21%.
AUM (Asset Under Management):
This is the net asset under management by the fund. The higher the net asset, the greater the number of investors that have invested their money in the fund. Generally, it is advisable to invest in the fund having AUM greater than Rs. 1000 crores
Now I will discuss some of the key ratios which will help you to better evaluate a Mutual fund.
Beta:
It is the volatility measure of the fund. It tells you how the fund changes with respect to the market. It is usually benchmarked against Nifty 50 or Sensex 30. The lower the beta, the lower the volatility. An investor should invest in a fund having a low beta. Read more on the beta here.
Standard Deviation:
It is the measure of how the given set of returns, deviate from the average. It can be understood as lower the standard deviation to lower the volatility of the fund. Suppose if a fund gives an average return of 15%, then the standard deviation of 5% indicates that the returns may lie in the range of 10-20%. Read more on Standard Deviation here
Alpha:
It is the risk-adjusted measure of the fund. By taking risks, the fund manager generates higher returns against the benchmark. If the fund has higher Alpha, the higher the performance of the fund will be. Read more on Alpha here.
Sharpe:
It helps you to predict the right investment moves made by the fund manager. It gives return generated by the fund on per unit of risk taken. A Sharpe ratio of 1.25 indicates that for every unit of risk taken, the fund would generate 1.25 times return. Read more on this ratio here.
Sortino:
It gives the risk-adjusted returns of any given mutual fund. It is usually used by conservative retail investors. It helps investors to have a clear picture of capping the downside volatility of the fund by the fund manager.
Example of 2 mutual funds
Scheme A : annual returns:15%, Downside Deviation: 13%
Scheme B: Annual returns: 10%, Downside Deviation: 4%
Risk-free return: 6%
Sortino ratio Scheme A: (15-6)/13 = 0.69
Sortino ratio Scheme B: (10-6)/4 = 1.00
Now Scheme B has a higher Sortino ratio compared to Scheme A even though Scheme A has a higher return compared to Scheme B. But as an investment option for a retail investor, Scheme B is better compared to Scheme A. You can read more on Sortino ratio here.
Note: Higher beta, higher Standard deviation, low Sortino ratio could give very unsafe returns and can also be detrimental to your investment if your time investment horizon is less.
I hope, the next time when you will be selecting a Mutual Fund Scheme you will keep in mind these ratios in your mind.
Read: Ranking criteria of CRISIL, VRO & Top Rated funds by them
