Fund Basics. Choosing an equity mutual fund scheme

Before investing in an equity mutual fund scheme, have a clear understanding of why you would like to invest, the time horizon that you would stay invested and a rough idea of your risk tolerance. Without this, it would be better to stay away from investing.

All investment ideas carry risks, in general. Factsheets of AMCs provide data on returns delivered by equity schemes over longer periods but retail investors do not always gain from such investments.

The first and foremost reason for this is the failure on the part of investors to understand volatility. Rather than looking at past performance, look at how volatile the scheme has been in the past.

A three-year volatility score gives you a good idea of how the NAV of the scheme would move up and down depending on market conditions.

For example, if a fund had an average return of 15 per cent and the volatility was 20, this would roughly mean that the range of returns over the period would have swung between -5 per cent and 35 per cent.

Individuals, however, exit a scheme once they see their investments going down by 10 per cent or 20 per cent. Understand the volatility (typically represented by standard deviation) of the scheme and choose the one that you would be comfortable with.

Do not rely solely on past performance. It is only an indication of how good the fund was and there is no guarantee that this would get repeated.

Upside capture ratio shows the scheme’s performance in an upmarket relative to its benchmark. Similarly, downside capture ratio shows the scheme’s performance in a down-market relative to its benchmark.

It is quite understandable from the definition that the upside capture ratio should be more than 100 and the downside capture ratio should be less than 100. There are schemes available in the market with downside capture ratios in the range of 45-70. Choosing schemes with low downside capture ratios might help earn better returns in the long run.

This information is available on websites dedicated to mutual fund analysis.

By looking at ratings and past performance you could end up on a scheme that would remain a laggard in the coming years. Instead, focus on a good mix of large-, mid- and small-cap funds. Stick to a maximum of six schemes in general.

If you can withstand higher volatility, then 60 per cent exposure to mid- and small-caps and the balance in large-cap would make sense.

If you would like to settle for lower volatility then increase your large-cap exposure to 60 or 70 per cent and invest the rest in mid- and small-cap funds.

Realign your mix as and when the situation demands.

Once you create a portfolio taking into consideration the three essentials discussed above, adopt the time-tested methods of systematic investing in equities or systematic transferring to equities.

The writer is an Investment Advisor Registered with SEBI, Co-founder of Chamomile Investment Consultants, Chennai

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