The Art of Mutual Fund Selection: 3 Key Criteria That Really Matter

In Short

• Rolling returns give you a more realistic picture of fund performance than point-to-point returns - think of it as watching the entire cricket match versus just checking the final score

• A high expense ratio can eat into your returns like termites in wood - even a 1% difference can significantly impact long-term wealth creation

• Your fund manager is like the captain of a cricket team - their experience, strategy, and track record can make or break your investment journey

• Understanding these three criteria will help you navigate through India's vast mutual fund landscape of 44 AMCs and 1000+ schemes

• These principles work best for equity mutual funds with a 7-10 year investment horizon

AI Generate image to illustrate selecting a mutual fund is like an experienced farmer picking the right fruit/flower from his garden

The Mutual Fund Maze

Imagine walking into a restaurant with a 1000-item menu. Overwhelming, right? That's exactly how most people feel when they look at India's mutual fund landscape. With 44 Asset Management Companies (AMCs) offering over 1000 funds, choosing the right one can feel like finding a needle in a haystack.

As Benjamin Graham, the father of value investing, once said, "Investment is most intelligent when it is most businesslike." So let's approach this challenge systematically with three time-tested criteria that separate the wheat from the chaff.

1. Rolling Returns: The Real Performance Story

It's like judging a student's academic performance - would you rather look at just their final exam score, or see how they performed across all tests throughout the year? That's exactly what rolling returns tell you about a mutual fund's performance.

While most investors look at point-to-point returns (like 1-year or 3-year returns), it's like judging a movie by its last scene. Rolling returns, on the other hand, show you the complete picture by considering fund performance across multiple time periods.

Here's how it works: Instead of just looking at how a fund performed from 2020 to 2023, rolling returns would show you how it performed from:

- January 2020 to January 2023

- February 2020 to February 2023

- March 2020 to March 2023

And so on...

This gives you a more comprehensive view of the fund's consistency. You can track rolling returns on websites like primeinvestor or rupeevest. Rolling returns help you understand if a fund's performance is genuinely consistent or just a flash in the pan.

2. Expense Ratio: The Silent Wealth Eroder

Think of expense ratio as the platform fee you pay on food delivery apps. Just as a high delivery fee can make your ₹200 burger cost ₹300, a high expense ratio can significantly eat into your returns.

The expense ratio is the annual fee that mutual funds charge to manage your money. It typically ranges from 0.5% to 2.5% of your investment. While this might seem small, let's crunch some numbers:

Suppose you invest ₹10,000 monthly for 20 years:

- With a 1% expense ratio, you'd pay approximately ₹6.5 lakhs in fees

- With a 2% expense ratio, this jumps to about ₹13 lakhs

Look for funds with lower expense ratios, particularly in large-cap categories where the scope for differentiation is limited.

3. Fund Manager: The Captain of Your Ship

If mutual funds were cricket teams, fund managers would be the team captains. Just as MS Dhoni's leadership transformed the Indian cricket team, a skilled fund manager can significantly impact your fund's performance. Think of it like you are handing over your money to this one person with an expectation that she will provide above average returns.

Evaluating a fund manager isn't as straightforward as checking returns, but here's what you can do:

1. Track Record: Look at their performance across different market cycles

2. Investment Philosophy: Follow their interviews and market views on platforms like MoneyControl and Economic Times. Webinars hosted by AMCs is also a good avenue to understand your fund manager.

3. Consistency: Check if they stick to their stated investment strategy even during market turbulence

4. Fund Manager Changes: Frequent changes could indicate internal issues

A key metric to evaluate fund managers is 'alpha' - the excess return of the fund relative to its benchmark index. It's like a report card showing how much value the manager adds compared to a passive investment strategy.

Understanding Alpha: Your Fund Manager's Report Card

Let's dive deeper into alpha, as it's your best tool to measure a fund manager's skill. Imagine you're running a race where everyone must cover 5 kilometers. The average runner (let's call this the benchmark index) completes it in 30 minutes. Now, if you complete it in 27 minutes, you've outperformed by 3 minutes - that's your alpha!

In mutual fund terms, alpha is the extra return that a fund manager generates compared to the benchmark index, after adjusting for market risk. Here's a practical example:

• If the Nifty 50 (benchmark) delivers a 12% return

• And your mutual fund gives a 15% return

• The alpha is 3% (assuming same risk level)

But here's where it gets interesting. A consistently positive alpha is rare and valuable - it's like finding a chef who makes every dish better than the recipe. Look for fund managers who have:

• Generated positive alpha over 5+ years

• Maintained alpha across different market conditions

• Achieved alpha without taking excessive risks

How to evaluate alpha:

1. Compare alpha across similar funds in the same category

2. Look for stability in alpha generation - wild swings might indicate luck rather than skill

3. Check if the alpha justifies the higher expense ratio of actively managed funds

The Bottom Line

As you navigate through India's mutual fund landscape, remember what Ben Graham said: "The investor's chief problem – and even his worst enemy – is likely to be himself." These three criteria provide a framework to make objective, well-informed decisions rather than emotional ones. 

Leverage mutual fund star ratings as your initial screening tool - like using IMDB ratings to shortlist movies for your weekend watchlist. Platforms like ValueResearch and Morningstar rank funds on a 1-to-5 star scale, helping you quickly identify funds that have historically shown strong performance. While these ratings shouldn't be your only criteria (just as you wouldn't watch a movie solely based on its IMDB rating), they're a handy first step to narrow down your options from thousands to a manageable few.

Start with analyzing rolling returns for consistency, keep an eye on the expense ratio to maximize your returns, and research your fund manager like you'd research a business partner. After all, they're going to be managing your hard-earned money!

Remember, past performance doesn't guarantee future returns, but as Mark Twain quipped, "History doesn't repeat itself, but it often rhymes." Use these criteria as your investment compass, and you'll be better equipped to make informed mutual fund choices.