Mutual Funds provide a great channel for diversification. The primary goal of diversification is to spread out the risk. One of the major metrics a normal retail investor considers while looking for a mutual fund is past performance. As the Fund Houses themselves advertise, past performances are not an indicator of future returns, but this remains the more ignored disclaimer by the investors! Worse still, investors look for very near-term (last 1-2 years) performance to select a mutual fund. A relatable analogy would be, how often you switched to a faster-moving queue or lane in traffic, only to see the other one starting to move ahead faster ?!
If your primary intention is to balance out risk, then are you aware of how much risk versus reward your funds are providing? To put it in simple terms, a typical risk-reward metric is an indicator of how much additional risk you are taking, and with that risk, how much additional returns your investment is going to generate compared to a near-to-zero-risk instrument such as Government sovereign bonds. One of the most popular industry indicators is the Sharpe ratio.
Another metric that every investor needs to have in consideration is the volatility. Keeping all other metrics aside (including risk-reward ratio, XIRR, etc.), how much appetite do you have to bear ups and downs in your portfolio? This is even more relevant as it directly plugs into investors’ psychology to react to the market’s swings and governs bad decisions, such as instinctive selling when the portfolio swings to red. Indicators such as Beta (often used also for direct equities) are useful metrics to track the fund’s behavior to changes.
With that said, it serves as a good idea to check out these metrics during the fund selection process. For example, pick any fund analysis page such as the one on moneycontrol.com. Once you select a fund scheme type, navigate to the Risk Ratios tab to view the risk and volatility indicators of the funds listed.
You can further navigate to the specific fund page and check the numbers. There will also be a brief description of how to interpret each of the indicators.
Stock concentration in the fund portfolio and how expensive they are could also be some factors for investment selection. For example, lately the S&P 500 index is getting increasingly skewed toward the Top 7 star performers in the Technology space. Even though they have stellar returns in the last few hours, this could get worrisome for a few of conservative investors.
Similarly for actively managed funds, you can check out the stock concentration in the portfolio in many of the fund analysis sites. One such would be the valueresearchonline analysis data.
A consolidated view of the PE ratio is also a more simplistic indicator of how expensive is the fund at the moment.
So how to connect the dots to make more informed decisions?
- The investment horizon and stock volatility metrics can be considered in unison. Particularly if you are looking at a shorter horizon (which is not suggested for equities!), high deviation numbers could be detrimental.
- Consider a better risk-reward ratio offering funds that make practical sense for any form of bet.
- For lump sum investing particularly, keep an eye on how expensive the fund is at the moment looking at the P/E and P/B numbers.
- If you are more concerned about under-diversification, keep an eye on heavy portfolio concentration.
And lastly to reiterate, do not get blind sighted only by the historical returns.
