How to compare mutual funds

Choosing a mutual fund seems to have become a very complex affair lately.

There are no dearth of funds in the market and they all clamor for attention.

The most crucial factor in determining which one is better than the rest is to look at returns. Returns are the easiest to measure and compare across funds.

At the most trivial level, the return that a fund gives over a given period is just the percentage difference between the starting Net Asset Value (price of unit of a fund) and the ending Net Asset Value.

Returns by themselves don't serve much purpose. The purpose of calculating returns is to make a comparison. Either between different funds or time periods. And, you must be careful not to make a mistake here. Or else, you could end up investing in the wrong funds.

Absolute returns

Absolute returns measure how much a fund has gained over a certain period. So you look at the NAV on one day and look at it, say, six months or one year or two years later. The percentage difference will tell you the return over this time frame.

But when using this parameter to compare one fund with another, make sure that you compare the right fund. To use the age-old analogy, don't compare apples with oranges.

So if you are looking at the returns of a diversified equity fund (one that invests in different companies of various sectors), compare it with other diversified equity funds. Don't compare it with a sector fund which invests only in companies of a particular sector.

Don't even compare it with a balanced fund (one that invests in equity and fixed return instruments).

Benchmark returns

This will give you a standard by which to make the comparison. It basically indicates what the fund has earned as against what it should have earned.

A fund's benchmark is an index that is chosen by a fund company to serve as a standard for its returns. The market watchdog, the Securities and Exchange Board of India, has made it mandatory for funds to declare a benchmark index.

In effect, the fund is saying that the benchmark's returns are its target and a fund should be deemed to have done well if it manages to beat the benchmark.

Let's say the fund is a diversified equity fund that has benchmarked itself against the Sensex.

So the returns of this fund will be compared vis-a-viz the Sensex.

Now if the markets are doing fabulously well and the Sensex keeps climbing upwards steadily, then anything less than fabulous returns from the fund would actually be a disappointment.

If the Sensex rises by 10% over two months and the fund's NAV rises by 12%, it is said to have outperformed its benchmark. If the NAV rose by just 8%, it is said to have underperformed the benchmark.

But if the Sensex drops by 10% over a period of two months and during that time, the fund's NAV drops by only 6%, then the fund is said to have outperformed the benchmark.

A fund's returns compared to its benchmark are called its benchmark returns.

At the current high point in the stock market, almost every equity fund has done extremely well but many of them have negative benchmark returns, indicating that their performance is just a side-effect of the markets' rise rather than some brilliant work by the fund manager.

Time period

The most important thing while measuring or comparing returns is to choose an appropriate time period.

The time period over which returns should be compared and evaluated has to be the same over which that fund type is meant to be invested in.

If you are comparing equity funds then you must use three to five year returns. But this is not the case of every other fund.

For instance, cash funds are known as ultra short-term bond funds or liquid funds that invest in fixed return instruments of very short maturities. Their main aim is to preserve the principal and earn a modest return. So the money you invest will eventually be returned to you with a little something added.

Investors invest in these funds for a very short time frame of around a few months. So it is alright to compare these funds on the basis of their six month returns.

Market conditions

It is also important to see whether a fund's return history is long enough for it to have seen all kinds of market conditions.

For example, at this point of time, there are equity funds that were launched one to two years ago and have done very well. However, such funds have never seen a sustained declining market (bear market). So it is a little misleading to look at their rate of return since launch and compare that to other funds that have had to face bad markets.

If a fund has proved its mettle in a bear market and has not dipped as much as its benchmark, then the fund manager deserves a pat on the back.