Choosing and recommending the right scheme from the hundreds of schemes is crucial for achieving clients’ objectives and goals. Many of these funds look attractive having performed well over both long-term and short-term horizon. However, distinguishing between successful fund managers riding on sheer luck and superior stock-picking abilities and/or asset allocation decisions is very important.
In this article, we will understand how to identify winners.
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Consistency in adhering to investment objective: Check for consistency between the investment objective.
As stated in the scheme documents and the actual holdings. So, a Small Cap Fund should be invested in small cap stocks not large cap stocks. -
Diversification: Check if the portfolio diversification reflects the nature of the scheme. Concentrated bets on individual stocks or sectors increase the risk of the scheme.
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Consistency of performance: Analysis of historical performance is a must. It’s recommended to consider a longer time period for analysis to get better idea of return consistence. Analysis based on recent good returns due to up rally would result in end-point bias. End point bias means if the end period returns are good, it will affect all other years return.
Good previous year performance does not guarantee better returns in future. What one should look for is consistency in funds return by taking into account at least 5-10 years historical return data.
Other important thing to consider is these returns should be compared to proper benchmark during relative performance analysis. -
Expense/Fee Analysis: Being aware of mutual fund fees and expenses and how they can affect investment return is critical for fund analysis. Just as an example, if I own two funds and the first has an expense ratio of 1.30% and the second has an expense ratio of 0.30% then other variables being equal, I will grow my money quicker by owning the fund with the lower expense. It is important to know, however, that a high expense ratio does not make a mutual fund bad and a low expense ratio does not make a mutual fund great.
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Risk analysis: Best mutual funds maximize returns and minimize risks. A ratio called as Sharpe Ratio explains whether a fund is risk free based on its expected returns compared against a risk free money market fund. For more on risk analysis read article on volatility measures.
Conclusion: The results can provide valuable insight into a manager's skill and help you enhance the investor's portfolio construction process. This type of analysis can provide the information required to properly construct a portfolio.