I started off my journey into equities by directly plunging into direct equity. It started off with random stock picking and hoping for miracle to make money (not the recommended way). One day I got a mail from my broker where they told about various investment products one of which was mutual funds. Luckily on the same day Uma Shashikant madam shared article by Pattu sir which was also on selecting mutual fund. That roused my interest in mutual funds as it was more easy money – just pick the right one and be done with it.

How I went on Shortlisting & Selecting Mutual Fund?

There are various ways to shortlisting and selecting mutual fund. I used pattu sir’s guide to shortlist the funds(here is the link to it). While I was selecting mutual funds, I had no clue about ABC’s of these ratios, only gut feeling was the guide.

Here is screen shot of how I shortlisted the balanced funds.

Shortlisting and Selecting Mutual Fund

The shortlisting of fund to invest happened on Value Research Online. Since I was not convinced of efficacy and workings of star ratings, I didn’t bother to look at them. I started off compiling all these data points in excel. After collecting the data selecting mutual fund out of it was breeze.

The thumb rules I followed were

  • 5 year and 10 year returns must be higher.
  • Lower the standard deviations better.
  • Lower beta is better.
  • Alpha should be higher.
  • R-squared must be higher.
  • Higher Sharpe Ratio is better.
  • Higher Upside Capture ratio is good.[updated]
  • Lower the Downside Capture ratio better.[updated]

These thumb rules are sufficient to pick a fund of choice but blind follow of them is certainly not going to make you good picker. So here is small explanation of what these risk measures mean.

Measures of Risk:

  • 5 and 10 year returns as usual is the rate at which the fund increased its value in past 5 year and 10 years. Simple stuff, 5y returns of 20% mean in past 5 years the fund has increased its value by average 20% every year.
  • Standard Deviation measures how much the returns have varied from average. Higher standard deviation means the returns achieved had lots higher up surges and lower crashes in its returns.
  • Alpha measures difference between average return of benchmark and average return of the fund. If Tata Balanced has alpha of 10 means that Average Returns of Tata Balanced – Average Return of Crisil Balanced Index is 10.
    Fund's Alpha = Fund's Average Returns - Benchmark's Average Returns
  • R-Squared measures level of benchmark index hugging. R-Squared of 86% or 0.86 means fund has increased/decreased its return 86% of the times when the benchmark has increased/decreased its return.
  • Beta compares volatility of benchmark and fund. A beta of 1 means that fund increased by 1% when benchmark increased by 1% and decreased by 1% when benchmark decreased by 1%. Lower beta means fund is less volatile than benchmark index and is good thing. Give importance to beta only if R-Squared is higher than 85%.
  • Sharpe ratio states the risk adjusted return. Higher the better.
  • Upside capture ratio tells how the fund has has performed when its benchmark index was rising. For example if BSE 200 rose by 100 points in past month HDFC Top 200 rose by 110 points in same period then its upside capture ratio for past month was 110. Since its above 100, its better. Above 100 upside means fund has out performed index in a rising market.
  • Downside capture ratio tells how much the fund fell when its benchmark index was falling down. Suppose Nifty fell by 100 points but the Franklin Bluechip fell only 60 points then the downside capture of Franklin blue chip is 60.  Lower downside is more desirable feature as it doesn’t erode unrealized value when index is falling down.

Do go through this article by pattu sir which visualizes various mutual fund risk measures.[Visualizing Mutual Fund Volatility Measures]