Ten years ago if you had started investing Rs 1,000 every month in funds such as HDFC Top 200 or DSP BlackRock Equity, you would have seen your investment (Rs 1,20,000) growing over 6-7 times by now. Both the funds have given around 30% annualised return over the past 10 years.

There are close to 60 such equity schemes that have given over 20% annualised return in the last 10 years. If only you had invested regularly in any one of them, you could have made big money over the years.

In hindsight, it sounds easy to choose one of these funds and keep investing in them for as long as 10 years to reap the benefits. However, the toughest part in making an investment decision is selecting the right product be it mutual fund schemes, stocks or commodities.

Besides, there is danger in choosing a product purely based on its past performance without giving much thought to other factors such as charges, downside risk, consistency of performance et al. Mutual fund investors often make the mistake, egged by unscrupulous financial advisors, of latching on to a mutual fund scheme that has given very high returns in very short time.

Wealth creation is like Test cricket where a whirlwind fifty or hundred may not always win you a game. You need the solidity of a Rahul Dravid or a Laxman more often than the flamboyance of a Sehwag to be able to emerge victorious over the five days.

Funds that left you poorer

But to be able to find the right fund amid hundreds on offer can be confounding, and if you make the wrong choice you could lose money in a big way.

So how do you go about selecting the right mutual fund? According to Shariq Hoda, executive vice-president & head, third party products, Religare Securities, investors first need to identify their investment objective, time horizon of investment and risk appetite to arrive at their investment plan.

Based on the investment plan, the category of funds should be chosen from debt, equity or hybrid category. Within a category the right scheme can be selected based on criteria such as past performance of the scheme, comparison with peer set and benchmark, volatility measures and risk adjusted performance of the scheme, scheme size, expense ratio of the scheme etc, he says.

Funds that made you richer

MONEY TODAY brings to you a few easy-to-remember points while you go about selecting a mutual fund scheme.

FUND HOUSE PEDIGREE

Before zeroing in on a scheme of your choice, you must select the fund houses on which you have enough faith to invest your money. Try to identify fund houses that have a strong presence in the financial world and provide funds that have a reasonably long and consistent track records.

A strong parentage would ensure efficient processes and the capability to build a strong business. In turn, these processes, which are a combination of investment processes, risk measures and operational efficiency, would ensure a sustained performance over a longer period, says Swapnil Pawar, chief investment officer, Karvy Private Wealth.

KNOW THE ALPHA, BETA OF MUTUAL FUNDS

Standard deviation (SD): Standard deviation measures the volatility of the returns from a mutual fund scheme over a particular period. It tells you how much the fund’s return can deviate from the historical mean return of the scheme. If a fund has a 12% average rate of return and a standard deviation of 4%, its return will range from 8-16%.

Sharpe Ratio: This measures how well the fund has performed vis-àvis the risk taken by it. It is the excess return over risk-free return (usually return from treasury bills or government securities) divided by the standard deviation. The higher the Sharpe Ratio, the better the fund has performed in proportion to the risk taken by it.

Alpha: The simplest definition of an alpha would be the excess return of a fund compared to its benchmark index. If a fund has an alpha of 10%, it means it has outperformed its benchmark by 10% during a specified period.

Beta: It measures a fund’s volatility compared to that of a benchmark. It tells you how much a fund’s performance would swing compared to a benchmark. A fund with a beta of 1 means, it will move as much as the benchmark. If a fund has a bet of 1.5, it means that for every 10% upside or downside, the fund’s NAV would be 15% in the respective direction.

Consistency is key: Will you invest in an equity fund that gave over 100% returns at a time when the equity markets were witnessing a secular bull run but showed a sharp drop in net asset value (NAV) when the markets were volatile? You don’t want a fairweather friend, do you? A good mutual fund scheme is one that consistently manages to outperform its benchmark over 3-5 years.

Look for consistency in performance over longer tenures like 3, 5 and 10 years, if that is available, rather than the short-term returns. Select schemes that have consistently beaten their benchmark indices (index to which a fund’s returns are compared) and compare reasonably with their peer set over the above time frames, says Ajit Menon, executive vice-president and head of sales, DSP BlackRock Investment Managers.

RISK-RETURN TRADE-OFF

Investments in most securities come with a degree of risk and if returns are not in proportion to the risks taken, it is not worth going for such investments.

A good mutual fund is one which gives better returns than others for the same kind of risk taken.

Risk-adjusted returns are evaluated against return given by a risk-free instrument- usually government-backed debt papers or term deposits of banks.

One of the indicators of risk-adjusted return is Sharpe Ratio, which is excess return given by the fund over return given by a risk-free instrument divided by a statistical term called Standard Deviation, which tells how volatile the returns of the fund have been over a period. The higher the Sharpe Ratio, the better the risk-adjusted return is (See Know the alpha, beta of your fund).

PORTFOLIO DIVERSIFICATION

By its very nature, mutual funds are supposed to provide diversification across different asset classes, stocks, sectors and even geographies. A diversified portfolio has lower risk than a portfolio biased towards a particular stock, an asset class or a sector.

Equity: Infrastructure

The ratio is the annual expenses incurred by the funds expressed in percentage of their average net asset. To make the choice between two similar funds, you should consider the expenses charged by them. Lower expenses benefit you in the longer term. Usually, schemes with higher assets have lower expense ratio than that of a smallsized fund.

Equity: Large- and Mid-cap

As the funds grow larger in size, the fixed expenses associated with the fund get spread out over more investors, reducing the expenses and leaving more funds for investment.

Expense ratio drops till the asset reaches a certain threshold after which the expenses bottom out and are typically stagnant. While the average expense ratio of funds with AUM less than Rs 1,000 crore is around 2.25%, the figure reduces and stagnates at an average of 1.9% for funds with assets greater than Rs 1,000 crore, says Swapnil Pawar, chief investment officer, Karvy Private Wealth.

There are other factors such as the fund manager, the asset size of the fund and its objective that decides the fate of a fund in the long term. All these factors have been taken into consideration in the MONEY TODAYValue Research ranking of mutual funds schemes for 2010-11 (See the Ranking Methodology). The ratings are a comprehensive report card on performance of mutual fund schemes across different categories measured on parameters such as risk-adjusted returns, consistency of performance and expenses.

Equity: Large Cap

Best Performing Funds

In 2010-11, equity markets traded within a narrow zone with both the Nifty and the Sensex ending the year with 10.94% gain while the broader index BSE 500 closing with a paltry gain of 8.55%. The markets during the year also saw a few nervous stretches of volatile sessions.

On the debt side, frequent interest rate changes by the Reserve Bank of India (RBI) kept debt fund manager on their toes. Bond prices fall with the hike in interest rates presenting opportunity for fund managers to take position in these securities. These are the kind of markets that test the real character of mutual funds and fund managers.

Equity: Mid- and Small-cap

The Money Today-Value Research annual rankings are based on past three year data for equity and hybrid funds (18-month data considered for debt categories). The rankings, therefore, judge the fund performances over periods of a secular bear market (April 2008-March 2009), a secular bull market (April 2009-March 2010) and a volatile market within a narrow range. In this year’s ranking, diversified equity funds have been further divided into subcategories — large-cap, large and mid-cap, multi-cap and mid & small-cap funds —depending on exposure to stocks of different market caps.

Such sub-categorisation gives a better picture of funds’ performance, the nature of their portfolio and their purpose in your portfolio.

Apart from these, there are infrastructure funds and tax-saving funds which also find separate mention in our rankings. Large-cap funds, as the name suggests, have more than 80% average three-year allocation to large-cap stocks. Considered to be an important part (core) of any portfolio, these funds lend stability to your investments. They are considered the least risky of all equity funds because of their exposure to stocks of large companies with strong financial and corporate background.

Equity: Multi-cap

The average three-year return of this category as on March 31, 2011 was 7.33%, against 7.2% of Nifty and Sensex. The toprated funds in this category (barring the index funds) comfortably outperformed their respective benchmarks during the three-year period.

Franklin India Bluechip Fund, DSP BlackRock Top 100 Equity and ICICI Prudential Top 100 Equity are three 5-star rated funds in this category with 14.20%, 13.41% and 12.35% annualised return respectively during the three-year period ending March 31, 2011.

In the large and mid-cap category (exposure to large caps at 60-80%), HDFC Top 200 emerges as the best fund with a 10-year track record during which it gave an annual return of 31.66%. In the three-year period also, it topped the category with 17.46% return. No surprises for guessing, therefore, that it’s a 5-star rated fund.

Equity: Tax Planning

All top 10 funds in this category gave double-digit returns in the three-year period ending March 31, 2011.

However, the biggest gainers are from the multi-cap and mid & small-cap categories. The simple reason for this is the higher allocation to mid and small-cap stocks, which sees a sharper rise (or fall) in rising (or falling) markets.

In the multi-cap category, HDFC Equity topped with 19.55% annualised return in the three-year period ending March 31, 2011, followed by UTI Dividend Yield (19%) and Quantum Long Term Equity (18.17%). In the mid and small-cap category, ICICI Prudential Discovery, Birla Sun Life Dividend Yield Plus, IDFC Small & Midcap Equity and ING Dividend Yield managed regular gains of over 20% annually in the three-year period.

Hybrid funds: Debt-oriented conservative

In the tax-saving category, Canara Robeco Equity Tax Saver, HDFC Taxsaver and Fidelity Tax Advantage Fund grabbed the 5-star ratings with over 15% annual return over the past three years. Seven taxsavings funds in the top 10 have been in existence for over 10 years and each of these seven funds have given over 20% annual return during the 10-year period ending March 312011.

This makes them one of the best tax-saving options available to you. Sadly, from April 2012, these funds would cease to exist thanks to the new Direct Taxes Code.

Among the hybrid funds, which have a combination of debt and equity instruments in their portfolio, Reliance MIP and HDFC Prudence emerged as the best funds in the debt-oriented and equity-oriented hybrid fund categories respectively. The hybrid fund category is gaining popularity and significance with most goal-based and asset allocation schemes such as child plans, monthly income plans and retirement plans belonging to this category.

Hybrid funds: Equity oriented

In the debt category, we have rated funds that are more relevant to retail customers than the institutional investors. Among debt funds we have rated funds in the short term, income and liquid fund categories.

In these categories small and medium fund houses such as BNP Paribas Mutual Fund, DWS Mutual Fund and Sahara Mutual Funds have performed better than many large fund houses.

If invested systematically, mutual funds could prove to be great tool for long-term wealth creation. In our story, Go for a Regular Exercise, we once again reiterate the virtues of long-term systematic investment in mutual funds. There are as many as 60 funds (check the mutual fund listings) out of 570-odd equity schemes that have given more than 20% annual return in the past 10 years. Most of these funds feature among the top 10 funds in their respective category.

Debt: Income

What amazes though is the sheer dominance of a few fund houses in the list of toprated schemes.Barring a few small and midsized players such as Quantum Mutual Fund, Taurus Mutual Fund Sahara Mutual Fund, ING Investment Management, Principal PNB Mutual Fund and Canara Robeco Mutual Fund, most of the 4 and 5-star rated funds are from larger fund houses such as HDFC Mutual Fund, DSP BlackRock Mutual Fund, Franklin Templeton Mutual Fund, ICICI Prudential Mutual Fund, Reliance Mutual Fund, Fidelity Mutual Fund and UTI Mutual Fund. In our story, Small Funds, Big Returns, we look at some of the schemes of small fund houses that have been keeping pace with the funds of larger AMCs in terms of overall performance. We will also discuss the pros and cons of investing in smaller fund houses.

A fund’s performance is a function of many factors and the biggest of them all is the abilities of the fund manager. Despite all processes and systems in place, a fund manager has the biggest influence on a fund’s performance. In our fund manager’s section View from the Driver’s Seat, we tried to nudge the ‘star’ fund managers to reveal a few tricks of their trade. We managed to convince some, but a few politely asked us to ‘excuse’ them.

Since fund managers play a crucial role in active fund management, their failure to deliver could prove costly for thousands of investors. For those who want to nullify this risk (also called fund manager’s risk), index funds (or exchange-traded funds) could be a good option.

Index funds are passively-managed funds, which build its portfolio with stocks of a particular index in exactly the same proportion in which the index has been formed. This limits the fund manager’s role to merely replicating the index. We have done a comparative study on index funds vis-à-vis actively managed funds in our story, Sidestepping the Fund Manager and tried to get the answer whether they yet have relevance in India where activelymanaged funds are consistently outperforming their respective benchmarks.

Our section Model Fund Portfolio completed one year on April 30, 2011. We will also revisit the performance of the MONEY TODAY-Value Research Lifestage Portfolios during the year. There are over 500 equity funds and finding the good ones among them could be a difficult task for even the most well-informed investor.

The MONEY TODAY-Value Research rating of mutual funds is an effort toward making this task easier for you.The mantra for successful wealth creation, though, continues to be systematic investment over the long term.

Ranking Methodology

There were 11 fund categories considered for this study primarily from the point of view of the interests of the retail investors.

Five of them are from the equity category: large cap, large and midcap, mid and small-cap, multi-cap, and tax-savings; two from hybrid: equity-oriented and monthly income; and three from the debt category: short-term, income and liquid funds. We considered past three years data for equity and hybrid funds, and past 18-month data for debt categories.

The methodology used to rank them was based on risk-adjusted returns.

Risk: To calculate risk, monthly/weekly returns were compared with monthly risk-free returns for equity and hybrid funds, and weekly risk-free returns for debt funds. For all practical purposes, State Bank of India’s 46-90 days term deposit rate, which is currently 5.5 per cent, was assumed as the risk-free return. For months/weeks that the fund had underperformed the risk-free return, the magnitude of underperformance was added. This was then divided by the category average to get a risk score, which was ranked with those of other similar funds and a relative risk score assigned.

Returns: The monthly/weekly returns of each fund (adjusted for dividend, bonus or rights) were compared with the monthly/weekly risk-free return to get the fund’s total returns in excess of the risk-free return.

The monthly average risk-adjusted return was then divided by the average category return for return score. In case of a negative category average, the risk-free return was used as the benchmark. The returns were then ranked with other funds of the same type and a relative return score assigned. All return estimations assumed reinvestment of dividend and were adjusted for bonus or rights. Finally, a composite risk-return score was obtained by subtracting the risk score from the returns score.

VALUE RESEARCH CLASSIFICATION

Value Research classifies diversified equity funds on the basis of their three-year average allocation to large, mid or small cap stocks. Diversified equity funds with average three-year allocation to large cap stocks more than or equal to 80% of portfolio are classified as large cap funds; 60-80% as large and mid-cap funds, 40-60% as multi-cap funds, and less than 40% as mid and small cap funds.

For equity tax-savings, all funds compliant with Section 80C of the Income Tax Act were considered.

In the hybrid category, funds with average equity allocation of 60% and above in the past three years have been classified as hybrid: equity-oriented funds and those with equity allocation up to 25% as Hybrid: Monthly Income. In debt category, funds with average maturity of 1-4.5 years in the last 6 months have been classified as short-term funds.