How to Analyse an Equity Mutual Fund?

Equity Mutual Funds invest the investor’s money into stocks of companies that are listed on the stock market. Equity mutual funds are those which have equities of companies traded in the stock market as its main asset class. This can be further classified as –

1. Large cap funds (at least 80% investments are in large market capitalisation companies)
2. Mid cap funds (at least 65% investment in mid cap companies)
3. Small cap funds (at least 65% investment in small cap companies)
4. Multi cap funds (which invests a minimum of 65% in equity and equity related instruments)
5. ELSS (at least 80% of the total assets is invested in equity and equity related instruments for a lock-in period of 3 years)

Building an Equity Mutual Fund Portfolio

Building a mutual fund portfolio involves two simple steps namely, 

1. Identifying a financial goal and translating the same into clear terms in the form of time and corpus. You should be aware of the amount that you require and the time horizon in which you require the same.
2. Identifying mutual funds that help you achieve your financial goal.

This would involve – 

1. Analysing mutual funds available in the market and choosing which one to invest in.
2. Figuring out the investment goal for which this mutual fund is being used for.
3. Deciding that the portfolio must ideally contain and deciding what are the asset classes and investment style must be adopted to manage the fund.
4. Figuring out the portfolio composition. For example, is the portfolio, just equity or just debt or a combination of both.
5. Figuring out how much is to be invested across each of the funds.
6. One must also decide the mode of investing must be resorted to – SIP or lump sum payments.
7. One must verify if the KYC procedures have been completed.
8. One must also check if one’s bank offers a net banking facility and if it does, then has it been activated for your account.
9. Periodic review and maintenance of the portfolio.

Please note: One need not have a demat account in order to invest in a mutual fund. The account can be opened directly with the fund house or through an easy-to-use, app-based investment platform like Fisdom where you can invest in any mutual fund at zero cost and zero commission.

What goes into picking a portfolio for the Mutual Fund?

An insight into the psyche of the fund manager and his investment choices might be beneficial to the investor – it will enhance not just his or her understanding about how his or her funds are being rerouted and redistributed, but also increase the faith in such a form of investment.

It is important to know that the fund manager uses multiple strategies like the top-down approach and the bottom-up approach to analyse the stocks for the fund ‘s portfolio with the aim of maximising returns of the fund in question.

As the fund’s performance is market linked, the risk associated with it is high. Therefore, the fund manager takes certain measures to hedge against these market and investment risks. For example, allocating a very small percentage of the portfolio toward debt or cash assets.

How to analyse an Equity Fund?

1. Run a few basic hygiene checks

This would involve finding out the orientation of the fund, the benchmark it operates against, the inception date of the fund, the details of the fund manager, investment objectives, sector weights etc.

2. Look at the stock selection/asset allocation of the mutual fund
   Nit-picking on the equity fund’s portfolio is not research. However, one can choose to do an attribution analysis where one can determine if a fund’s performance is driven by asset allocation or the performance is driven by stock selection.
   
3. Find out if the fund is a flagship product of the fund house
   This can be done by looking into the percentage of the assets under management (AUM) that the fund constitutes for that specific Asset Management Company (AMC). If it were to be a flagship product, then it can be reasonably inferred that the fund house would not mess with its flagship fund.

4. Find tax efficient funds
   Lower taxes translate into higher returns, which makes it important for you to select tax-efficient funds.

5. If the fund flow is steady and the AUM increase is gradual, then it is a sound investment
   The large AUM problem that investors are often warned against will not pose a problem if the AUM increase is gradual, as the fund manager has enough of an opportunity to manage the surge.

6. Gauge the expense ratio of the fund
   Direct plans have lower expense ratios than regular plans and that would amount to nearly half of the latter. The investor must consider if the expense ratio is worth the investment as it can prove to be quite costly, especially in the long run.

7. Important mutual fund metrics must be looked into
   This would include a careful perusal of the following metrics – 

• Standard deviation
• Sharpe ratio
• Alpha ratio
• Beta ratio
• R Squared
• Portfolio turnover ratio

The alpha and beta ratio must be looked up for 3 year, 5 year and 10 year period.

8. Study the past returns
   This study must not be done for a short period of time but for a period over 3 years. One must look at the rolling returns, the average returns and the spread between the maximum and minimum returns. On seeing this, an important question to ask is, are the returns at the cost of higher risks?

9. Carry out the Risk-return analysis
   One must look into the risk-reward matrix to get a better picture. Few online websites will do it for you and it can be easily accessed. The risk-reward ratio can even be compared to the benchmark.

10. Analyse the Capture ratios
    One must look at both the upside and downside capture ratios to understand the risk management strategy and capabilities of the fund house. Again, it can be done on a 5 year or a 10 year basis.

11. Analyse a manager’s tenure
    One must also analyse the manager’s tenure before making the investment – a new manager’s stellar record might be misleading.

Frequently Asked Questions

1. Who Should Invest in Equity Mutual Funds?
   The following investors must consider investing into equity mutual funds – 

• Investors looking for long term investments, for an investment horizon beyond 5 years, equity investments are advised.
• One can choose the kind of equity fund that best suits his or her investment goal after a little deliberation. For instance, an investor looking into tax saving, can opt in for an ELSS.

2. What are the advantages of investing in an equity fund?
   The following advantages are derived by the investor when he or she invests into an equity fund –

• Professional management
• Portfolio diversification
• High liquidity
• Convenience in terms of mode of investment.

3. What are the main factors that affect a mutual fund’s performance?
   The following factors greatly influence the mutual fund’s performance – 

• Fund’s history
• Fund Manager
• Assets under Management
• Performance relative to the benchmark
• Portfolio allocation
• Objective of the fund 
• Lock-in period etc.

Unless you are an active investor who closely follows the market trends the world of mutual funds might seem like a rather consuming, alien-like world to you. Reach out to us and our team will assist you in any way possible!