How to select an equity fund?

An equity fund is a mutual fund scheme that invests predominantly in equity stocks.

To select an equity fund, one should start with comparing the fund’s performance against its benchmark and its category average return.

Compare these returns over one-year, three-year, five-year and 10-year horizons. Give higher weight to longer-term performance in your assessment. Also, do a calendar year wise comparison of the fund’s performance against that of its benchmark over the past 5 to 7 years.

Now look at the fund’s performance during the years when its benchmark gave negative returns. Did the fund fall less or more than its benchmark? Ideally, you want a fund that not only offers good returns in rising markets, but is also able to contain the downside risk (by declining less than its benchmark).

Next, check the number of stocks that the fund holds. One that holds only 15-25 stocks would be a concentrated fund. A fund that holds a higher number of stocks would be a more diversified offering.

The next step is to check out the fund’s concentration in the top five sectors, that is, the percentage of the portfolio that the top five sectors account for.

By comparing this figure with that of its peers, you will be able to assess whether its fund manager runs a concentrated or diversified strategy. You may also carry out a similar assessment for the level of concentration in the top five stocks.

Concentrated funds are capable of delivering high returns, but are also likely to be more volatile. Investors with lower risk appetite should prefer more diversified offerings.

Next, check the turnover ratio of the fund. A low turnover ratio compared to peers means that the fund manager has a tendency to buy and hold stocks. On the other hand, a high turnover ratio indicates he churns his portfolio more. This could either mean he follows a momentum-oriented strategy, which is fine if it works, or that he does not know what he is doing and hence chases stocks that are rising.

Also, compare the expense ratio of the fund with the median for the category. A high expense ratio will make it more difficult for its fund manager to beat the benchmark.

Finally, compare the fund on a measure of risk-adjusted return, such as Sharpe ratio, over a five-year period. Compare this number with that of its peers. You want to go with a fund manager that is able to generate higher return while taking lower risk.

Once you have assessed a fund on these parameters, you will be able to pick a fund that has performed across market cycles. There is no guarantee that a fund that has performed in the past will continue to do so in the future. Nonetheless, you will avoid the mistake of selecting recent winners.

Finally, once you have picked a fund after such a detailed assessment, stick to it across market cycles that’s seven years at least or more.