When to choose what mutual fund?

Published: September 2, 2017 at 11:36 am

In this post, I discuss a simple way to find out if a certain fund or a certain fund category is suitable for our need. We shall the use often-mentioned idea of standard deviation as a simple measure of volatility. Although not perfect, it is good enough to differentiate type based on daily market risk (there are other types of risk that cannot be quantified on a daily basis like credit risk).

Go to the Value research fund page of Quantum Liquid fund and click on the “performance” tab. If you scroll down that page, you will see this box:

The mean represents the average of the last 36 month returns of the fund =6.99%.

The Std Dev is the standard deviation of the above mean. That is, it is a measure of much each monthly return has deviated from the average.

It is incorrect to show the mean alone. The right representation is

mean +/- std deviation.

So for quantum liquid, it is 6.99 + 0.29.

For the liquid fund category, it is 7.42 +/- 0.34

Since the standard deviation is significantly lower than the average, each month return does not deviate much from the average. Meaning the volatility over the measure 3 year period is quite low. Therefore liquid funds can be safely used for a 3-year investment.

Of course, if your investment duration is 6 months or one year, you will have to repeat this exercise over that period. This data is not available online. So you can simply plot all possible  6 month or 1Y returns (your duration)  over the last 3Y or so to get a visual measure of volatility. See this post for an example: Are Debt Mutual Funds an Alternative to Fixed Deposits? and you can use this tool to calculate for yourself: Mutual Fund SIP and Lump Sum Rolling Returns Calculators

Now suppose we plot the category average 3Y monthly return and its standard deviation for all Value Research categories with the understanding that such categorization is arbitrary and dynamic, we would get the following graph.

The red balls represent the 3Y monthly average and the blue line the spread (+/- standard deviation) in returns.

Notice how the spread increase as we move from:

liquid funds —-> Ultra short term funds —> Gilt short term —> and so on.

This is the data:

I have added some arbitrary colours (like a signal) and risk grades over a 3 year period. you will have to look at individual funds before deciding.

Notice the data for Pharma and IT funds!!

As a thumb rule, a 3Y standard deviation in double digits or close to it, implies the fund or the fund category is only suitable for long-term (10+) or at least medium term (7+) durations. You can see this post for more details: What Return Can I Expect From Equity Over the Long term? Part 2

This is a simple way for the interested investor to figure out “when to choose what”.

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