Want to select mutual funds with quantitative factors? Here are four key ratios

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With 1,513 of schemes out there in the mutual fund (MF) industry and more getting added every other day, there are too many options for investors to choose from. Investment advisors and distributors are there to help those who need a guiding hand. But if you invest directly in MFs, apart from the past performance, here are four ratios that can help you separate the wheat from the chaff.

Standard deviation

Standard deviation measures how volatile the fund has been. Simply put, standard deviation measures the dispersion of fund’s returns from its average return.

Look for schemes with low standard deviation if you’re conservative. But if the fund manager is too conservative, it could also result in over-diversification or underperformance.

Check how standard deviation varies over different periods of time, to get a better sense of how volatile the fund can be during different phases of stock markets.

The main drawback of standard deviation is that it does not distinguish good and bad volatility as it blindly takes into account both negative and positive returns from the average return.

Sharpe ratio

The Sharpe ratio of a scheme helps you understand how a fund has performed in relation to the risk taken by it. This ratio looks at the additional returns a fund has generated over risk-free return from an investment like a short-dated Government Treasury Bill, for the volatility of the fund. In other words, if your fund has a higher Sharpe ratio, it means it has delivered better risk-adjusted returns.

Mid and small-cap funds have high Sharpe ratios, especially during bull markets. Ravi Kumar TV, co-founder of Gaining Ground Investment Services, says this is because there is more scope for stocks to get re-rated (i.e., get higher valuations) in mid- and small-caps. “As and when valuations of mid and small-cap stocks run-up, the Sharpe ratio rises,” he says.

But, Sharpe ratio should not be the sole criteria for investing in a fund, as a higher Sharpe ratio might also mean that the fund takes higher risks. Data from ACE MF shows that the top-five funds in terms of sharpe ratios as per the latest data are Union Mid Cap Fund (1.12), BOI AXA Flexicap Fund (1.12), UTI Small Cap Fund (1.05), Baroda Large and Midcap Fund (0.92) and IDFC Emerging Business Fund (0.72).

Beta

If you just wish to know how much more risky your fund is versus its own benchmark index, then look at the Beta ratio. If the scheme’s beta is more than 1, it means that it is more volatile than the index. If it is just 1, it means your fund is just as risky as the benchmark index. All passively-managed funds like index funds and exchange-traded funds have a beta of 1.

If the fund’s portfolio largely overlaps that of the index, here too the Beta is closer to one. That is not good news though, because your scheme would just be delivering index returns, despite charging a fees for active fund management.

If the beta is less than one, it means the fund is less volatile than its benchmark index.

Portfolio turnover

Your fund manager buys and sell securities regularly, if the scheme is actively managed. But does she buy and sell too much or selectively? How frequently your fund manager churns the portfolio is measured by a calculation called the portfolio turnover ratio. Typically, it is measured over the past one-year time period.

A low turnover ratio means that the fund manager typically follows a ‘buy and hold’ strategy. But a high turnover ratio isn’t necessarily bad; it could be because of the preference for taking profits regularly off investments.

Within diversified mutual funds, HDFC Large and Midcap has the lowest turnover ratio (5.78 percent), as per the latest data. This is followed by HDFC Small Cap (6 percent), Kotak Emerging Equity (6.09 percent), Kotak Flexicap (7.44 percent) and UTI Small Cap (7.68 percent). This excludes funds that were recently launched.

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