How to compare mutual funds?

Mutual funds is one of the very important avenues of investments for any individual who wants to create wealth over time. I say this as this is the one route that provides you lot of flexibility in terms of your goal horizons, your risk taking capacity, potential returns and ease of purchase and redemptions.

How most people compare mutual funds?

I have many a times seen that my friends and colleagues start picking up funds based on their star ratings (more on this in, are you buying top rated funds?)

Or, they simply see the high historical returns of the mutual funds and pick them. This is possibly because they have been investing in FD's and have been comparing interest rates since long. Why this is wrong? And the answer is for following reasons

• While, for FDs it's ok to compare the interest rates, the rate of returns for mutual funds are not interest rates - they are instead historical rate of returns. Note, interest rates are for future and rates of returns are for past. 
• Another important aspect that we ignore here is the associated risk - while FDs are fairly riskless, each mutual fund is different from other in terms of the associated risk and this is true even when they belong to same category (say both midcap funds)

How to actually compare mutual funds?

Hence, what we need to understand is the five key parameters that help us measure the risk of a fund's portfolio and allows us to compare this with another.

Higher the better 

• Alpha - alpha measures the funds performance with the index on risk adjusted basis. A positive value simply means given the same risk the fund would perform better than the index fund. So higher the alpha the better 
• Sharpe Ratio - this is calculated by subtracting the risk-free rate of return (for layman terms, understand as avg FD return) from the rate of return for a fund and dividing the result by the fund's standard deviation of its return. Hence, higher the value the better

Lower the better

• Beta - this is measure of volatility and indicates the tendency of the mutual funds return to respond to swings in the market. The lesser the value the more stable the fund's portfolio 
• Standard Deviation - this is spread of the returns of the mutual fund from its mean return. Now this helps you in understanding how far away the mutual fund's return deviates from its mean value. Hence, Lower the standard deviation the better
• R-Squared - this basically measures how closely the fund tracks the index. The closer it is, lesser the chances to perform better than index. The lower it is means better the fund managed, more the value added by fund manager. You can simply assume, the lower the better

Just memorize this image and you are done, now it would be easy to compare two funds.